Letter: What a Tax Reform Plan Should Include

By Jason Bailey
January 3, 2012

Governor Beshear has said that he will announce plans for addressing tax reform in the coming weeks. Here’s what should be in a tax plan that would move Kentucky forward.

January 3, 2012

Honorable Steven L. Beshear
Governor
State Capitol
Frankfort, KY 40601

Dear Governor Beshear:

Thank you for calling on Kentucky’s leaders to join together in restructuring the state’s tax system in your second term. Forward progress in education, health and countless other areas requires that Kentucky have the revenue needed to make critical investments. To raise that revenue, we must fix our tax system.

The specific attributes of a tax reform plan are critical to its success. Some plans would truly move Kentucky forward; some would make little difference; and some could actually do harm to our state by making our tax system less robust and less fair.

Positive tax reform must: generate the revenue for stronger investments in schools and other essential institutions; increase tax fairness by bringing more balance to our tax structure; and sustain revenue over time by aligning the system to growth in our economy. To meet those principles reform should be “revenue-positive” (raising more funds from day one), alleviate rather than increase poverty and inequality, and broaden the tax base by reducing exemptions and loopholes.

More specifically, the ingredients of a positive tax reform package in Kentucky include the following:

1. Preserve the role of the income tax in Kentucky’s tax system and make it more progressive.

To some, tax reform has become synonymous with reducing or eliminating our individual income tax. But decreasing reliance on the income tax violates all of the core principles of good tax reform. It makes our tax system less fair and less able to generate a sustainable stream of revenues.

According to a distributional analysis of Rep. Bill Farmer’s 2011 bill included in a report we released, eliminating our individual income tax and shifting to sales taxes results in higher taxes for the poorest 60 percent of Kentuckians and an average tax cut of over $27,000 for the highest-earning one percent of Kentuckians, who make more than $323,000 a year. Shifting the balance from the income tax to the sales tax simply transfers tax responsibility away from the wealthy and over to low- and middle-income Kentuckians.

At the same time, there is no evidence supporting the claim that income tax cuts lead to economic growth. People simply do not migrate to places with lower income tax rates in any significant numbers. State-to-state migration in general is actually very uncommon, and the migration that does occur is driven primarily by quality of life and amenities, job opportunities, housing costs, proximity to family, and climate. States like North Carolina, which not only has an income tax but has one with a higher marginal rate than Kentucky’s, have shown that economic growth is perfectly compatible with a progressive income tax. North Carolina has prospered because it has made investments in education, in building an innovative economy and in improving the overall quality of life.

Any changes made to the individual income tax as part of tax reform should preserve its role in our overall revenue system and be designed to make the tax better reflect various Kentuckians’ ability to pay. Kentucky, like the nation as a whole, has seen growing income inequality. Between the late 1980s and the mid-2000s, on average the incomes of the richest 20 percent of Kentuckians grew 41 percent while the poorest 20 percent of Kentuckians had no statistically significant income growth.

Positive potential changes to the income tax include the following:

  • Putting in place a refundable earned-income tax credit, as 25 other states have, which would provide much-needed support to low-income working families and a boost to our economy.
  • Restructuring the income tax rates to introduce an additional higher marginal tax bracket on high earners.
  • Using adjusted gross income rather than net income as the starting point for the individual income tax, as 10 other states including West Virginia and Indiana already do. That would remove the deductions that disproportionately benefit higher income people and lessen the extent to which our income tax policy must continuously respond to decisions made by Congress.
  • Reducing the overly-generous private pension exclusion, a growing drain on revenues that will only become larger as the population ages. One option is to phase it out for higher-income retirees.

These changes would result both in more revenue and more elasticity (responsiveness to economic growth) in the income tax.

The income tax is the cornerstone of a diverse and fair tax system and is absolutely essential to generating the revenue we need. The 2002 Fox report to the Kentucky legislature calculated that Kentucky’s income tax had grown faster than any other major form of taxation. The Institute on Taxation and Economic Policy notes that virtually any income tax “will outperform the sales tax in keeping pace with the cost of funding public investments.” Good tax reform will preserve, protect and improve the income tax as a tool for fairly generating needed funds.

2. Modernize the sales tax to include services and remove selected exemptions.

It is well known that Kentucky’s sales tax is outdated and needs to include more services. Kentucky taxes only 28 of 168 services taxed by at least one state. The Office of the State Budget Director estimates that we lose $1.8 billion in revenue from not taxing services, and the Center on Budget and Policy Priorities projects Kentucky could collect $1.1 billion from taxing a feasible set of services. The broader the range of services that are included, the more elastic the tax becomes and the less the state discriminates in favor of certain types of purchases.

If the revenues that would be raised from a very broad expansion of the sales tax base are more than can be reasonably collected, it is preferable to lower the sales tax rate than to cut income tax rates. Sales taxes are regressive, meaning they make up a larger share of the incomes of low-income people, while income taxes are progressive, meaning they are based more on ability to pay. Using the excess revenues to reduce the sales tax rate rather than the income tax rate thus creates more balance in our tax system.

An alternative to broad expansion of the sales tax is to target the expansion to services more likely to be used by wealthier individuals, as in Rep. Jim Wayne’s proposal. Targeted expansion would be a good first step towards bringing the sales tax into better alignment with the modern economy while doing as little as possible to negatively impact the distribution of tax responsibility.

Also, there are sales tax exemptions that should be examined and closed. In 2005, the legislature passed a resolution to study Kentucky’s sales tax exemptions, but the study was never produced. While business purchases of inputs into a final product should generally continue to be exempted from the sales tax to avoid tax pyramiding, and we should still exempt food and medicine, there are other exemptions that could be closed. For example, Kentucky still exempts the purchase of pollution control equipment from the sales tax even though such purchases are required for compliance with environmental laws.

3. Preserve Kentucky’s corporate income tax and limited liability entity tax and close loopholes.

Some claim that elimination or reduction of Kentucky’s corporate income tax and limited liability entity tax would make the state more attractive for business. However, again, no evidence supports that claim, as we outlined in a report last summer. Almost every state has some form of business tax, and those taxes (including Kentucky’s) are a very small part of the cost of doing business. Nationwide data suggest that state corporate income taxes are on average under 0.25% of the cost of doing business. Since corporate income taxes are a relatively minor cost, eliminating or reducing them is very unlikely to draw companies to Kentucky. And since cutting them reduces revenue for public investments in the fundamentals needed for job creation, the result can be harm to our economic development efforts.

At a small cost to businesses, corporate income taxes are an important part of a diverse state tax system. Since the economic recovery began, they have been a much-needed revenue source as other state taxes have stagnated due to weak consumer demand, stagnant wages and continued high unemployment. Because corporate profits have been high, corporate income tax revenues in Kentucky have been elevated. A diverse tax system includes many different types of taxes, and the corporate income tax is an important part of that mix.

Rather than eliminating the tax, we should shore it up to remove loopholes and make sure it is applied fairly. Recently, we co-released a report showing that many Fortune 500 companies are paying little-to-no state corporate income taxes across the country. There are clear reforms that can remove loopholes and address tax avoidance, including the following:

  • Adopting combined reporting, which requires that parent companies and subsidiaries be treated as single units for tax purposes.
  • Enacting a throwback rule to ensure that all corporate profits are taxed in at least one state.
  • Fully decoupling from the domestic production deduction, a federal tax break that provides no special incentive for business to locate in Kentucky.
  • Putting in place a sunset and review process for economic development tax incentive programs to more closely scrutinize their cost-effectiveness.

Tax reform must also avoid creating new holes in the corporate tax system, such as by enacting single sales factor for corporate income apportionment, eliminating other business taxes, or creating new or expanded business recruitment incentives. We can make Kentucky a good place to do business first and foremost by investing in the foundation of a strong economy—education and other essentials—and by doing more to support small business development and sector-specific workforce training, all of which require adequate public funds.

There are other tax reform options besides changes to income, sales and business taxes that are important to consider. House Bill 44, Kentucky’s property tax limitation, limits the role of the property tax in our overall tax system and has driven down the state property tax rate from 31.5 cents per $100 in 1979 to 12.2 cents per $100 today. Because it applies at the local level as well (in a different way), House Bill 44 also limits school and local government revenue. Kentucky should at least freeze the state property tax rate to keep it from continuing to decline. At the same time, the state could adopt a circuit-breaker that provides a rebate if property taxes exceed a share of household income, as in 18 other states. A circuit-breaker is a more targeted strategy to address the issue of property tax affordability during times of rising property values than an arbitrary limit like House Bill 44.

We need to look more closely at the coal severance tax. The state’s coal severance rate is one percentage point lower than West Virginia’s, for example, and Kentucky could raise much-needed revenue by matching West Virginia’s rate. We should also decouple from federal estate tax changes that by default eliminated Kentucky’s estate tax. 15 states have made this change, and a number of other states have similar inheritance taxes that were never linked to the federal estate tax. The estate tax applies only to very large estates.

Thank you for your consideration of these ideas. I look forward to the opportunity for further public dialogue on this important issue.

Sincerely,

 

Jason Bailey

Director

Kentucky Center for Economic Policy