KY Policy Blog

New Tax Expenditure Report Obscures Growing Costs

By Pam Thomas
December 21, 2017

The Office of State Budget Director (OSBD) released the Tax Expenditure Report for the 2018-2020 biennium late last month. The new report is misleading because it does not include in the grand total of all expenditures located in the executive summary a number of tax expenditures detailed in the body of the report, making total costs appear smaller than they actually are.

The purpose of the Tax Expenditure Report, which is required by language in the executive branch budget, is to identify revenues lost for the current and next two fiscal years from exemptions, exclusions or deductions from the base of a tax, or preferential tax rates. Policymakers use the Tax Expenditure Report to help identify tax preferences, and to know how much they cost, and as such, the policy decisions that are made about what items are included in the report and what items are excluded is important.

In the 2018-2020 version of the report, the OSBD significantly departs from past practice in a couple of important ways. For the first time, OSBD has separated out exemptions, exclusions, and deductions from the individual income tax that exist because of Kentucky’s general conformance with the Internal Revenue Code (IRC). In justifying this change, OSBD states: “Because of the coordination with Federal tax rules, the Office of State Budget Director believes that it would not be practical or advisable to consider the elimination of many of the Federal expenditures.” The OSBD takes this position even though many states, Kentucky included, often decouple from the provisions of the IRC when Congress enacts provisions that are costly or otherwise undesirable for states to adopt. In fact, the instructions for Kentucky’s individual income tax return for 2016 list 28 differences between federal and state income tax laws. The OSBD identified some $3 billion in tax expenditures that it states have been excluded from the total amount of tax expenditures provided in the executive summary, however it appears that the total does, in fact, include the individual income tax expenditures identified as federal.

To complicate matters further, the OSBD’s classification and separation of expenditures as federal or state is not consistent. The OSBD has classified two income exclusions from the individual income tax that are strictly state-based, with no relationship to the IRC, as federal exclusions from income. Those are the state-only exclusion of military pay, at $10.7 million in 2018, and the state-only exclusion for private pension and individual retirement account income at $339.6 million in 2018. The report also lists the state postsecondary education tuition credit, valued at $28.7 million in 2018, as being a federal credit when it is a state credit. Likewise, there are some expenditures that clearly stem from our state’s conformance with the IRC listed as state expenditures. The report also completely fails to list the expenditure related to state and  local public pension income received, and it is unclear whether this large exclusion is completely missing, or is included as part of one of the other listed pension exclusions. These all appear to be errors, and they are important errors to note when using the report.

Finally, the OSBD has changed the way it identifies services not subject to the sales tax in the 2018-2020 report, although it retains its oft-stated opinion that services should generally not be included as a tax expenditure because they are categorically not a part of the intended base of the tax. The 2016-2018 report listed broad categories of services with no detailed identifying information to allow users to determine what specific services were included within the broad categories. The 2018-2020 report describes excluded services in much more detail using North American Industrial Classification System (NAICS) codes to identify specifically listed services. The 2018-2020 report identifies $4.38 billion in lost revenues from not taxing listed services, compared to $2.78 billion identified for 2018 in the 2016-18 report – so the new, more refined list identifies the loss of an additional $1.6 billion in potential revenues in 2018 because we do not broadly tax services.

Contrary to the opinion of the OSBD, many services should be subject to sales tax, based on the purpose of the tax, which is to generate revenues from consumer spending. At the time our sales tax was enacted, consumers primarily bought tangible goods, so it makes sense that those purchases were the primary focus of the tax. Since that time, consumer spending on services has increased dramatically with approximately two thirds of all consumer spending today being for services. The failure of our sales tax to capture this growing category of expenditures means that the revenues from the tax simply cannot keep up with economic growth, leaving us short of the revenues we need to make crucial budgetary investments.

If we include the newer, higher number for excluded services, the total tax expenditure number for 2018 grows to $13.75 billion compared to $13.14 billion for the same year in the prior tax expenditure report. Kentucky continues to give away more money in tax breaks than we collect in tax revenue and our budget problems are the result.

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