Now that Kentucky has ended its 2014 budget year, the governor’s office will announce how big the state’s year-end revenue shortfall is sometime in the next two weeks. It’s expected to be “significantly larger” than the $27.7 million shortfall officials projected this spring.
Eleven months into the budget year, the main revenue source to fall short of expectations is the individual income tax. From July 2013 through May 2014, it grew only 0.5 percent, much less than the projected growth rate of 2.4 percent. That makes a big difference to total revenue collections, since the individual income tax is the largest source of state General Fund revenue, responsible for about 40 percent of what Kentucky collects.
Other taxes are also factors in the pending shortfall. Property taxes are falling short of expectations. Coal severance taxes, cigarette taxes and lottery revenues are slightly below where they were expected to be. Corporate income taxes are significantly above what was projected, but limited liability entity taxes (another corporate income tax) are far below expectations, making corporate taxes as a whole reasonably close to the estimate. Sales taxes are doing somewhat better than projected.
But the individual income tax is where the main challenge seems to lie. We’ll know more about what happened once the state releases final numbers and more detail is shared with the General Assembly over the next month or so.
We already know, however, that weaker-than-expected individual income tax revenues are showing up in many states this year, according to a recent report by the Nelson A. Rockefeller Institute of Government at the State University of New York. The authors say that last year’s income tax revenues were artificially inflated because of a timing issue having to do with federal tax law changes. That issue created a one-time bump in revenues for 2013 that were shifted from 2014.
The specific timing issue goes back to December 2012, when Congress was facing the “fiscal cliff”—the name given to the showdown over the expiration of the Bush tax cuts and other measures. Among the tax cuts that were set to expire was a lower rate on capital gains—investment income received from the sale of assets like stocks and real estate. The uncertainty around what would happen with the negotiations provided an incentive for individuals to realize the income from the sale of capital gains in tax year 2012—which corresponds to states’ 2013 fiscal year—when the rate was still lower.
Many wealthy individuals around the country appear to have taken such action. Since they claimed more capital gains income in 2013, states’ income tax revenue for that year was artificially increased—but at the expense of income tax revenue in 2014.
Did such shifting happen in Kentucky? We’ll know more when officials report on year-end results. But state income tax revenue in Kentucky grew by an impressive six percent in 2013. And the Rockefeller Institute report says that Kentucky was one of four states with more than a 30 percent drop in estimated income tax payments (which high-income people pay on investment income) for January through April of 2014 compared to the prior year.
Granted, the report also notes that Kentucky has less income from capital gains than most states; capital gains make up 2.58 percent of state adjusted gross income compared to 4.09 percent for the U. S. as a whole. Kentucky ranks 30th among states in the report’s measure of how dependent states’ income taxes are on capital gains.
A shortfall in income tax revenues for 2014 has implications down the road. As mentioned, the state’s revenue forecast assumed 2.4 percent individual income tax growth in 2014, while growth so far equals only 0.5 percent. Going forward, the state’s two-year budget is built on the forecast’s assumption of even faster income tax growth in 2015 and 2016—4.3 percent and 4 percent respectively. Growth will have to be even stronger than that to make up for this year’s income tax shortfall, or the gap will have to be made up in better-than-expected growth in other tax revenues.
There’s certainly more to learn about the causes of the shortfall and possible solutions, but there are reasons to be concerned about Kentucky’s ability to generate the revenues needed to balance the budget.