Structural Deficits & Strategic Response: Tax Reform in Kentucky

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State Tax Reform
Options, Challenges & Creativity

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The February/March 2013 edition of ABFM’s newsletter, Line Item, features several articles on the pertinent topic of State Tax Reform. Click here to check out the rest of this special issue, and click here for information on a special webinar featuring contributors to this issue, hosted by AABPA on Wednesday, March 13th (1PM Eastern).

By Dr. William Hoyt (University of Kentucky), Dr. William Fox (University of Tennessee at Knoxville) and Michael Childress (University of Kentucky)

Kentucky Governor Steven Beshear created the Blue Ribbon Commission on Tax Reform in February, 2012, and charged it with developing recommendations to improve the fairness, competitiveness, simplicity, elasticity, and adequacy of the state’s tax system. With these five goals in mind, we—the economic consultants to the Commission—examined Kentucky’s tax system and offered numerous options to meet the long-term needs of the state. Our analysis yielded two basic conclusions: a broader tax base is needed so that revenue can keep pace with future economic growth and changes are needed to improve Kentucky’s economic competitiveness.

KentuckyFigure1Kentucky faces a structural deficit that could reach $1 billion by 2020 (see Figure 1). Fundamental tax reform that improves the elasticity in the system—ensuring that tax revenues grow adequately with the economy—will go a long way toward solving Kentucky’s structural deficit. Addressing this structural deficit promises to become more difficult in the future since the underlying economic, demographic, and political trends that reduce elasticity continue and show no sign of abating. Moreover, a number of financial factors are likely to intensify state-level budgetary pressures in the future, such as Kentucky’s $30 billion underfunded pension obligation and long-term fiscal problems at the federal level.

Revenue growth in Kentucky has slowed in the last several years. For eight of the eleven years from 2000 to 2011, tax revenue either failed to keep pace with the economy or declined more than the economy. If the revenue trend demonstrated from 2000 to 2008 continues to 2020, then state expenditures would fall below 6.5 percent of the economy—a level not seen since 1968. Meanwhile, if expenditures such as education, health care, and infrastructure continue to grow at about the same rate as the economy, then by 2020 tax revenue would be more than $1 billion short of expected demand for public services.

KentuckyFigure2Kentucky’s total tax collections as a percentage of personal income declined steadily from its peak of 8.52% in 1995 to 6.94% in 2011 (see Figure 2). The state’s recurring budgetary problems are due, in part, to the long-term decline in revenue elasticity. Kentucky’s main revenue sources are growing slower than its economy (Table 1). While the average elasticity in the earlier periods has been about 1.0, it has slowed to 0.81 from 2000 to 2008; and it is the same for neighboring states—declining from about 1.0 to 0.86.

KYTable1We simulate Kentucky revenue to 2020 using two different assumptions. In the first scenario we assume that tax revenues will grow at the same rate as the economy—which was the case, more or less, from 1970 to 2000. Then, in the second scenario we assume that revenue will grow at the same elasticity that occurred from 2000 to 2008. The second scenario is more likely since the factors that have been reducing revenue elasticity are still in place and are expected to remain for the foreseeable future. In both scenarios we assume that Kentucky’s economy will grow at the compound annual rate of 4.2 percent, which is the rate experienced from 2000 to 2008.

KentuckyFigure3While total tax revenue grows in both scenarios, it is markedly lower in the second scenario (see Table 2). By definition, tax revenue remains at about 6.9 percent of the economy in the first scenario but declines below 6.5 percent in the second scenario (Figure 3). Addressing this structural deficit by improving revenue elasticity is necessary for the long-term finance of Kentucky state government services and investments—regardless of the size of government.

KYTable2There are a number of factors contributing to the gradual reduction in elasticity, including the gradual shift in personal income away from taxable sources (e.g., wages, salaries, and proprietors’ income) and toward mostly nontaxable sources (e.g., some transfer payments and nontaxable employee benefits, like pensions, retirement income, and health insurance); the transition from consumption of taxed tangible goods to consumption of largely untaxed services; the rise of remote retail sales (e.g., Internet and catalog purchases) where it is difficult to capture the sales tax; an aging population whose spending patterns generate less revenue compared to younger cohorts; and the prevalence of tax exemptions.

The long-term decline in revenue elasticity will likely continue in the absence of tax reform. Many of the options we proposed are intended to increase the elasticity of the system. These include broadening the sales tax base to include more personal and household services thereby more accurately reflecting current and what we expect to be future consumption patterns. A more elastic income tax base requires inclusion of more income in the base, particularly income which we might well expect to increase in the future. Given the increased aging of Kentucky (and other states) population, we offered, as an option increasing the taxation of pension income. More generally, we proposed efforts at broadening tax bases while keeping rates relatively stable.

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Dr. William Hoyt is Chair of the Department of Economics, Gatton College of Business and Economics, and Professor, Martin School of Public Policy and Administration, University of Kentucky.

Dr. William Fox is Professor, Department of Economics, and Director, Center for Business and Economic Research, University of Tennessee at Knoxville.

Michael T. Childress is a research associate at the Center for Business and Economic Research, Gatton College of Business and Economics and in the College of Communication and Information, both at the University of Kentucky.