Kentucky Income Tax Reform 2022: Details and Analysis
After weeks of closed-door deliberations between legislative leaders in the Kentucky House and Senate, lawmakers on March 29 unveiled and swiftly passed a committee substitute for House Bill 8, which was passed by the two chambers with a supermajority without a veto on the same day. The amended legislation uses tax triggers to reduce Kentucky’s personal income tax rate, with the ability to phase out the tax over many years using future income growth. The bill also broadens the sales tax base and imposes new taxes and charges on electric and hybrid vehicles.
Some of the tax changes in the bill are structurally sounder than others, but overall these changes move the Kentucky tax code in the right direction. In particular, the reduction in the personal income tax rate will promote economic competitiveness and growth, paving the way for further growth-enhancing reforms in the near future.
The bill specifies that a reduction of 0.5 point in personal income tax will be triggered under two conditions. The first condition is that the balance of the Fiscal Reserve Trust Fund (BRTF), Kentucky’s Rainy Day Fund, be at least 10% of certain General Fund (GF) revenue at the end of a fiscal year. . The second condition is that GF revenues at the end of a fiscal year exceed FG appropriations by at least the amount that would be required to reduce the personal income tax rate by one percentage point. complete. If these conditions are met for fiscal year 2021, Kentucky’s flat personal income tax rate of 5% will automatically be reduced to 4.5% beginning January 1, 2023. If these conditions are met again in in fiscal year 2022, this would be certified as sufficient to bring the personal income tax rate to 4% in 2024, although this further reduction would be subject to reaffirmation by the General Assembly.
Within these parameters, personal tax rate reductions in 2023 and 2024 are very likely. Kentucky ended fiscal 2021 with a $1.1 billion surplus that brought the BRTF balance to nearly $1.9 billion, or more than 16% of GF spending. Additionally, the most recent revenue forecast for the Kentucky FY2022 project will end the current fiscal year with $1.9 billion more revenue than projected when the FY2022 budget was passed. In late March, lawmakers passed a two-year budget for fiscal years 2023 and 2024 that leaves about $1 billion unspent to achieve those tax cuts.
While the text of the bill is worded such that a reduction in 2023, if triggered, would occur automatically, any reductions triggered in future years would require “future action by the General Assembly” before take effect. Although contingency clauses requiring future legislative action are not usually found in tax trigger statutes – because the purpose of triggers is to automatically induce tax changes if or when certain conditions are met – this wording offers another safeguard to ensure that triggered tax cuts only occur when the legislature agrees that they are fiscally prudent.
A flat personal income tax rate of 4% would make Kentucky’s income tax much more competitive, especially since Kentucky is surrounded by several low-income or no-tax states. Currently, of all the states with personal income tax, only neighboring Ohio and Indiana, in addition to Pennsylvania and North Dakota, have a rate below 4%.
On the sales tax front, the bill expands the sales tax to additional services to offset a small fraction of the planned income tax cuts. Newly taxed consumer services under the bill include personal fitness, massage, athletic classes, cosmetic surgery, parking, auto clubs, household moves and admissions to additional events and labor services. Taxing consumer services modernizes the sales tax and generates new revenue in a structurally sound way, while injecting progressivity into the sales tax, since services tend to be purchased more frequently by middle- to middle-income consumers. raised. However, the bill’s expansion of the sales tax to various business inputs, including marketing, telemarketing, lobbying and website-related services, is discouraged, as it further exacerbates the tax pyramid that is occurring already with the taxation of other companies. – commercial transactions in Kentucky.
As discussed in previous analyses, the sales tax pyramid occurs when one sales tax is levied on top of another. When businesses pay sales taxes on the goods and services they purchase, these tax burdens are often passed on to consumers in the form of higher prices for goods and services sold at retail. Then when a ad valorem sales tax is appropriately levied on the price of the final good or service sold at retail, the end consumer ends up paying more sales tax accordingly, and in a non-transparent manner.
Some of the services newly taxed under the bill, such as social event planning and event space rental, are consumed by individuals and businesses. In these cases, the most effective way to avoid taxing business-to-business purchases is to include the service in the sales tax base, but allow businesses to present sales tax exemption certificates. to benefit from an exemption when they make an otherwise taxable purchase. This is a policy change that Kentucky lawmakers should consider going forward.
Although a tax memo for the final legislation is not yet publicly available, the income tax cuts under this bill are expected to reduce taxes by a much larger amount than will be generated by the expansion of the sales tax, the reductions being largely financed by general revenues. growth. However, some businesses will see a net increase in tax due to the taxation of additional business inputs, especially since the bill results in reductions only in personal income tax, not in corporate income tax.
In addition to changes to income tax and sales tax, the bill includes several changes to excise tax. In particular, the bill aims to standardize the taxation of all vehicle rental services, including carpooling, peer-to-peer car sharing, taxis, limousine services and traditional car rentals, by taxing these services at a rate of 6% (corresponding to the sales tax rate). This is functionally quite similar to the inclusion of these services in the sales tax base, as appropriate, although the administration of this excise tax may differ slightly. In addition, HB 8 creates a new tax on energy distributed through electric vehicle charging stations and new registration fees for electric and hybrid vehicles.
Taken as a whole, this reform package continues the modernization of Kentucky’s tax code, building on the state’s 2018 reforms. If Kentucky’s personal income tax rate were 4% and sales and excise tax changes were fully implemented today, Kentucky would rank 16th on our State Enterprise Tax Climate Indexagainst 18 today.
While a significantly lower personal income tax rate will help Kentucky be regionally and nationally competitive, other areas of its tax code, highlighted in our recent reform options guide Kentucky tax system, are still in critical need of reform. Going forward, policymakers should prioritize repealing the Limited Liability Entity Tax (LLET), as well as reducing the corporate tax rate. On the local tax front, policymakers should strive to phase out all local income taxes, including business licensing and net profit taxes. This can be done by allowing a local option sales tax to replace the revenue currently generated by local income taxes. The repeal of local inventory and inheritance tax should also be a priority.
Notably, progress could still be made on local tax reform this year when the legislature meets again for two days next week. Two local taxing authority bills, HB 475 and 476, have passed the House and are awaiting consideration by the Senate. If passed by the Senate with a 60% supermajority, HB 475 would not need to be approved by the governor, as it proposes a constitutional amendment that would instead need to be approved by voters. Specifically, this legislation asks voters to amend the constitution to allow the General Assembly to authorize a state-administered local sales tax with a base that matches the state sales tax base. . HB 476, meanwhile, clarifies that if the Constitutional Amendment passes, local taxing authority shall extend only to the extent authorized by the General Assembly through state law, and that local sales taxes will not yet be authorized by the legislature. This will give the legislature more time to consider ways to balance local sales and income taxes.
Independent of the changes included in HB 8, the General Assembly made progress toward a better UI tax structure with HB 4, which was signed into law in March over a Governor’s veto. Among other changes to Kentucky’s Unemployment Compensation (UC) system, this law allows new employers to qualify for a lower unemployment insurance tax experience rate – known in Kentucky as the dues – after one year instead of three, a proposal that we have recommended.
Overall, Kentucky is making commendable progress toward a more modern and competitive tax code, but more work on comprehensive tax reform should be a priority in the upcoming session.