Updated Kentucky Tax Reform Package Would Boost State from 33rd to 18th on the State Business Tax Climate Index (Updated)

With one of the worst-funded pension systems in the nation, among other pressing fiscal concerns, Kentucky lawmakers are searching for revenue. There have been several proposals for raising additional revenue, most of them straight-up tax increases. The latest proposal, emerging from legislative conference committee this morning, is more intriguing: it raises an additional $487 million over the next biennium for a cash-strapped state government, but does so in the context of fundamental tax reform, trading additional revenue for measures which simplify the state’s tax code and improve its overall competitiveness.

In fact, while overall revenues would be higher, improvements in tax structure would propel the state on our State Business Tax Climate Index, which measures tax structure and rewards simple, neutral, stable, and transparent tax codes. If these changes were fully in effect today, Kentucky would rank 18th overall, an improvement from its current ranking of 33rd in the nation. The state would also experience marked improvement on most of the Index’s subcomponent ranks.

Here’s what’s in the plan:

• Replacing Kentucky’s current six-bracket individual income tax, which has a top rate of 6.0 percent, with a 5 percent single rate individual income tax;
• Broadening the starting income tax base by removing most deductions and repealing the personal exemption credit ($10 per filer, $20 per dependent);
• Decrease the amount of pension income excluded from income tax from $41,110 to $31,110;
• Replacing the current three-bracket corporate income tax, with its top rate of 6.0 percent, with a 5 percent flat rate;
• Phasing out the inventory tax using a tax credit;
• Adopting single-sales factor apportionment and conforming to the federal Internal Revenue Code as of December 31, 2017;
• Suspending several business tax credits;
• Expanding the sales tax base to include select services (landscaping; janitorial services, pet care and grooming, and small animal veterinary services; fitness and recreational sports; laundry, dry cleaning, and linen supply; non-medical diet and weight loss centers; limousine services; bowling; overnight trailer campgrounds; extended warranties; and other personal services); and
• Raising the cigarette tax from 60 cents to $1.10 per pack.

It’s true, of course, that the proposal constitutes a net tax increase, raises the cigarette tax, and taxes some intermediate transactions (with the potential for the sales tax getting embedded in the price of the final product multiple times over). Earlier rumored versions would have made great strides, eliminating the antiquated and uncompetitive gross receipts-style business alternative minimum tax (the LLET). But overall, the plan creates a more stable sales tax, with less effort devoted to picking winners and losers though the tax code. It implements low, single-rate individual and corporate income taxes, which matters at least in part because flat taxes are harder to raise in the future.

In sum, it eliminates costly and economically inefficient tax preferences in favor of broader bases and lower rates, which is exactly what tax reform is supposed to do.