Executive Summary

Overview

Tax reform has been on Kentucky lawmakers’ minds for years, and while significant progress has been made recently, substantial work remains to be done. In 2018, the General Assembly made important strides in creating a more neutral, pro-growth tax structure even while generating a net increase in revenue. With its reduction in income tax rates, consolidation of brackets, and modest sales tax base broadening, Kentucky put itself on the map as a state that is serious about reorienting its tax structure to enhance productivity and promote economic growth. 

Much has changed in the world since 2018, with taxpayers and governments everywhere confronting new challenges on top of the old ones. There’s more motivation than ever to remove barriers that for too long have stood in the way of individuals’ and communities’ ability to thrive.

Kentucky’s challenges are many—the state continues to lag the national average in terms of personal income growth, gross state product growth, and state inbound migration—but the Commonwealth’s opportunities are greater. In this new era of increased workplace flexibility, where many people are leaving high-tax, high cost-of-living states in favor of more affordable alternatives, Kentucky holds a competitive advantage.

Many similarly situated states are seizing opportunities to make their states more attractive to individuals and businesses alike, and pro-growth tax reforms have been central to those efforts, with 11 states enacting laws to reduce their income tax rates in 2021 alone and more expected to come in 2022.

Kentucky is projected to experience robust revenue growth over the next few years, presenting a valuable opportunity for policymakers to pursue reforms. Ultimately, the goal of tax reform should be to enable the state and local governments to raise sufficient revenue to fund government services in a manner that avoids hindering business productivity, job growth, and personal wage growth.

In the pages that follow, we identify numerous structural deficiencies in Kentucky’s tax code and outline a series of reform solutions. Several of these reform solutions could be implemented on their own because their revenue impacts would be minimal, while others would be possible through revenue triggers that tie future reforms to future growth, and still others could be accomplished through tax swaps that reduce reliance on economically harmful taxes by increasing reliance on less harmful alternatives. (Pay-fors, where appropriate, are discussed throughout the publication.) All of these reforms—whether taken a few at a time or more comprehensively—would make the state’s tax code more structurally sound and more conductive to fostering long-term economic growth.

Menu of Kentucky Tax Reform Solutions

Business Taxes

Kentucky has relatively well-structured and competitive corporate and individual income taxes at the state level but is held back by substantial taxes on business and personal productivity at the local level, as well as a complex state gross receipts tax on limited liability businesses. Kentucky also has room for improvement in its treatment of business investments and in its heavy reliance on incentives that add complexity to the tax code. The following recommendations would create a more competitive environment for businesses that would encourage long-term investment in Kentucky.

• Repeal the Limited Liability Entity Tax (LLET), imposed on C corporations and limited liability pass-through entities based on gross receipts, thus burdening startups, low-margin businesses, and companies experiencing losses.
• Reduce the corporate income tax rate, particularly given the continued existence of local net profit taxes which raise the overall burden of this harmful tax well above the 5 percent state rate.
• Improve treatment of business capital investments, raising the Section 179 expensing allowance for small businesses and offering permanent full expensing like that available under IRC Section 168(k) to reduce the tax code’s bias against investments in machinery and equipment.
• Evaluate and streamline incentives, empowering the Legislative Research Commission to evaluate the economic impact of these incentives and convening a commission or committee to study the LRC’s findings.
• Use revenue triggers to phase in reforms, ensuring revenue stability and reducing uncertainty while phasing in rate relief or pro-growth structural reforms.

Individual Taxes and Municipal Income Taxation

In 2018, the General Assembly significantly improved the individual income tax by consolidating six brackets into one and reducing the rate, using modest sales tax base broadening as an offset. While these reforms significantly improved the Commonwealth’s competitiveness and mitigated its overreliance on income taxes, there remains work to be done. Over the past two decades, Kentucky has lagged its competitors in terms of growth in gross state product, personal income, and inbound migration. States with no or low income taxes perform well on these metrics, and other states are increasingly taking notice and reducing taxes on productivity as a way to improve their competitive standing in an increasingly mobile economy.

• Pay down individual income tax rate reductions with sales tax modernization, creating a more stable and pro-growth tax system.
• Shift from local income taxes, granting localities the authority to levy less harmful taxes in lieu of occupational license and net profit taxes, which are uncommon elsewhere.
• Shift to single sales factor apportionment of local net profit taxes, ensuring that local taxation aligns with state-level apportionment.

Sales and Use Taxes

Kentucky has one of the lower sales tax rates in the country and is among a minority of states prohibiting local governments from using a sales tax as part of their revenue toolkit. Kentucky’s under-reliance on sales taxes leaves state and local governments turning to more economically harmful alternatives. In addition, despite valuable reforms undertaken in 2018, the sales tax base still falls short of capturing modern personal consumption patterns. If policymakers are to pursue comprehensive tax reform that rebalances Kentucky’s revenue source toward growth, sales tax modernization is a critical piece of that puzzle.

• Modernize the sales tax base, capturing more final consumption to generate additional revenue that can be used to reduce reliance on more economically harmful taxes.
• Allow a local option sales tax, permitting municipalities to levy sales taxes in lieu of more economically harmful taxes, including net profit and occupational license taxes on business and personal income, inventory, and other taxes on tangible personal property.
• Consider raising the state sales tax rate, using rate increases to offset income tax rate reductions that would yield a highly competitive income tax environment while keeping Kentucky’s sales tax in line with, or more competitive than, regional peers.

Property and Inheritance Taxes

Kentucky is one of a few states that uses property taxes as both a local and state revenue source, but the Commonwealth’s real property tax collections are quite modest, due in large part to rate and levy limits that have been in place for decades. However, taxes on business inventory, machinery, and equipment, as well as inheritance taxes on individuals, introduce complexity and economic distortions into the property tax code. Kentucky has an opportunity to rebalance its revenue sources away from economically distortive taxes on tangible property and toward far less economically harmful taxes on real property.

• Repeal the inventory tax or improve the inventory tax credit, ensuring that a 2018 policy intended to blunt the impact of the inventory tax actually provides relief for business taxpayers.
• Create a de minimis exemption for tangible personal property (TPP) taxes, eliminating compliance costs for businesses with minimal liability.
• Modify the local property tax recall provision, replacing it with a more straightforward system of voter ratification of increases above the cap.
• Permit one-time property tax rate adjustment in excess of limits to rebalance local tax bases, should an effort be made to shift local governments away from municipal income taxation.
• Raise the state real property tax rate to offset income tax rate reductions, providing a stable source of revenue that could be used to yield highly competitive income tax rates even as combined property tax burdens remain at or below national averages.
• Repeal the inheritance tax, an outlier tax (only six states tax inheritances) which drives people out of Kentucky while generating only $48 million in revenue in FY 2020.

Other Taxes

While it is understandable that Kentucky’s largest sources of state and local tax revenue—income, sales, and property taxes, respectively—have been the primary focus of public discourse, other taxes have important fiscal and economic implications and deserve policymakers’ attention. Kentucky’s gas tax—a critical source of revenue for the Road Fund—has been raised infrequently, has failed to keep up with inflation, and has lost much of its purchasing power over time. Likewise, the unemployment insurance (UI) tax, which is paid by businesses and funds Kentucky’s unemployment compensation (UC) trust fund, has numerous structural deficiencies that ought to be reexamined.

• Reform the gas tax by converting from a variable-rate to a specific tax, raising the gas tax rate, and indexing it for inflation to ensure that it remains a viable revenue stream for transportation expenditures going forward.
• Use federal funds to replenish the UC trust fund, beginning to build up a fund that has been insolvent for decades.
• Charge employers UI tax according to base period wages, to avoid disincentivizing the hiring of laid off workers.
• Further reform UI taxes by shortening experience rating qualifying periods and repealing the solvency tax, allowing businesses to more quickly earn the lower tax rates associated with keeping layoffs to a minimum and reducing the degree to which UI taxes rise when they are likely to have the most adverse effect.

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