Kentucky Blue Ribbon Commission on Tax Reform Holds Second Meeting

Timothy Eifler Erica L. Horn Louisville Lexington 502.568.4208 859.231.3037 [email protected] [email protected]

Jennifer S. Smart Jackson White Lexington Lexington 859.231.3619 859.231.3617 [email protected] [email protected]

Erica L. Horn

The second meeting of Kentucky’s Blue Ribbon Commission on Tax Reform (“Commission”) was held on Tuesday, April 10, 2012. In addition to Commission Chairman Lt. Governor Jerry Abramson, approximately fifteen (15) to eighteen (18) of the twenty-three (23)1 Commission members were present. The agenda for the meeting included an update on the retention of a consultant for the Commission, a review of prior tax reform efforts and a more in-depth review of certain Kentucky taxes.

Report on Retention of a Consultant

Lt. Governor Abramson reported that a consultant had not been selected, and that the process was taking longer than originally expected. He assured the Commission that the consultant would be retained by and present at the May meeting. A request for proposal (“RFP”) was issued for a consultant to aid the Commission. A subcommittee of the Commission has been reviewing the responses to the RFP. The details of the RFP and responses are exempt from Kentucky’s Open Records law until a consultant has been selected.

Review of Prior Tax Reform Efforts – General Comments

The next order of business was a review of prior tax reform efforts in the Commonwealth. Greg Harkenrider, Deputy Executive Director of the Governor’s Office for Economic Analysis, walked the Commission through a slide show that described the prior efforts and the positives and negatives of some of the proposals. He also fielded questions from the Commissioners. Mr. Harkenrider’s slide show is available at: http://ltgovernor.ky.gov/taxreform/Documents/20120410_PriorTaxReformInitiatives.pdf.

Between 1982 and 2006, there were twelve studies or proposals related to potential tax reform in Kentucky. Some of these proposals or analyses were done by outside consultants and economists while others were done by personnel of the Commonwealth, e.g., the Revenue Cabinet (now “Department of Revenue”) or the State Budget Director’s Office. The studies, their dates and authors are as follows:

1 The number “23” includes the six non-voting, ex officio members of the General Assembly: Rep. Rick Rand, Rep. Jim Wayne, Rep. Bill Farmer, Senator Bob Leeper, Senator Paul Hornback and Senator Gerald Neal.

Date Title Author

November A Proposal to Reform and Simplify the Kentucky Tax Revenue Cabinet 1982 System (A Flat Rate Individual Income Tax and A Corporate Business Activity Tax to Replace Eight Existing Taxes)

April 1983 A proposal to Reform and Simplify the Kentucky Revenue Cabinet Individual Income Tax System

February Governor Wilkinson’s Revenue Revitalization Program: Finance and Administration 1990 Questions and Answers Cabinet

November A Blueprint for Comprehensive Tax Reform Kentucky Commission on 1995 Tax Policy

December A Comparative Analysis of Kentucky’s Tax Structure Barents Group, LLC 1999

December Financing State and Local Government: Future Kentucky Long-Term Policy 2001 Challenges and Opportunities Research Center

February Report to the Sub-Committee on Tax Policy Issues Prof. William (“Bill”) F. Fox 2002

January Securing Kentucky’s Future Governor Patton’s 2003 Administration

November Solving Kentucky’s Fiscal Crisis Governor Patton’s 2003 Administration

November Kentucky’s Economic Competitiveness, A Call for Paul Coomes, Ph. D. 2004 Modernization of the State’s Fiscal Policies

January Governor Fletcher’s Jobs and Opportunity Bipartisan State Budget Director’s 2005 Solution (JOBS) for Kentucky Office With Consultation from Prof. Bill Fox

June 2006 Final Report of the Task Force on Local Taxation, Legislative Research House Bill 272 Commission

Despite the continuous study from 2001-2006, there were no significant changes in Kentucky tax law until Governor Fletcher’s “Tax Modernization” (as it was described) in 2005.2

2 The exception is a one percent (1%) increase in the sales tax rate in 1990.

Mr. Harkenrider made comments about many, but not all, of the studies. In some instances, he provided information regarding the impetus for a particular study, and he also conveyed the observations and recommendations from some of them. With regard to the recommendations and whether they were accepted or rejected by the General Assembly, much of this information was presented in connection with a discussion of Kentucky’s taxes most prone to reform – income, sales and use, property and “sin” taxes, such as taxes on cigarettes, other tobacco products and alcohol. Following Mr. Harkenrider’s lead, in this memorandum the most important recommendations from the studies and their disposition will be discussed after a general review of the various tax reform studies.

The 1980 and 1995 Studies

The two studies in the early 1980s were precipitated by the double-dip recession and double- digit inflation of that time period. The Commonwealth was desperate for money, but no changes were made to the tax system as a result of either study.

One of the most significant studies was the November 1995 study, A Blueprint for Comprehensive Reform. The “Kentucky Commission on Tax Policy”, which produced this report, was composed of 47 members, including five cabinet secretaries from the Executive Branch; six state senators and nine state representatives from the General Assembly; and 27 members from the private sector. The study was undertaken based on the premise that Kentucky's tax code was antiquated and a better code needed to be developed. The goals of the commission were to secure adoption of a new tax code; create a globally competitive tax environment; adequately fund public programs; and create a tax system that was fair and simple. The commission was guided by four of the general principles guiding this Commission: adequacy, competitiveness, fairness and simplicity.

Mr. Harkenrider described this study as “well done” and full of “lots of good tax policy”. However, there was not sufficient urgency to result in change stemming from the report. While the commission commented on the growth in limited liability companies, the state was not ready yet for changes to the tax base.

The 2001-2005 Studies

Tax reform was the subject of a great deal of study during the second term of Governor Paul Patton’s administration (December 1999 through December 2003). Nearing the end of his first term, Governor Patton identified the need to look at tax reform because of the amount of money being used for Medicaid and corrections. In 2001, the Governor sought to address the foreseeable structural imbalance in the Commonwealth’s budget. Then, the country entered the recession that followed the terrorist attacks of September 11, 2001.

Bill Fox, a professor of economics at the University of Tennessee, prepared and issued the “Report to the Sub-Committee on Tax Policy Issues” in February 2002.3 The Report was comprehensive. It addressed performance of the existing tax structure and the impact of that structure on both families and business competitiveness. The report concluded with twenty (20) recommendations.

3 See http://www.lrc.state.ky.us/ijcomm/a&r/taxpolicy/kyfinalreport.pdf.

Mr. Harkenrider described the 2004 report of Dr. Paul Coomes as a “specialty report” that focused on the geographic areas of Kentucky from which significant tax dollars were received and the subsequent distribution of those amounts. Dr. Coomes is a professor of economics at the University of Louisville. Dr. Coomes observed that the Louisville, Lexington and Northern Kentucky metropolitan areas accounted for over one-half of all state government taxes and fees collected in fiscal year 2003, but received only about one-third of state expenditures, a net cash transfer out of $1.4 billion.4

The 2005 study was done by the State Budget Director’s Office with consultation by Prof. Fox. Many of the recommendations from this study, which focused primarily on changes to the corporation income tax and taxation of pass-through entities, were incorporated into 2005 HB 272, which passed the Kentucky General Assembly and was signed by Governor Fletcher in March 2005.5

Review of Prior Tax Reform Efforts by Type of Tax – Recommendations and Subsequent Actions

Individual Income Tax—The recommendations of the various studies relative to the individual income tax were as follows:

Proposal Study Action

Update to conform to Internal Wilkinson Administration, Kentucky currently conforms to the Revenue Code (“IRC”); February 1990. IRC as in effect at 12/31/066; Eliminate the federal tax Federal tax deduction was deduction; Implement a low- eliminated; Low-income tax credit income tax credit. has been implemented.

Adopt filing statuses used by Commission on Tax Policy, No action. federal government. November 1995.

Adopt the federal standard Commission on Tax Policy, No action. deduction, personal November 1995. exemptions, and eliminate the low-income tax credit.

Retain itemized deductions in Commission on Tax Policy, Itemized deductions retained. existence at that time. November 1995.

Adopt a flat 6% rate structure Commission on Tax Policy, No action. on income as modified. November 1995.

4 See Kentucky’s Economic Competitiveness, A Call for Modernization of the State’s Fiscal Policies, http://monitor.louisville.edu/taxes/Manuscript%20fy03.pdf. 5 A report on the study is at http://www.kytreasury.com/NR/rdonlyres/20A68608-DA4A-46D8-9091- 68131650A785/0/2003CowgillLegislativeBriefing_JOBS.pdf. 6 The last estimate of the cost of conforming the federal code to a more recent date was $50M per year.

Proposal Study Action

Expand low-income tax credit Patton Administration, 2003. Credit expanded and modified to 100% of federal poverty based on family size. guidelines.

Increase the threshold for the Patton Administration, 2003. “Modified AGI” used to determine low-income tax credit and eligibility for the family size tax eliminate ability of wealthy credit. taxpayers with high levels of exempt income to qualify for the credit.

Reduce or eliminate the tax to Coomes, November 2004. No action. attract talented people and reduce the drain on disposable incomes of residents in Louisville, Northern Kentucky, and Lexington.

Increase the lowest bracket for Fletcher Administration, 2005. Credit expanded and modified wage earners and exclude based on family size; Income tax from tax persons whose rate for $8,000-$75,000 reduced to income is at or below $12,000; 5.8%; Top bracket of 6% retained Adjust other brackets for this for income in excess of $75,000. change; Clarify who is eligible for low-income tax credit; Reduce top rate of tax to 5.68% or lower.

Phase out tax-exempt status of First introduced by Patton Pension exclusion capped at large portion of retirement Administration; Re-introduced $41,110; Inflation adjustment income for higher income by Fletcher Administration, deleted. retirees or phase out the 2005. pension exclusion and index for inflation.

Remove the deduction for First introduced by Patton Implemented. taxes paid to a foreign Administration; Re-introduced country. by Fletcher Administration, 2005.

Mr. Harkenrider reviewed with the Commission the tax expenditures7 associated with the individual income tax. There are 34 exclusions from income that constitute tax expenditures estimated

7 The 2010-2012 Tax Expenditure Report may be accessed at http://www.osbd.ky.gov/NR/rdonlyres/DBC47EB8-FE21- 4429-A283-7357388BF39B/0/1012TEA_TaxExpenditureDoc.pdf.

at $1.6B for fiscal year 2012. An additional $1.3B is attributable to deductions allowed in arriving at taxable income. The majority of the deductions are the result of Kentucky adopting the IRC for purposes of calculating taxable income. By piggybacking on the IRC, many tax expenditures are not systematically reviewed by the General Assembly.

The most significant individual income tax expenditures are described in the Expenditure Report as “Retirement Support”.8 In total these exclusions from income and deductions are estimated at nearly $800M for fiscal year 2012. Of that $800M, five exclusions make-up 88% of the balance: exclusion of pension contributions and earnings ($219M); exclusion of social security benefits and similar amounts ($119M); exclusion of federal and military retirement income ($60M); exclusion of state employee pension benefits and contributions ($62M); and exclusion of private pensions and individual retirement accounts ($245M). The majority of these expenditures were referred to as “Kentucky giveaways” meaning that they are not the result of piggybacking on the IRC.

Two of the Commissioners, Jason Bailey and John Williams, noted that some states use the calculation of adjusted gross income (“AGI”) on the federal return as a starting point for their individual income tax rather than using federal taxable income.9 Indiana was mentioned as an example of such a state. Rep. Farmer relayed that the exclusion of both public and private pension income from a United States Supreme Court case in which the Court ruled that if a state was going to exclude public pension income it had to exclude private pension income also. At that point, the General Assembly had a choice - either tax or exempt all pension income. Kentucky chose to exempt both public and private pension income.

One commissioner asked what is meant by “base broadening”. Mr. Harkenrider explained that adding pension income to the tax base would be an example of broadening the tax base.

Next, Mr. Harkenrider talked briefly about the perennially proposal in the General Assembly to eliminate the individual income tax. He stated that the positives of this approach may be increased competitiveness and simplicity. The conventional wisdom is that the lack of an individual income tax attracts high income individuals; for example, the CEO of a large company. As a result, that CEO may be more inclined to locate the company’s headquarters in Kentucky. The negatives are the inability to replace the income, which is significant in Kentucky, and it does not make a state recession proof as suggested.

Rep. Wayne expressed skepticism as to whether the lack of an individual income tax would actually encourage companies to locate their headquarters in Kentucky. Commissioner Bailey indicated that the lack of an individual income tax only has a marginal impact on attracting people because there are so many other variables to consider. Commissioner Williams stated that he did know of individuals moving to Florida and establishing residency before liquidating investments so that they would not have to pay state tax on the gain on the investment.

Mr. Harkenrider reminded the Commission that when considering the individual income tax one must also consider the occupational license fees (“OLF”) imposed on income by most Kentucky localities. The OLF raises the effective tax rate of individuals in Kentucky. The Commission

8 Id., p. 24. 9 Kentucky adopted the federal definition of taxable income in 1954. The 1995 Commission on Tax Policy recommended moving to federal AGI.

requested additional information regarding effective tax rates of state and local taxes in other jurisdictions. There was agreement that this type of information may be hard to obtain, but Mr. Harkenrider stated he would try.

Mr. Harkenrider also addressed the pros and cons of (1) raising the top marginal tax rate and (2) broadening the tax base. He stated that raising the top marginal rate would be consistent with the policy considerations of fairness (adds progressivity to an overall regressive system), elasticity and adequacy. It could possibly be inconsistent with competitiveness because of higher income individuals being more mobile, and it would be neutral to negative with regard to simplicity and compliance. With regard to broadening the base, Mr. Harkenrider stated the pros and cons would be the same as with raising the top marginal rate.

At this juncture, Mr. Harkenrider asked the Chairman if the Commission would like to discuss eliminating the exclusion of pension income from Kentucky’s tax code. Lt. Gov. Abramson stated that public input was still needed and that the consultant could help prescribe the next steps regarding the individual income tax.

Sales Tax

Moving on to discuss the sales tax, Mr. Harkenrider noted that Kentucky’s sales tax was imposed in 1960 (after a failed attempt at a gross receipts tax in the 1930’s). The original rate was 4%. The rate was increased to 5% in 1968 and 6% in 1990. Mr. Harkenrider stated that “base narrowing” started in 1966 and had been occurring ever since. He also noted that the elimination of food and prescriptions from the tax base was enacted in 1972.

Recommendations from the various tax studies included the following:

Proposal Study Action

Broaden the base to include Commission on Tax Policy, Added a few very select services; services. November 1995; and others. e.g., transportation of natural gas.

Allow food to remain exempt Commission on Tax Policy, Food remains exempt. from tax. November 1995 and others.

Eliminate special exemptions Commission on Tax Policy, No action. offered to certain industries. November 1995; Prof. Bill Fox, February 2002.

Treat farm exemptions on par Commission on Tax Policy, No action. with other business November 1995; Prof. Bill exemptions. Fox, February 2002.

Eliminate the double-taxation Kentucky Long-Term Policy No action. present through taxation of Research Center, December intermediate-goods. 2001; Prof. Bill Fox, February 2002.

Proposal Study Action

Achieve more uniform Kentucky Long-Term Policy No action. taxation of final consumption Research Center, December (transaction taxes versus 2001; Prof. Bill Fox, February selective sales tax on tangible 2002. goods).

Encourage Kentucky Prof. Bill Fox, February 2002. No action. Congressional delegation to support a new nexus standard for remote vendors to require collection of tax on behalf of the state.

Enact an affiliate nexus Prof. Bill Fox, February 2002. Implemented. standard.

Investigate alternatives for Prof. Bill Fox, February 2002. Implemented for certain industries. enhancing use tax compliance through audits.

Impose tax on unbundled Patton Administration, 2003. Implemented. natural gas transactions.

Join the Streamlined Sales and Patton Administration, 2003. Implemented. Use Tax Initiative.

Limit vendor compensation at Patton Administration, 2003. Implemented. $1,500 per reporting period.

Raise the tax rate to 7%; Patton Administration, 2003. No action. Legalize video lottery terminals, then roll-back and the sales tax to 6% after two years.

Assess sales tax on direct First introduced by Patton Implemented as part of HB 272. broadcast satellite services at a Administration; Re-introduced 7% rate. during Fletcher Administration, 2005.

Based on these studies, the action that the Commonwealth has continuously failed to take is broadening the sales tax base by applying the sales tax to certain services. Commissioner John Williams mentioned a study he had reviewed that indicated there were 183 types of services that could be subject to tax. He stated that approximately 61 of the services were for “personal consumption”

while the remaining 122 were primarily business services. Approximately 16 states are taxing the 61 personal services. Mr. Williams opined that sales taxation of certain services could create an anticompetitive atmosphere specifically mentioning advertising and computer processing. The Chairman asked Mr. Harkenrider to compile a list of personal versus business services for the information of the Commission.

As with the individual income tax, Mr. Harkenrider reviewed the pros and cons of raising the rate and broadening the base of the sales tax. He stated that raising the rate would impact fairness and competitiveness negatively because the sales tax is a regressive tax and Kentucky has a large population living in border counties. Raising the rate would impact elasticity and adequacy positively and would be neutral with regard to simplicity and compliance.

As for broadening the base, Mr. Harkenrider stated that fairness, elasticity and adequacy would be positively impacted, competitiveness negatively impacted and that there would be little to no effect on simplicity and compliance. Rep. Farmer stated that simplicity should be positively impacted because repealing exemptions, and thereby expanding the base, would make things simpler. Rep. Farmer explained that the Kentucky sales tax return currently has 18 to 19 lines for exemptions plus two lines for “other”. Mr. Harkenrider agreed that if the sales tax applied to everything it would be a positive factor with regard to simplicity, but an a la carte application is not helpful.

Commissioner Bailey took exception to the idea that increased fairness would be achieved with base broadening. He stated that lower income persons are more susceptible to the some of the services that may be taxed, car repairs, for example. Mr. Harkenrider replied that generally the purchases of low-income persons are more “goods”-based while higher income persons consume more services. Mr. Harkenrider said he would like to see empirical evidence regarding fairness as it relates to broadening the sales tax base.

Taxes on Tobacco Products and Alcohol

Mr. Harkenrider next discussed cigarette taxes. The first recommendation to raise the rate of the cigarette tax came from the 2002 Study by Prof. Fox. Prof. Fox also recommended raising the tax rate on beer, wine and distilled spirits. In 2003, the Patton Administration recommended raising the tax rate on cigarettes, imposing tax on other tobacco products (“OTP”), and consolidating and simplifying wholesale taxation of alcohol products. The Fletcher administration’s 2005 JOBS for Kentucky proposal advocated increasing the cigarette tax to $0.26 per pack, and imposing an excise tax on OTP of $0.095 per ounce. These changes were implemented as part of 2005 HB 272. The cigarette and OTP tax rates were increased again in 2009.

Currently the cigarette excise tax rate in Kentucky is 60¢ per pack. The national average is $1.46 per pack. Missouri, Virginia and West Virginia have rates lower than Kentucky’s. Tennessee, Illinois, Indiana and Ohio have rates higher than the Commonwealth’s. Mr. Harkenrider noted that when Kentucky raised its rate from 3¢ to 30¢ per pack in 2005, Indiana and Ohio increased their rates. Additionally, most of the cigarettes exported from Kentucky are exported to northern states. Commission member Dr. Sheila Schuster noted that youth and pregnant women are the most sensitive to increases in cigarette taxes. Therefore, an increase would have health benefits. Mr. Harkenrider opined that the state has “room” to increase both the cigarette tax rate and the OTP rate.

Commissioner Weigel asked whether there was any room to increase taxes on wine and beer. Mr. Harkenrider replied that the wholesale tax rate paid assessed on all alcohol was increased from 9% to 11% in 2005. Then, four years later, the General Assembly repealed the exemption of alcohol from sales tax. Thus, today wholesalers are paying an 11% wholesale tax and purchasers pay a 6% sales tax.

The Road Fund

Next, Rep. Wayne asked whether the Commission was going to address the Road Fund. The Chairman replied that information regarding the Road Fund would be shared so everyone would have an understanding. Mr. Harkenrider commented that receipts from the gasoline, special fuels and other taxes are deposited in the Road Fund.

Property Taxes

With little time remaining, the Commission approached the subject of property taxes. The recommendations from prior tax reform studies regarding property taxes are as follows:

Proposal Study Action

Freeze the state rate on real property. Prof. Bill Fox, February, 2002; No action. Patton Administration, 2003.

Calculate the real property state rate Prof. Bill Fox, February, 2002; Implemented 2005 by excluding new property before Fletcher Administration, 2005. HB 272 imposing the 4% limit.

Eliminate property tax on motor Prof. Bill Fox, February, 2002; No action. vehicles and personal watercraft. Patton Administration, 2003.

Eliminate property taxes on intangible Patton Administration, 2003; Implemented. property. Fletcher Administration, 2005.

Mr. Harkenrider indicated that freezing the real property tax rate likely would be most beneficial because then the state could realize income as assessments increase. He said that all the consultants have commented that Kentucky has limited its only tax with elasticity and the possibility of growth. More than 50% of the tax expenditures related to property tax are a result of the HB 44 limit. As for eliminating personal property taxes, Mr. Harkenrider stated that the state portion of these taxes are low and thus, taxpayers would not get much relief, but the state would lose a revenue source.

Commissioner Williams asked whether anyone had recommended repeal of HB 44. Mr. Harkenrider remarked that property taxes are primarily a local issue, but there had been “chatter” in the past two legislative sessions about “fixing” HB 44. Commissioner Williams noted local officials would like more flexibility. Commissioner Williams also asked about the Commonwealth’s inheritance and estate taxes. He stated this area should be a positive for the state.

Commission Discussion of Upcoming Meetings

Prior to adjournment, the Chairman and Commissioners discussed the public meetings that will begin near the end of May. Commissioner Schuster asked whether the Commission would hear testimony regarding the adequacy of state funds. Lt. Gov. Abramson replied he thought it would be appropriate to hear about trends and that he would expect to hear from folks in social services and education.

The Chairman also reported that he and his staff were still considering how to structure the two hour public meetings. The public is being invited via television, radio and newspaper advertising and coverage. He anticipates the meetings will be “open mic”. They will be interactive only to the extent that Commissioners have questions of or need clarification from speakers. The “topics” will be open, and Lt. Gov. Abramson expressed his desire for the Commission to hear new options and how people view tax reform. The staff is trying to schedule advocacy groups such as the Kentucky Chamber of Commerce, Kentucky Association of Manufacturers and similar groups for specific dates. State senators and representatives will be advised when the Commission will be in their district.

The Chairman concluded by saying the Commission agenda for the next meeting will include a discussion of severance taxes, tax expenditures, possibly trends in state spending, and testimony by experts from the state universities. The next meeting is scheduled for May 8, 2012 at 1:00 p.m. in the Capitol Annex in Frankfort, Kentucky.