What Could Modernizing Kentucky’s Tax Code Look Like?
The overall theme of the Governor’s tax plan is to “reduce tax rates for families and businesses.” As with many things, the devil is in the details and reducing tax rates without reducing revenue necessarily entails broadening the tax base.
Repeal the Death Tax
Governor Bevin’s tax plan calls for repealing the inheritance tax:
The state inheritance tax (the so-called “Death Tax”) should be repealed immediately, allowing family members to pass on their businesses and property to their descendants without having part of it taken away by the state government. Kentucky is one of only six states that still has an inheritance tax. This is an antiquated and unfair form of double-taxation.
The implementation for the repeal of the inheritance tax is very clear cut – just eliminate the tax. In fiscal year ending June 30, 2015, the inheritance tax brought in almost $51 million, according to the Department of Revenue’s Annual Report.
Decrease Personal and Corporate Income Tax Rates
Governor Bevin’s tax plan calls for decreasing Kentucky’s personal and corporate income tax rates, the top marginal rate of each is currently 6%:
Both personal income tax and corporate income tax rates must be gradually decreased. This will leave a higher percentage of earnings in the hands of job creators and Kentucky families and will make us more competitive with surrounding states. Any short-term losses to the state treasury, would be more than made up for over time from the compounded economic growth that would result from a consistent reduction in tax rates.
The corporation income tax brought in over $528 million and the individual income tax brought in almost $4.1 billion in fiscal year 2015.
A reduction in tax rates could be accomplished in multiple ways. One way would be to reduce corporation and individual income tax rates by the same amount. Assuming the tax base remained the same, a 1% reduction in the tax rates might cost over $750 million, which is more than the corporation income tax.
What about eliminating the corporation income tax altogether? Presumably, this could make Kentucky much more competitive with other states for big corporations to locate in Kentucky.
Another thing to consider are local income taxes. In certain localities, these can add over three percent to the effective marginal tax rate! The question becomes, however, what to put in place for these local taxes.
Simplify the Tax Code
Governor Bevin’s tax plan calls for the laudable goal of simplifying the Kentucky tax code:
We must reduce the complexity of our existing tax code. Our new tax code must be simpler, easier to understand and easier to comply with.
Tax simplification is something with which everyone can get onboard. As to income taxes, Kentucky government should commit to an annual adoption of the current federal Internal Revenue Code. This should also include resynching Kentucky depreciation with federal depreciation so that Kentucky businesses do not have to maintain two sets of depreciation schedules; there are creative ways of addressing the revenue issues.
The corporation income tax includes complicated rules including the related party add-back and the mandatory nexus consolidated return rules. One possibility is adopting combined reporting, a method which is itself quite complicated but is used by other states.
Another area of complexity is the computation of cost of goods sold for purposes of computing the limited liability entity tax under the gross profits method. Simplicity would require computing the limited liability entity tax using the federal income tax rules.
Significantly Reduce Tax Expenditures
Governor Bevin’s tax plan calls for reducing Tax Expenditures, which would also reduce the complexity of Kentucky’s tax code:
As governor, I will call for a significant reduction in the tax exemptions known in state budget parlance as, “Tax Expenditures”. There are nearly 300 such exemptions which are costing Kentucky nearly $10 billion dollars annually. There is little to no oversight or review of these favors being doled out at taxpayer expense.
The Governor’s Office for Economic Analysis regularly puts out a Tax Expenditure Analysis report which identifies tax expenditures. The most recent is the one for Fiscal Years 2014-2016, dated April 30, 2014, available at osbd.gov.
The Tax Expenditure Analysis identifies Tax Expenditures for seemingly every tax that the Commonwealth imposes: income taxes, limited liability entity tax, sales and use tax, property tax, excise taxes, etc.
When viewed from 10,000 feet, one could certainly view certain Tax Expenditures as “favors” but the big dollar amounts appear to have some basis in tax policy. This is best illustrated with examples.
The dividend income deduction for corporation income tax is listed as a tax expenditure, but the policy behind it is to prevent double taxation of the same income. Likewise the cost of goods sold deduction in arriving at LLET gross profits and the small business exemption are identified as tax expenditures, but each were added to make the LLET, which is based on gross receipts regardless of profitability, a more fair tax.
Significant Tax Expenditures for individual income tax include medical insurance exemptions, retirement and pension related exemptions, itemized deductions (e.g., home mortgage interest, charitable contributions, etc.), the standard deduction, and credits (e.g., the expanded low income tax credit, etc.). Perhaps, by eliminating certain Tax Expenditures and thereby increasing the tax base, income tax rates can be lowered.
The sales tax is viewed generally as a regressive tax because it is borne by consumers, regardless of income. Many Tax Expenditures for sales tax are meant to make it less regressive, such as the exemptions for food items, prescription medicine (which insurance generally does not cover), and residential utilities. Exemptions for manufacturers and for the agricultural industry prevent pyramiding of the sales tax (i.e., imposing a tax on a tax) and help Kentucky-based manufacturers compete with those based in other states that provide such exemptions.
Probably the biggest Tax Expenditure is for excluded services. Most other states do not impose broad-based taxes on services. Doing so has the potential to make Kentucky an outlier. Imposing a sales tax on services, particularly, where the delivery of the service, the recipient, and the benefit have the potential to be different states, has the potential to add complexity to the sales tax code.
To be sure, it is fair to say that some Tax Expenditures are “favors”. But, one must carefully evaluate each to discern whether a particular Tax Expenditure is a favor or not.
One can anticipate that Governor Bevin will eventually, sooner or later, propose to overhaul Kentucky’s tax code. It will be interesting to see the details of his proposal when it is introduced as a bill in the General Assembly.
This is a modified version of Mark A. Loyd’s regular column, Tax in the Bluegrass, “Modernizing Kentucky’s tax code” which appeared in Issue 1 2016 of the Kentucky CPA Journal.