Back to The Impetus for Tax Modernization: Economic, Demographic, and
Political ChangeFrom Financing State and Local Government
p. 123-136, published 2001
While acknowledging that numerous efforts in the name of “reform” have fostered cynicism and undermined the credibility of new undertakings to modernize the Commonwealth’s tax structure, this chapter reviews notable 20th century reforms to Kentucky’s tax system, their impetus, and their effects. It then turns to an examination of the trends that have emerged from tax reform efforts in other states during the 1990s and concludes with observations about the implications for comprehensive versus incremental change in Kentucky’s tax system.
Tax reform has been the focus of numerous study groups and commissions, gubernatorial initiatives, and legislative actions in Kentucky and the 50 states over the past several decades. The goals and content of tax reform initiatives change over time reflecting different economic and demographic conditions, intergovernmental tax environments, and other factors. The success or failure of tax reform efforts depends on a number of factors including public understanding of the reform issues, the commitment of policymakers to the reform effort, and supporting “drivers” or trends and events which enhance the possibility of reform. This chapter provides a historical perspective of tax changes and reform efforts in Kentucky since 1930 along with a review of tax changes in the other states during the past decade. The review of Kentucky tax reform efforts considers the types of tax changes that have occurred, the circumstances surrounding such changes and their implications for future tax reform initiatives. The analysis of tax changes in the other 50 states includes a summary of the changes enacted regarding the three major state taxes (personal income, sales, and corporate income) including rate changes, base changes, and administrative adjustments. By reviewing Kentucky’s tax reform history and more recent tax law changes in the other states, insights regarding tax reform trends and factors influencing comprehensive and incremental tax reforms may be found. In turn, such insights might support future tax reform efforts in the Commonwealth.
As suggested, tax reform has been on Kentucky’s public policy agenda for decades. In response to changes in Kentucky’s economy, demographics, income, expenditure needs, federal tax policy changes, and other factors, Governors, Special Tax Task Forces or Tax Study Commissions, and members of the Kentucky General Assembly have proposed tax changes that have often been described as “tax reforms.” The enacted “reforms” have eliminated taxes, introduced new taxes, increased and decreased tax rates, expanded or contracted tax bases, and changed administrative processes regarding the assessment and collection of Kentucky taxes. The various tax reform initiatives have adjusted tax burdens for segments of Kentucky’s taxpaying population and modified Kentucky’s competitive position, taxwise, relative to neighboring states.
While changing economic, demographic, and fiscal trends in Kentucky may have created conditions that called for comprehensive tax reform, broad-based reform has occurred infrequently during the last century. When major restructuring or “comprehensive reform” did occur, reform efforts were often supported by “drivers” or “triggering events” such as a court decision, a state fiscal crisis, or the emergence of broad public concern regarding the fairness of a specific tax. Meanwhile, incremental tax changes have occurred frequently and have often been driven by intensive lobbying by special interests, efforts to align state taxes with changes in federal tax laws, and national tax reform “waves” regarding individual taxes such as the property tax limitation that swept across the nation in the 1970s.
As suggested, whether initiated by members of the legislative branch, the Governor or interest groups, tax changes are often proposed as “tax reforms.” The term “tax reform” is often used by tax change advocates whether or not the proposed tax changes enhance a state’s tax structure relative to accepted tax principles. Apparently, the term “reform” is attached to tax initiatives to make the proposed adjustments more acceptable. Consequently, the term “tax reform” has been attached to legislation that enhanced state tax structures relative to “good tax principles” as well as tax changes that have narrowed state tax bases, enhanced complexity, reduced state tax equity (horizontally or vertically), and reduced the adequacy of state tax systems. The latter tax changes marketed with the “tax reform” label have limited opportunities for enacting true state tax reform legislation.
In other words, the indiscriminant use of the term “tax reform” has fostered credibility problems for true tax reform efforts in recent years. The public and the press often perceive that tax changes proposed in the name of reform do not, necessarily, mean that proposed changes will produce a tax code that is more equitable, simpler, more neutral, more competitive, or more adequate—the traditional goals of “true” tax reform legislation. This credibility problem has enhanced cynicism about tax reform and has made meaningful tax reform efforts more difficult.
While cynicism may present an obstacle to true, comprehensive reform, there are cases in Kentucky’s history when reform initiatives have produced meaningful, tax-principle-based changes in Kentucky’s tax structure. For example, tax changes in the mid 1930s, 1960, the early 1970s, and 1990, were based on one or more of the accepted tax principles (the principles of adequacy, simplicity, equity or fairness, neutrality, and competitiveness). It should be noted that while these successful reform efforts were based, in part, on accepted tax principles, their ultimate passage was facilitated by the support of “reform drivers.” Among the drivers were broad-based public concerns about the fairness of Kentucky’s tax structure (1930s and perhaps 1960), legislative and executive branch efforts to focus public opinion on a tax reform issue (1960 and early 1970s), or the intervention of the courts regarding a related policy issue such as the adequacy of Kentucky’s education financial support in the 1989 Supreme Court case (1990). These major or comprehensive reform initiatives are reviewed in sections that follow to indicate the types of tax reforms that were enacted and the forces or drivers that enhanced the potential for major tax reform success.
Other tax changes of the century tended to be incremental. Some of Kentucky’s incremental changes involved tax-principle-based reform while other changes involved special tax changes supported by groups of individuals, businesses, or “special interests.” Some of the latter incremental changes were passed with minimal focus on their broader tax policy implications. Still, such special tax legislation was often considered “reform” by its advocates whether the change was true reform or simply involved special benefits for certain taxpayer groups. Some of Kentucky’s incremental reforms and changes are also cited below.
Changing economic conditions and the financial crisis of the depression led to the enactment of a gross receipts tax in 1934 to modify the state’s historical reliance on the property tax as its main source of revenue. Studies(138) indicate that 60 to 70 percent of Kentucky’s revenue came from property taxes between 1830 and the 1920s with the remainder coming from a variety of minor sources such as special fees and licenses. However, in the 1930s, the economic downturn reduced state revenues and raised concerns about the state’s heavy dependence on the property tax for financial adequacy and equity reasons. The property tax was the main source of state revenue even though property was no longer the principal source of wealth. Tax policy reform advocates indicated that changes in the economy had made wages, salaries, profits, and dividends equivalent sources of income and wealth (to property) and that a tax system based on property taxes was no longer equitable or reflective of ability to pay. As a result, there was public clamoring for change in the state’s tax system. In response to public concern, a 3 percent gross receipts tax was enacted in 1934 and the property tax was reduced to a nominal rate of five cents per $100.(139)
After the enactment of the 1934 gross receipts tax, administrative problems and perceived regressivity made the gross receipts tax extremely unpopular. Public concern regarding the tax focused on its differential impact on different sectors and its perceived burden on lower income groups. As a consequence, the tax was repealed and replaced by Kentucky’s first personal and corporate income taxes along with a system of “selected” sales taxes on alcoholic beverages, cigarettes, amusements, and utility receipts in 1936.(140)
The comprehensive reform and modernization initiatives of the 1930s were followed by a period of relative tax structure stability until the 1960s. Exceptions were the enactment of a pari-mutuel tax in 1948, modest changes in tax rates for the income and corporate taxes in 1950 and incremental adjustments to other tax and fee structures. Kentucky also passed legislation in 1954 that made Kentucky the fourth state to have an income tax withholding system. In the same period, Kentucky adopted the federal definition of net income with minor exceptions.(141)
In the 1960 session of the Kentucky General Assembly, Kentucky became the 34th state to enact a sales and use tax. A 3 percent tax was imposed on the “privilege of making retail sales in Kentucky.” The tax, part of Governor Combs’ education initiative, was broad-based and applied to all tangible personal property sales. The imposition of the sales and use tax, along with changes in the income tax, fundamentally altered the structure of Kentucky’s general fund tax base. As a result of that legislation, the sales tax produced almost half of the state’s general fund revenue (48 percent) compared with 21 percent for the previous year when the state had a selective sales tax structure enacted in 1936. Income taxes (individual and corporate) that had produced 50 percent of state revenues now contributed only 33 percent of total general fund revenues. The enactment of the broad-based sales tax in 1960 was followed by a rate increase to 5 percent in 1968. With that increase, the dominance of the sales tax as Kentucky’s principal revenue source increased from 50 percent of General Fund receipts in FY 1968 to 59 percent in FY 1969 while income taxes provided 29 percent of total FY 1969 revenues. It is noted that the Kentucky legislature began narrowing the sales tax base in 1966—a mere 6 years after the enactment of Kentucky’s first broad-based sales tax.(142)
The reform efforts of 1970 and 1972 focused on equity issues associated with the sales tax. It was, apparently, assumed that the taxation of food and prescription drugs imposed an inequitable burden on lower-income Kentucky taxpayers and that the elimination of these taxes provided a fairer tax structure. As a result, in 1970, prescription drugs were exempted from the sales tax along with a series of minor tax code changes. Food was added to the exemption list in 1972. To replace the revenue loss associated with the food sales tax exemption (13 percent of general fund revenues), a severance tax was also passed during the same session. The severance tax legislation imposed a 4 percent tax on the gross value of coal mined, or 30 cents per ton, whichever was greater. The tax rate was raised to 4.5 percent or 50 cents per ton in 1976. It is noted that the food and prescription drug exemptions continued the trend of narrowing Kentucky’s sales tax base which began in 1966—an example of the positive and negative tradeoffs which occur when tax reform initiatives are undertaken.(143)
The sales tax exemptions and the enactment of the severance tax were the major changes in Kentucky’s tax structure in the 1970s except for House Bill 44 (HB44) that was passed in 1979 by a special session of the Kentucky General Assembly called by Lieutenant Governor Thelma Stovall. The legislature initially struggled with the purpose of the call but eventually passed a property tax limitation bill. The bill, which continues to be referred to as HB44, was recognized as the Kentucky version of special property tax limitation legislation that swept the nation in the 1970s.
The property tax limitation wave that eventually passed through 20 states began in Iowa and became nationally prominent when California passed Proposition 13. The California initiative resulted from a growing concern over rapidly increasing state property taxes. The escalating California property taxes were driven by inflated property values that were not offset by lower tax rates. It is interesting to note that the property tax limitation wave impacted Kentucky even though Kentucky had significantly reduced its dependence on the property tax in the 1930s and was considered to be a low property tax state.
The 1979 legislation limited property tax growth to 4 percent per year (a combination of assessed value and rates) for state government. Local taxing districts were made subject to the same revenue limitations although the rules are different. For example, new property is not subject to the 4 percent property tax revenue growth lid for local governments. Combined with earlier adjustments to Kentucky’s tax code, HB44 ensured that property taxes would remain a minor part of Kentucky’s tax portfolio for decades to come.
Kentucky’s tax structure, again, stabilized during the 1980s. The exception was a series of modifications to existing taxes enacted in the 1985 Extraordinary Session of the Kentucky General Assembly. Known as the Kentucky Equity Tax Act (KETA), the changes were principally enacted to provide funding for Governor Collins’ Educational Improvement Act. KETA included a slight expansion of the sales tax base (to include rentals and leases), rate changes for the corporate income and license taxes, and revisions in Kentucky’s depreciation schedules. In addition, business inventory taxes were reduced, the federally-based depreciation schedule was replaced by a separate Kentucky depreciation system, and the formula for apportioning business income and capital employed by multistate corporations was changed to allow double weighting of the sales factor and assigned equal weight for property and payroll factors. KETA also revised the inheritance tax to reflect changes in the economy, particularly inflation, and eliminated all inheritance taxes on property passing from the decedent to the surviving spouse.(144)
The 1990 session of the Kentucky General Assembly provided a unique opportunity for Kentucky to revise and adjust the structure of its revenue base. Under pressure from a 1989 Kentucky Supreme Court decision that declared Kentucky’s system of elementary and secondary education unconstitutional, including its system of finance, the Governor and the General Assembly sought ways to reform and refinance Kentucky’s education system.(145) The major refinancing issues involved providing sufficient revenue to meet the Court’s concerns for school financing adequacy and reforming the state’s system of distributing state school support to the state’s school districts to achieve greater financing equity.
In a surprising initiative, Governor Wilkinson proposed a comprehensive tax reform program that would have raised taxes by approximately 18 percent and restructured the state’s tax system in several dimensions. Governor Wilkinson’s proposal included the following elements:
Governor Wilkinson’s proposal was designed, primarily, to provide additional revenue for Kentucky’s elementary and secondary schools. It also, however, was designed to increase the progressivity of Kentucky’s income tax by eliminating the deductibility of federal income taxes paid and the enactment of a low income tax credit. Limited progressivity gains were also anticipated from the broadening of the sales tax to include items and services more frequently consumed by higher income groups. The proposed broadening of the sales tax was also designed to reflect changes in the Kentucky economy which was experiencing a gradual shift from a focus on goods-producing sectors to a greater emphasis on service-related sectors. Meanwhile, the rate increases for the corporate and cigarette taxes were included for revenue enhancement reasons. Compliance with the federal tax code involved a periodic update of Kentucky’s income tax code to reflect changes in the federal income tax.
After considerable debate and negotiations, the Kentucky General Assembly adopted a tax reform package that omitted two of Governor Wilkinson’s tax proposals including the increase in the cigarette tax and the broadening of the sales tax. In order to produce equivalent revenue, the Kentucky General Assembly enacted a tax bill that increased the sales tax from 5 to 6 percent. While the increase in the sales tax provided additional revenue to meet educational finance needs, the benefits of a broadened sales tax base were not realized. Still, the 1990 tax legislation enhanced the progressivity of Kentucky’s tax structure, dealt with the adequacy concerns of the Kentucky Supreme Court, and simplified portions of Kentucky’s tax code.
After the major tax changes of the 1990 session, Kentucky returned to the national trend of enacting frequent incremental tax structure reforms. For example, House Bill 1 of the 1995 Extraordinary Session of the General Assembly called by Governor Jones exempted the first $35,000 of income from private pensions and individual retirement accounts (IRAs) from Kentucky’s personal income tax. The pension and IRA income exemptions were largely driven by public and private sector employee horizontal equity concerns. Those concerns arose after state government and educators’ pension exemptions were extended to federal employees as a result of the Davis vs. Michigan case. That case found that special treatment of state employees vis-à-vis federal government employees regarding the tax exemption of pension funds was unconstitutional. In addition, legislation passed during the same session phased in an exemption for Class A beneficiaries from the inheritance tax over a four year period.
Figure 42 summarizes Kentucky’s tax changes enacted during the 1990s by major tax. The reforms included 4 changes to the corporate income tax, 13 amendments to the Kentucky personal income tax statutes, and 2 sales tax changes. The corporate tax amendments included an increase in the top corporate tax rate in 1990, a change in the date that interest is due on refunds for net operating loss (NOLs) carry-backs in 1992, a skills-training investment credit, and a Kentucky Investment Fund Tax Credit in 1998. The personal income tax changes are shown in Table 26 and include a variety of changes including the previously cited enactment of a low income tax credit in 1990 and an increase in the standard deduction during the 1996 legislative session among others. Sales tax “reforms” included the previously noted increase in the general sales tax from 5 to 6 percent in 1990 and a broadening of the industrial supply exemption in 1996.
Figure 42: Number of Tax Law Changes in Kentucky, 1990-2000
Table 26: Kentucky Income Tax Changes in the 1990s
Like Kentucky, the other 49 states were actively engaged in modifying tax structures during the 1990s in response to changing economic and fiscal conditions and the pursuit of tax reform goals. This section provides an overview of the tax change trends regarding the three major state taxes during the 1990s including the personal income tax, the state sales tax, and the corporate income tax. The trend analysis benefited from data obtained from the National Council of State Legislatures (NCSL). The NCSL data are acquired annually from the 50 states and provide brief descriptions of tax legislation passed by the respective states. The data include information about whether the tax changes increased or decreased tax rates, expanded or reduced the base for a tax, and/or adjusted administrative processes associated with state taxes. It is noted that administrative process and rule changes such as changes in the definitions of items subject to the sales tax, accelerating the processing of tax returns by hiring more personnel, and allowing energy companies to transfer unusable tax benefits to other corporations and the like, can directly or indirectly impact state revenues. Unfortunately, the NCSL data do not provide information on the purposes or goals of the tax changes enacted by the states in the 1990s such as the enhancement of a state’s tax structure adequacy, the simplification of a state’s tax structure, and the like. Consequently, an analysis of state tax reform goal trends was not permitted. However, an assessment of major state tax changes during the 1990s provides useful perspectives on the state tax policy reform environment.
The NCSL data indicate that there were 489 corporate tax changes, 522 individual income tax code changes, and 457 sales tax changes enacted during the 10-year period from 1990 to 1999 (see Figure 43). The tax changes involved a variety of actions that increased or lowered the revenue yield of the respective state tax types. For example, 154 actions increased state income taxes while 368 legislative changes produced less state income tax revenue. Sales taxes had a similar pattern with 273 tax reductions and 184 tax increases. Meanwhile, 300 state corporate income tax changes involved tax decreases while 189 changes were anticipated to increase state corporate revenue.
Figure 43: Tax Changes in the States, 1990-1999
In Figure 44, state personal income and sales taxes changes are broken into three categories including base changes, rate changes, and administrative process changes. As shown, base changes dominated sales and income tax changes during the decade, as 339 income tax base changes were enacted by the states while 72 rate and 111 administrative changes were passed. Similar patterns were found for the sales tax as 280 base changes were enacted; 78 rate changes and 90 administrative changes were legislated during the decade.
Figure 44: State Sales and Income Tax Changes, by Type of Change: 1990-1999
Tax legislative changes involving base, rate, or tax administration and procedures can increase or decrease revenue. Figure 45 indicates the revenue impact associated with the various state income tax adjustments made during the 1990s. As shown, revenue reductions dominated the state income tax base and rate changes made during the period as 272 base amendments decreased revenue compared to 67 base changes that enhanced revenue. Rate changes reducing revenue exceeded rate change increases by 46 to 27. Meanwhile, income tax administrative revisions increased revenue more often than they decreased state revenues (60 changes increased revenue while 51 administrative process changes decreased state income tax revenues).
Figure 45: State Income Tax Changes: 1990-1999
Figure 46 indicates a similar pattern of state tax reducing actions for the sales tax. As shown, legislation passed regarding sales taxes resulted in 264 reductions in sales tax revenue while 184 changes increased state revenues. However, analysis of tax modifications by category of change (base, rate, and administrative changes) provides a slightly different picture. For instance, 190 base-narrowing actions, including special exemptions among others, were enacted while 90 sales tax-broadening initiatives were enacted. However, sales tax rate changes resulting in increased state revenues exceeded sales tax rate reductions by a margin of 43 to 35 while administrative changes increased revenue 51 times compared to 39 actions which reduced state sales tax proceeds.
Figure 46: Sales Tax Changes 1990-1999
While revenue-reducing actions, regarding the state’s three major taxes, dominated state tax changes in the 1990s, other trends are apparent. Figure 46 indicates overall trends regarding these state taxes for the period in terms of the number of reforms or changes. For example, tax increase actions (via rate, base, or administrative change) exceeded tax reduction actions, overall, from 1990 until 1993. This was, of course, a period in which states were witnessing slow state revenue growth. Apparently, to acquire needed revenues, tax revenue-raising measures were the dominant state tax policy. By contrast, from 1994 through the remainder of the decade, tax measures designed to reduce state revenues exceeded actions designed to increase state revenues. Figure 47 also indicates that state tax change frequency increased during the last half of the decade as state incomes increased and fiscal conditions improved.
Figure 47: State Major Tax Increases, Decreases, and Net or “Overall” Changes: 1990-1999
This chapter has presented a brief overview of Kentucky’s tax change and/or reform history. It was observed that comprehensive or major restructuring of Kentucky’s tax base has occurred infrequently during the past century. Four periods were highlighted as times when analysts might conclude that comprehensive reform was accomplished. It was further suggested that the major reforms had identifiable drivers such as broad-based taxpayer concern regarding the existing tax structure, court cases, strong executive and/or legislative leadership, or the state was facing major fiscal problems and economic challenges. In the intervening periods, tax policy in Kentucky has been dominated by change or reform initiatives that could be classified as incremental or marginal changes. The drivers for those changes tended to be particular interest groups uniquely impacted by a tax or special efforts by executive or legislative branch officials who focused on a specific tax equity, simplicity, or tax competition problem. These small or marginal changes occurred frequently over the past several decades. Unfortunately, some of the marginal changes were enacted with little consideration of their impact on the overall fairness, neutrality, simplicity, adequacy, or competitiveness of the Kentucky tax structure.
From this review, it appears that Kentucky is like most states in its approach to tax policy matters. State tax changes enacted in the 1990s suggest a return to the tendency to mirror or “emulate” tax initiatives of other states, while simultaneously adjusting taxes to deal with state specific issues. The tendency to emulate actions of other states included, historically, the wave of property tax limitation legislation that spread across the country in the 1970s. For the 1990s, national “emulation” trends included both tax increases (the first part of the 1990s) and tax reductions (during the latter part of the decade).
Another characteristic of state tax policy suggested by the NCSL data is the tendency for states to enact incremental rather than major or comprehensive tax reforms. In the absence of overriding reasons for major reform, states have tended to enact frequent marginal changes in rates, bases, or administrative processes. In other words, when drivers for major change are not present such as court decisions, declining fiscal conditions, or special needs, incremental change tends to dominate state tax policy.
Perhaps, in the absence of major fiscal issues or taxpayer concerns, state tax policymakers prefer to revise state tax structures incrementally so that changes in state revenues are small and tax policy impacts on taxpaying groups are marginal. With small changes, state revenue and tax impacts may be easier to determine and fluctuations in state revenue streams from the direct and behavioral impacts of tax changes may be limited. The tendency for incremental or gradual tax policy change does not necessarily doom comprehensive state tax reform. Rather, it may suggest that comprehensive reform may have a greater chance for success, absent a major “driving force or event,” if reform goals are set and incremental changes toward those goals are enacted over time.
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Political Change
* The author wishes to acknowledge the excellent research support of Suzanne Perkins, Graduate Research Assistant at the Martin School of Public Policy and Administration, University of Kentucky. Return to text.
138 Kentucky Department of Revenue Report, 1950 and others. Return to text.
139 Ky. Dept. of Revenue. Return to text.
140 Ky. Dept. of Revenue report, 1950. Return to text.
141 Ky. Dept. of Revenue reports, various 1950-1960. Return to text.
142 Ky. Dept. of Revenue report, 1959-60 and others 1960-1970. Return to text.
143 Ky. Dept. of Revenue annual reports, 1970-73. Return to text.
144 Ky. Dept. of Revenue annual reports, 1980-1989. Return to text.
145 Rose vs. Council for Better Education, Inc. Return to text.