From Foresight, Vol. 8, No.1
published 2001
The focus of more than one recent task force and unsuccessful initiative, the difficult issue of tax reform is likely to remain a priority for Kentucky policymakers and citizens. Recent revenue shortfalls and changing consumer behavior have raised questions about the adequacy of our current tax structure, just as a number of private nonprofit organizations have repeatedly questioned its fairness to low-income taxpayers.
Generally, tax policy experts agree that the ideal state tax system should: (1) provide appropriate (i.e., adequate) and timely revenues; (2) distribute burdens equitably; (3) promote economic efficiency and economic growth (i.e., be competitive with those in nearby states); (4) be easily administered; and (5) ensure accountability.(1) Yet, because of economic changes, demographic shifts, and changing social priorities, a state and local tax structure can slowly evolve into a less-than-optimum system.
In this article we present data on the state and local tax system in Kentucky and discuss changes in the state’s economy that are affecting this system. More than half of the combined state and local tax revenue in Kentucky comes from two sources: the individual income tax (or the occupational tax at the local level) and the general sales and use tax. However, the adequacy and efficiency of the state’s tax system will be affected as structural changes in the economy unfold. These structural changes include:
The gradual shift in personal income away from taxable sources (e.g., wages, salaries, and proprietors’ income) and toward mostly nontaxable sources (e.g., transfer payments and nontaxable employee benefits)—Obviously, this shift is important because the state is highly dependent upon the individual income tax for general fund receipts (44 percent in FY 2000).(2) And at the local level, the occupational tax accounts for more than a quarter of tax collections.
The transition from a goods-producing economy to a service-providing economy—The mix of personal consumption among consumers has gradually shifted from goods to services. This is important because sales or use tax is due on most goods, but most services are not subject to taxation. And sales and use tax are the second most important source of state general fund revenue (35 percent in FY 2000).(3)
The rise of “mail order” or remote retail sales, which includes Internet and catalog purchases(4)—These types of retail sales have steadily increased as a percentage of total retail sales, and it is widely believed that few people pay the taxes due on these purchases.
Overall, the structure of state and local tax systems in Kentucky differs markedly from the average state.
State General Fund Receipts. An estimated 77 percent of the total tax collections in Kentucky are made at the state level compared to an average of about 61 percent nationally. The two major sources of Kentucky’s general fund receipts are the individual income tax and the sales and use tax. Between them, they account for about 75 percent of state general fund receipts. However, their relative importance has changed dramatically over the past 25 years.
Kentucky’s general fund receives a smaller percentage from the sales and use tax and a higher percentage from the personal income tax than it did 25 years ago. In the mid-1970s the individual income tax comprised about 25 percent of general fund receipts while the sales and use tax accounted for around 40 percent. However, by fiscal year 1999-2000 the individual income tax comprised almost 42 percent of general fund receipts while the sales and use tax had declined to just over 33 percent (see Figure 1).(5) And if the general sales tax rate had not been increased from 5 to 6 percent in 1990, the trend in sales tax revenue (as a percentage of total receipts) would no doubt have been a far sharper decline.
Figure 1: General Fund Receipts by Major Sources, 1974-2000
Local Tax Revenue. An estimated 23 percent of the total tax collections in Kentucky are made at the local level compared to a national average of about 39 percent. More than one half of the tax revenue for local governments in Kentucky comes from property taxes, around 8 percent is in the form of selective sales taxes,(6) and more than a quarter issues from occupational or payroll taxes (see Figure 2).(7) The extent to which these sources of state and local tax revenue remain robust into the future will be dependent upon changes in Kentucky’s economy, the effects of these economic changes on Kentucky’s tax system, and the response of policymakers.
Figure 2: Sources of Local Tax Revenue in Kentucky, 1997
The composition of personal income can exercise a large effect on state and local revenue growth since the personal income tax combined with the occupational tax constitutes the largest portion of Kentucky’s state and local revenue receipts.(8) Over the last several years Kentucky has experienced a shift in the composition of personal income that has affected revenue adequacy, according to the 1995 Kentucky Commission on Tax Policy.(9) And this shift is expected to continue into the future.
The percentage of total personal income by various types is shown in Table 1. In 1960, wages, salaries and proprietors’ income comprised 76 percent of total personal income in Kentucky. Dividends, interest, and rent, which are generally subject to taxation, made up another 12 percent. The final two categories, other labor income and transfer payments, which are essentially nontaxable, made up the remaining 12 percent.
Table 1: Sources of Kentucky Personal Income, 1960-1999
By 1999, however, wages, salaries, and proprietors’ income had declined to just under 60 percent of total personal income. Dividends, interest, and rent increased to about 18 percent of personal income, which was not enough to offset declines in wages, salaries, and proprietors’ income. The remaining categories of other labor income and transfer payments nearly doubled as a percentage of total personal income from 12 to 23 percent. Other labor income consists of employer contributions to health insurance, welfare and retirement funds, and transfer payments consist of government programs like Social Security, Medicare, Temporary Assistance for Needy Families (TANF), and Supplemental Security Income (SSI) payments (to name a few).
The changing nature of personal income is important because of the structure of Kentucky’s tax system. As illustrated in Figures 1 and 2, the individual income tax is the most important source of state general fund receipts, and the occupational tax is the second most important source of local tax revenue. If the composition of personal income continues to shift toward nontaxable sources and the tax structure remains the same, then future revenue problems will likely develop.
Despite recent reports of a “New Economy” in Kentucky, economic activity has been changing here for the last several decades. Figure 3 shows how Kentucky’s economy has been shifting away from the production of goods and toward the provision of services. The data in this figure measure the major sectors in Kentucky’s economy as components of the total gross state product (GSP).(10) In the late 1970s, services accounted for about 40 percent of Kentucky’s economic output, but in the early 1980s the provision of services contributed more to the state’s economy than the production of tangible goods. And by the late 1990s services accounted for over 50 percent of Kentucky’s economy.
Figure 3: Services and Goods in Kentucky's Economy as a Percentage of Gross State Product, 1977-1998
This economic shift from goods to services has also been manifested in the changing mix of personal consumption expenditures over the last several decades. Table 2 illustrates the changing consumption patterns for the typical American consumer. In 1960, durable and nondurable goods accounted for 34 percent of personal consumption while services accounted for 25 percent. However, by 1999 services constituted 43 percent of personal consumption while durable and nondurable goods made up 24 percent.(11)
Table 2: The Changing Mix of Personal Consumption Expenditures, 1960, 1990, and 1999
Clearly, this economic shift has affected the amount of sales and use tax revenues. As described by the Kentucky Commission on Tax Policy, “Kentucky imposes a sales tax on the purchase of ‘tangible personal property,’ which applies to items like clothing, appliances, and furniture. But when the purchase is for a service, like a haircut, dental examination, car repair, or attorney services, the sale is not subjected to a tax.”(12) Obviously, if the state’s economy and consumption patterns continue to tilt away from goods and toward services, the sales and use tax base will slowly diminish unless the sales and use tax rate is increased or the sales tax base is widened to include some services. And economists observe that, in general, a lower rate on a wider base is better than a higher rate on a narrower base.(13)
Complicating the mix of changes in consumer buying is the dramatic rise in remote shopping. Americans are buying more and more items from catalogs, the Internet, and home shopping networks on television. The National Mail Order Association along with Marketing Logistics Inc. estimate that in 1998 U.S. consumer mail order sales reached $185 billion. Of this total they estimate that consumer Internet purchases accounted for $5.6 billion.(14) Mail order sales have been increasing faster during the decade of the 1990s than total retail sales and the subset of retail sales that closely approximates nondurable goods.(15) Nondurable goods such as apparel are the items most likely to be purchased remotely. During the 1990s total U.S. retail sales increased at an average annual rate of about 5.1 percent while mail order sales increased by around 8.3 percent.(16) As a result of this faster growth rate, mail order purchases comprise a higher proportion of total retail purchases today than in 1990. Table 3 illustrates how mail order purchases increased from about one fifth of nondurable goods to about one quarter during the 1990s.
Table 3: Americans Are Spending More of Their Retail Dollar as Mail Order Purchases
The rise in remote sales has important tax implications. We have estimated that Internet purchases by Kentuckians will likely result in annual use tax losses that range from $7.6 million to $57 million by 2004.(17) And the state is likely losing many times this amount as a result of non-Internet mail order sales like catalog purchases. For example, we estimate the cumulative amount of use tax owed on non-Internet mail order sales in Kentucky from 1998 to 2003 at nearly $600 million.(18) As more Kentuckians shop online and order from catalogs, policymakers will be challenged to develop new and better ways to increase the use tax compliance rate. While survey results show that over half of Kentuckians say they are very or somewhat likely to pay their use tax,(19) other research suggests that no more than 16 or 17 percent of the use tax owed nationally is actually paid.(20)
States that disproportionately depend on the sales tax or the income tax for general fund receipts are likely to feel the effects of structural changes underway in the economy sooner than most. For example, Tennessee and Washington are highly dependent on the sales tax while Oregon and Maryland rely heavily on the personal income and occupational tax. Kentucky, on the other hand, is not “overly dependent” (relatively speaking) on any one tax source. Yet Kentucky’s percentage of state and local tax revenue from the general sales tax, selective sales tax, and individual income tax is 68.9 percent (see Table 4), the fifth highest percentage in a ranking of all states and well above the U.S. average of 57.7 percent. This suggests that Kentucky’s state and local tax system will begin to feel the effect of these long-term structural changes in the economy before many other states.
Table 4: Percent of State and Local Tax Revenue by Tax Source, 1997
* Mr. Childress is the Executive Director of the Kentucky Long-Term Policy Research Center. Return to text.
1. Financing State Government in the 1990s (National Conference of State Legislatures and National Governor’s Association, 1993) 16. Return to text.
2. Kentucky Revenue Cabinet, Annual Report 1999-2000, 15 Dec. 2000, 14 Feb. 2001 http://www.state.ky.us/agencies/revenue/pdf/annualreport99-00.pdf. Return to text.
3. Kentucky Revenue Cabinet. Return to text.
4. Mail order sales include those placed by mail, phone, or electronically (over the Internet) without the person who places the order coming to the point of sale. Refer to Table No. 1288, Statistical Abstract of the United States: 1999 (Washington, D.C.: U.S. Census Bureau, 1999). Return to text.
5. These data are from two sources. The 1974 to 1991 data are from the Kentucky Finance and Administration Cabinet, as presented by William Hoyt, “Trends in Kentucky Taxes and Their Implications for Future Tax Policy,” in Exploring the Frontier of the Future (Frankfort, KY: Kentucky Long-Term Policy Research Center, 1996) 243-53. The data from 1992 to 2000 are from various Kentucky Revenue Cabinet annual reports (see note 2). Return to text.
6. Selective sales taxes include those on alcoholic beverages, amusements, insurance premiums, motor fuels, pari-mutuels, public utilities, tobacco sales, and other selective sales taxes. Return to text.
7. Author’s calculation based on data from State and Local Government Finance Estimates, by State: 1996–1997, U.S. Census Bureau, 6 March 2001. The 1995-96 data are available online at http://www.census.gov/govs/estimate/96stlss1.xls. Local governments includes counties, cities, school districts and special districts. Return to text.
8. Refer to Table 4. The individual income tax, which includes the local occupational tax, comprises 31.2 percent of Kentucky’s state and local tax revenue. The next largest category, the general sales tax, comprises 21.2 percent. Return to text.
9. Kentucky Commission on Tax Policy: A Blueprint for Comprehensive Reform, 15 Nov. 1995: 22. Return to text.
10. Goods-producing industries include agriculture, mining, construction and manufacturing. Service industries include: transportation and utilities; wholesale trade; retail trade; finance, insurance and real estate; and services. Data are from the Bureau of Economic Analysis, 8 Feb. 2001, http://www.bea.doc.gov/bea/regional/gsp. Return to text.
11. The 1999 data are estimated from U.S. Department of Labor, Bureau of Labor Statistics, Consumer Expenditure Survey data, 14 Feb. 2001 ftp://ftp.bls.gov/pub/special.requests/ce/standard/1999/region.txt. Return to text.
12. Kentucky Commission on Tax Policy, 23. Return to text.
13. Hoyt. Return to text.
14. National Mail Order Association, 1998 Mail Order Sales Results, 8 March 1999, 22 Feb. 2001 http://www.nmoa.com/Library/1998sale.htm. Return to text.
15. In this category we include SIC codes 53 (general merchandise group stores), 56 (apparel and accessory stores), 57 (furniture group stores), and 594 GAF (stores which specialize in department store types of merchandise—general merchandise, apparel, furniture, and miscellaneous shopping goods stores). Return to text.
16. Calculated by the author from Census Bureau estimates. U.S. Census Bureau, Table 2: Estimated Total Annual Retail Sales, 23 Feb. 2001 http://www.census.gov/svsd/retlann/view/artssal.txt. Return to text.
17. Michael T. Childress, “Revenue Implications Grow As More Kentuckians Shop Online,” Foresight (Kentucky Long-Term Policy Research Center) 7.4, 2000: 1. Return to text.
18. This is the amount owed, not the amount lost. Refer to Peter Schirmer, Kevin O’Neil, and Michael T. Childress, “The Internet as a Virtual Tax-Free Zone: Implications for the State Budget,” in Collecting Taxes in the Cyberage (Frankfort, KY: Kentucky Long-Term Policy Research Center, 1999): 20. Return to text.
19. Childress, “Revenue Implications …” 3. Return to text.
20. The U.S. Advisory Commission on Intergovernmental Relations reports a rate of 16.5 percent in Taxation of Interstate Mail Order Sales: 1994 Revenue Estimates.
Return to text.