Closing this tax loophole would bring Kentucky billions. Will you have to pay more?

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Kentucky’s tax problem

Kentucky’s legislature needs billions of dollars to pay down the state’s unfunded pension liabilities. As it happens, Kentucky essentially gives away billions of dollars every year through what are called “tax expenditures.” Will Kentucky lawmakers close some of these loopholes?

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Editor’s note: This is the fourth in a series of stories about tax breaks and incentive programs that cost Kentucky billions of dollars each year, leaving lawmakers little money to fix Kentucky’s ailing pension systems.

Consider a wedding.

According to The Knot, a popular wedding website, the average wedding costs about $22,888 in Kentucky. The wedding dress, the rings, the suit, the flowers, even the wine and beer, are subject to a sales tax. The hairstylist, the nail salon, the photographer, the caterer, even the round of golf the morning of the wedding, are not.

That’s because Kentucky’s 6 percent sales tax, which lawmakers approved in 1960, is applied to goods (such as rings) but excludes most services (such as manicures).

Kentucky’s sales tax generated more than $3.4 billion in fiscal 2017, but the state could have brought in an additional $2.5 billion in revenue that year if it expanded the sales tax to cover services, ranging from haircuts to legal work.

With ailing public pension systems that could potentially require $2.7 billion in the next year and an estimated budget shortfall of $155 million this year, lawmakers would have no problem finding ways to spend the billions that an expanded sales tax would generate.

The idea of eliminating the sales tax exemption on services has bipartisan support, but for different reasons. Liberals see it as a way to raise more revenue for the state to spend on education or roads, and conservatives see it as a way to counter income tax cuts.

But every year, standing in the way, is the political power of the industries whose services are exempted from the sales tax. Of the top 10 groups that donated money to current members of the state House of Representatives in the 2016 election, six represented industries exempted from the sales tax.

In addition, the legislature is filled with members who work in these industries. Lawyers, for example, make up about 20 percent of the state legislature. Exempting the services provided by attorneys from the sales tax costs the state about $133.8 million a year.

In his State of the Commonwealth address in February, Gov. Matt Bevin promised to examine every “single sacred cow that people think can’t be touched on a tax front” to consider whether it should be cut. But a spokesman for Bevin didn’t respond when asked recently whether Bevin would consider eliminating the sales tax exemption for services.

Former House Speaker Jeff Hoover, R-Jamestown, said there wasn’t a single discussion among lawmakers about tax reform over the course of the summer.

“It’s been proposed in the past, on different bills that have been filed,” Hoover said of expanding the sales tax to services. “So that’s always been discussed, because when you’re looking for money, that’s the big-ticket item. But what can you do politically? That’s the other thing.”

A changing economy

Until the 1930s, states relied heavily on property taxes to pay their bills, but as the Great Depression hit and property values plummeted, so did state revenue.

Enter the sales tax.

In 1930, Mississippi became the first state to tax the sale of consumer goods. Within the decade, 21 states would follow. Today, all but five states have a sales tax.

Meanwhile, the economy has changed drastically.

In 1947, commodities made up 72.9 percent of consumer expenditures, according to the Bureau of Labor Statistics. By 2012, 60.3 percent of consumer expenditures were on services.

That trend has left Kentucky, in which sales taxes make up about a third of General Fund revenue, scrambling to pay for basic services.

“If we’re going to have a sales tax, it has to align to the economy,” said Jason Bailey, executive director of the left-leaning Kentucky Center for Economic Policy. “So it’s a key part to tax reform.”

jason bailey
Jason Bailey, executive director of the Kentucky Center for Economic Policy, said Kentucky’s sales tax fails to capture revenue from services, the fastest-growing sector of the economy. Photo provided

There are basically two ways to increase tax revenue: Raise the tax rate or make more people pay the tax.

The legislature hasn’t raised the sales tax since 1990, when it increased from 5 percent to 6 percent. That increase passed as part of a much broader plan to overhaul the state’s education funding system, which courts had ruled unconstitutional.

Today, there is no appetite in the Republican-led state legislature to raise the sales tax rate, but experts argue that they should seriously consider expanding its reach to services.

“Most public finance experts across the political spectrum would say expanding the sales tax base to services is a meaningful tax reform that policy makers should consider,” said Scott Drenkard, the director for state projects at the right-leaning Tax Foundation in Washington, D.C.

Critics of the idea, though, suggest that taxing professional services isn’t practical. If businesses must pay sales taxes on the services they buy, some owners would move to other states, said Charles George, government affairs director for the Kentucky Society of Certified Public Accountants.

Only four states tax professional services, George said.

“I think when it’s actually put into practice, it’s a lot more difficult than when you put it on paper,” he said.

Expanding the base

The list of services exempted from Kentucky’s tax code breaks down like a Russian nesting doll.

There are exemptions for big services (legal, financial and health care) and exemptions for small services (coin-operated laundry, locksmiths and one-hour photo developing). There are exemptions for beauty (interior design, nails) and waste (septic tank repair); the important (mental health treatment) and the frivolous (miniature golf).

As the list grows larger, so does the amount the state loses in revenue.

The state will forgo collecting a projected $2.7 billion because of service tax exemptions in fiscal 2018, according to the state’s most recent analysis of tax loopholes, which are formally called tax expenditures. That is about 21 percent of the state’s estimated $13 billion in tax expenditures.

The bulk of that lost revenue comes from exempting professional services, including health care, accounting and legal advice.

For example, state economists estimated that taxing health care services would have generated an estimated $821.4 million this fiscal year, more than three times the revenue that Kentucky collects from lottery proceeds.

Even if there weren’t a physician, a nurse and a hospital CEO in the legislature, taxing health care isn’t viewed as politically feasible. Lawmakers aren’t likely to tax a mother’s breast cancer screening or an addict’s stay at a rehabilitation center.

“When you start taxing certain services, you’re really creating a substantial burden on low-income people and retirees,” said Senate Minority Leader Ray Jones, a lawyer in Pikeville.

Even setting health care aside, experts see plenty of room for expanding the sales tax.

An analysis by the Kentucky Center for Economic Policy found that Kentucky taxes only 28 of the 168 services that were taxed by at least one state in 2011. (The few services Kentucky does tax include lodging, sewers and prepaid calling.)

Jordan Harris, executive director of the right-leaning Pegasus Institute in Louisville, suggests that Kentucky lawmakers should apply the sales tax “across the board” to all services, then make advocacy groups “come to Frankfort to have to justify why their particular exemption should remain in the system.”

Jordan Harris
Jordan Harris, director of the Pegasus Institute, shown in Frankfort in August, advocates expanding the sales tax to services as a way to balance cuts to Kentucky’s income tax. Bobby Ellis

Harris, though, doesn’t support taxing services unless lawmakers cut other taxes, particularly the income tax.

He would like Kentucky to follow the example of Tennessee, where residents owe no income tax but must pay an average sales tax rate of 9.373 percent.

“I’m for basically eliminating every loophole to broaden the base as much as possible on the consumption side,” Harris said.

Bailey, though, is wholeheartedly opposed to using the service tax to balance an income tax cut. Sales taxes take a much higher toll on low-income families, he argues, because they must spend almost all of their income on basic necessities. An income tax, on the other hand, requires high-income families to pay more.

“No sales tax, even if it’s applied to everything and every service, is ever going to be as good of a revenue source as an income tax,” Bailey said. “So if it’s an overall shift, that is not helpful; it’s harmful.”

Bailey’s group has worked with state Rep. Jim Wayne, D-Louisville, on a bill that would make several changes to Kentucky’s tax code, including putting a sales tax on services often used by the wealthy, including limousines, tailors and country clubs.

Jim Wayne
State Rep. Jim Wayne, D-Louisville, has proposed applying Kentucky’s sales tax to luxury services. Legislative Research Commission

“The rich, they can generally afford six cents on the dollar to get their lawn done and their suit tailored,” Wayne said.

Wayne has proposed the same bill every year since 2010, but it has never gotten a vote on the House floor. In 2011, officials estimated that taxing luxury services would generate $104 million a year for the state.

Threading the needle

When asked why it is so difficult to expand the sales tax to services, the Tax Foundation’s Drenkard has a simple answer.

“Do you want to pay more in taxes?”

When the city of Washington, D.C., proposed expanding its sales tax to include gyms, yoga studios and other athletic clubs to offset an income tax cut, gym owners throughout the city spoke out.

To protest, dozens of yogis gathered outside city hall and stood in warrior pose shouting “tax Slurpees, not burpees.”

It didn’t work; the tax passed. But the political power of gym owners in Washington pales in comparison to the power of lawyers, accountants and business owners in Frankfort.

“The people who are willing to be the loudest on an issue usually get their way at the expense of the overwhelming majority,” Harris said. “And if you look through the tax expenditure book, there are dozens and dozens of stories where that’s the case, and you can see them laid out right there, where someone was willing to be loud enough to get their way at the expense of the majority.”

Since threatening to take the state’s sacred tax cows to the slaughterhouse, Bevin has been less than clear about his intentions.

In his State of the Commonwealth address, Bevin promised a special legislative session this year to overhaul the state’s ailing pension systems and its antiquated tax code. He said Kentucky can’t afford a revenue-neutral tax overhaul, urging lawmakers to “think big; be bold” as they restructure the tax system to raise more money.

Now, the agenda of a possible special session has been limited to pension reform, and even that is in question. Bevin also pledged in August that he won’t raise taxes to finance pensions, although he has left open the door to eliminating tax expenditures in his next state budget proposal.

“The whole initial justification for this is just falling apart,” Bailey said, referring to Bevin’s initial pledge to raise revenue through tax reform. “You’ve got to wonder why we’re talking about it at all.”

Daniel Desrochers: 502-875-3793, @drdesrochers, @BGPolitics

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