Tax breaks are budget loophole

FRANKFORT — In the past year, horse enthusiasts bought more than half a billion dollars worth of prized Kentucky horseflesh on which they paid no state sales tax. Tax breaks covered the horses.

Utility companies spent hundreds of millions of dollars for mountains of coal on which they paid no sales tax. A tax break covered the coal.

But when business owner Mike Sause bought a DVD player and two DVDs at a Best Buy in Lexington before Christmas, he paid $12 in sales tax, the 6 percent typically charged on tangible goods.

Sause, 22, says he's used to paying the tax, but he wants to know more about those who don't. The state's General Fund is expected to collect about $3 billion in sales taxes during fiscal year 2010, compared to about $2.4 billion the state will forgo in sales tax breaks for horses, coal and dozens of other items.

"I think that people should really be aware of tax exemptions being given to businesses, whether they're local or international," Sause said. "With all this money we're giving away, we ought to know more."

The basics about tax breaks are published every two years by the state budget office. Kentucky will forfeit an estimated $6.9 billion in different taxes in 2010. By comparison, the state's General Fund is budgeted to collect $9.1 billion. The money lost to tax breaks is rising about 7 percent a year as the General Assembly — often at lobbyists' urging — creates new loopholes in the tax laws without closing old ones.

But that's as much as most people know.

Almost nobody knows who gets tax breaks because the state Department of Revenue won't tell. Nobody knows if most of them work as intended because, despite repeated calls to examine them, the legislature has not done so — and has no plans to. Lawmakers don't know whether targeted tax breaks encourage new industries, such as ostrich farming, or expand old industries, such as coal.

In 2005, the General Assembly passed a law requiring a legislative study of tax breaks to determine whether their costs are justified. The study never was done. Three years later, the House killed a bill that would have set time limits on tax breaks and required a public discussion of their results before they could be renewed.

"Unfortunately, we have some pretty timid folks running Frankfort, and they keep these tax breaks off the table so we never debate them," said Rep. Jim Wayne, D-Louisville.

Even an estimated shortfall of at least $1.5 billion in the next two-year budget may not be enough to spur much discussion of reviewing tax breaks when lawmakers return to Frankfort on Tuesday, Wayne said.

"Whatever painful spending cuts we're going to have to make in 2010, these tax breaks already are set in stone for another year," said Wayne, who sponsored the failed bill to set time limits.

Without an automatic review process, tax exemptions for items such as pollution-control equipment live on even though their reason for existence died long ago.

In 1974, the General Assembly wanted to protect the environment, so it added a break on sales taxes for factories and power plants buying pollution-control equipment. Since then, the state and federal governments have passed laws and regulations requiring nearly all the pollution controls that were once voluntary.

Still, Kentucky's tax break for that now-mandatory equipment remains — at an estimated cost of $113 million over the next three years.

East Kentucky Power Cooperative has spent about $350 million installing scrubbers on two units at the Spurlock Power Station in Maysville to meet more stringent air-quality standards, said spokesman Nick Comer. The company claimed about $19 million in tax breaks under the exemption.

Comer called the exemption "helpful," but added that "we would have installed those scrubbers anyway because it's the most economical approach."

This is why tax breaks need a thorough examination, says Rep. Bill Farmer, R-Lexington, who advocates closing many exemptions as part of an overall tax system overhaul.

"There are a lot of exemptions out there, and we don't know how useful they are or whether we still need them," Farmer said, calling the pollution-control exemption a good example. "Are we getting our money's worth?"

Politicians uninterested

Kentucky has struggled with budget shortfalls over the years, and every time, to the chagrin of many elected leaders, some groups in Frankfort have suggested closing tax breaks or otherwise overhauling the state's patchwork tax system.

In the 1990s, a panel appointed by Gov. Brereton Jones recommended reworking the tax system. The panel noted that if sales taxes were extended to services, such as lawyer and accountant fees, enough revenue would be generated to cut the tax rate in half. A state report issued under the next governor, Paul Patton, suggested much the same thing. Both times, lawmakers said they were not interested.

Now Kentucky lawmakers must find an extra $1.5 billion in the next two-year budget or make deep cuts in education, social services, public safety and other areas of state government.

Despite the shortfall, Gov. Steve Beshear repeatedly has said he opposes tax reform this year. Instead, he stakes his political capital on trying to pass expanded gambling. Chairmen of the legislature's budget committees also say they see little interest among rank-and-file lawmakers in tackling tax breaks this winter.

However, last month, House Speaker Greg Stumbo, D-Prestonsburg, and Senate President David Williams, R-Burkesville, said they might be willing to look at tax reform.

Stumbo is particularly interested in examining taxes on the service sector, the fastest growing part of Kentucky's economy. State budget officials estimate that if untaxed services were included in the sales tax, it could bring the state more than $1 billion a year.

Still, when lawmakers begin talking about tinkering with the tax code, businesses and lobbyists argue that tax breaks are essential to the economic health of the commonwealth. Letting a company pay less in taxes means it can hire more people or expand a facility, they say.

But experts say closing numerous loopholes is needed to update an archaic system that no longer provides adequate revenue for government services.

A smarter tax policy would replace most loopholes with a broader base of taxes that everyone pays, but at a lower rate, they say.

"Here's the thing about tax breaks," said Thomas Pope, a reform advocate who teaches taxes and accounting at the University of Kentucky. "We could come up with reasons we should give a break to every industry in Kentucky. And if we did that, we'd be broke."

Myriad exemptions

Tax breaks, exemptions and loopholes are part of every state's tax fabric.

In their purest form, they are supposed to encourage people and businesses to do what they might not without a financial incentive. But they're also sometimes used by legislators as political favors.

Most tangible goods have a sales tax of 6 percent in Kentucky. The state exempts sales taxes on food, health care and residential utilities — almost a billion dollars in tax breaks that help the poorest Kentuckians the most.

Kentucky's other sales tax breaks range from the sweeping (a 1960 exemption for new and expanded industry, estimated to cost the state more than $72 million a year) to the specific (a 1976 exemption for tombstones worth $7.2 million).

Definitions of who can receive the breaks often are changed. For several years in the 1990s, lawmakers quietly expanded the pollution-control equipment loophole to include all the repair and replacement parts required to make steel, a provision with a rare sunset clause that terminated it in 1994.

Other exemptions include:

■ Coal burned for electricity and other fuels used in manufacturing, mining or processing are exempt from sales tax. Those taxes would be worth $347 million to the state over the next three years.

■ Tax breaks for agriculture, including farming, could cost the state as much as $835 million over the next three years. That includes a tax break on many multi-million-dollar horses sold at Lexington sales companies. The breaks are scattershot: Cattle farmers get a break on feed, but horse farmers do not.

■ Some tax breaks are aimed specifically at certain companies without being named. An exemption for jet fuel, which is estimated to cost the state $20 million in 2010, is given to certified air carriers after the first $1 million spent on aircraft fuel, clearly aimed at UPS in Louisville and carriers at the Cincinnati/Northern Kentucky Airport.

■ Trucks over 44,001 pounds are not subject to the motor vehicle use tax, costing Kentucky about $11 million a year. Add to that another $2.5 million that won't be paid next year in sales tax on repair parts for large trucks.

■ Manufacturers also get a break in property taxes on the pollution control equipment they own, along with all their other equipment, to the tune of about $65 million a year, according to the state.

Who benefits?

Nobody knows the economic results of Kentucky's tax breaks, but other states document theirs better.

For instance, Oregon identifies not only the exemptions and the revenue lost but also describes the recipients and the intended purpose, so that lawmakers can determine whether the state is getting what it wanted.

Experts on budget planning say the last thing states should do is exactly what Kentucky does: Keep adding new exemptions over the decades without examining their effectiveness.

Once tax breaks are approved, "only the beneficiaries... tend to remember their existence," the National Conference of State Legislature writes in its publication Fundamentals of Sound State Budgeting Practices. "Individual tax expenditures should be reviewed just as other state expenditures are."

Even when tax breaks are narrowly targeted, state officials don't want to discuss who benefits.

For example, a tax exemption on recycling and compost equipment was expanded in 2006 to include a tax credit for "major recycling projects" — those that include more than $10 million in equipment, have physical plants worth more than $500 million and have more than 750 full-time employees.

That language means only a handful of companies in Kentucky are eligible for the credit, but the Department of Revenue won't name them.

Piecemeal taxes

Many economists agree that the most rational sales tax policy is one that is more broadly based with lower rates. Even some beneficiaries of tax breaks agree.

Manufacturing provides 15 percent of the jobs in Kentucky and receives a variety of tax breaks, from property and sales tax breaks on machinery to breaks on the fuel they use.

But Greg Higdon, president of the Kentucky Association of Manufacturers, said sales tax exemptions mean some companies benefit when others don't.

"We don't like piecemeal taxation," Higdon said.

Despite all the advice, lawmakers are squeamish about closing tax loopholes. Every tax break has a constituency that fiercely defends it, making it politically easier to ignore them once they're established.

"These are very, very difficult for us to get our arms around," said Rep. Rick Rand, D-Bedford, chairman of the House budget committee. "Generally, it's not a direct appropriation that we're going to have to account for — like if we appropriate $1 million for a new science building at UK — so we don't. We could do a better job."

"If we're asking our social service agencies and education to further trim their spending, then at some point we need to be able to say whether all this money we're spending on tax expenditures is doing what it's supposed to do," Rand said. "Is it really creating jobs? Is it really developing the economy? Is it the best way to achieve the results we want?"

Experts warn that bad economic times — with an increased demand for government services — should prompt a review of who pays and how much they pay. A tax break for one person means higher taxes or fewer services for others.

"I think the job of lawmakers in evaluating these requests should be to think about the big picture," said Matt Gardner, director of the Institute on Taxation and Economic Policy in Washington, D.C. "For every million dollars you're not collecting, that million dollars has to come from somewhere else. Tax exemptions work like a water bed. You push down one place, it rises up somewhere else."