"An archaic tax system that works against us, not for us." That's how Gov. Steve Beshear described Kentucky's tax code in his State of the Commonwealth speech.
Unfortunately, he's right. The state's top income tax rates are among the highest in the nation, making it costly to do business in the Bluegrass State.
This year, Kentucky's ranking in the Tax Foundation's State Business Tax Climate Index fell two places, from 25th to 27th. While other states reformed their tax codes to encourage economic growth, Kentucky made few such reforms, and is falling behind. And as Kentucky's overall economic performance continues to lag behind the nation on the whole, the tax reform discussions should be focused on smart tax policies that will contribute to economic growth.
To start with, the state needs to take a close look at local income taxes. Only 12 states even have local income taxes at all. These taxes can cause negative economic consequences as they distort decisions concerning where to live, own a home, and work. As of 2011 (the most recent available comprehensive data), Kentucky had 218 different local income tax jurisdictions charging rates ranging from 0.01 percent to 2.5 percent.
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The result of Kentucky's high local income taxes is that the combined average local tax rate and top state tax rate in Kentucky is the 11th highest income tax in the nation, 8.08 percent, kicking in at just $75,000. This puts many middle-class households in a tax bracket equivalent to what a person earning $208,500 a year pays in Ohio.
Phasing out the local income tax would meaningfully reduce Kentuckians' tax burdens without endangering the state government's finances, and would reduce business' compliance costs. Both of these are good for economic growth. The problem, of course, is that localities would face a revenue shortfall.
However, Beshear has called for the implementation of local-option sales taxes, or short-term local sales taxes applied in order to finance specific local projects. While taxes on consumption (sales taxes) are generally less economically damaging than taxes on income, the addition of yet another local tax will just make Kentucky's tax burdens even higher. Furthermore, temporary taxes like those the governor proposes make long-term tax planning difficult.
Localities in most states get along just fine without having local sales, income and property taxes, so it's unclear why Kentucky localities need all three. But if local income taxes were replaced with less economically damaging sales taxes applied on a permanent basis, Kentucky's localities could see their position improved without any revenue losses. Lower income taxes will especially help Kentucky recruit and retain the high-skilled workers and entrepreneurs who contribute so much to lasting economic growth.
Finally, as the Governor's Blue Ribbon Commission made clear, the state needs to broaden the sales tax base. Right now, the state taxes goods consumed, but not most services.
Want to hire a lobbyist? Tax free. Want to get yourself a nice shave at a barber shop? Tax free. Want to buy a razor and do the shave yourself? Pay the sales tax.
As more of the economy is composed of services, not goods, it is imperative that the state tax those services. This will create a significant revenue windfall which could be used to lower the income tax still further, making the state even more attractive for new investment.
This task of including all final consumer goods and services in the tax code is one of the most important (and most difficult) reforms that a state can undertake, and is an essential component of any tax modernization effort.
Kentucky needs tax reform. But contrary to what Beshear and others have proposed, tax reform doesn't mean coming up with new taxes to take more money from Kentuckians. Instead, it means replacing the bad features of Kentucky's tax code with something better.
Real reform would take the hobble off the horse of Kentucky's economy, remove obstacles to success, and put the state on a path to growth.