On March 4, 2022, Rep. Jason Petrie, R-Elkton, presents House Bill 8. The law set in motion a process for gradually eliminating the state individual income tax. (Photo by LRC Public Information)

FRANKFORT — Republican supermajorities in the Kentucky General Assembly are expected to begin the 2025 legislative session the same way they began the 2023 session with a popular bill that will cut the state income tax rate by one-half of 1 percentage point.

In 2023 the legislature cut the individual income tax rate from 4.5% to 4%, effective Jan. 1, 2024. After gaveling in the 2025 session on Tuesday, expect lawmakers in perhaps one of their first actions to drop the rate to 3.5%, effective Jan. 1, 2026.

But for those paying careful attention the sense of déjà vu will not likely be total.

Consequences are different, for one thing, as the 2025 cut will come on top of the cuts made in 2022 and 2023, raising more serious questions about Kentucky’s ability to raise sufficient revenue to adequately fund its needs beyond the new year.

Circumstances are different too. The COVID era revenue boom that produced massive revenue surpluses in nearly all states is fading further into the past.

The National Association of State Budget Officers predicts a “return to normal” for state budgets in 2025 “after multiple extraordinary years of widespread, substantial surpluses, record setting revenue growth, and a large uptick in one-time spending in the years following the onset of the COVID-19 panic.”

Closer to home, Democratic Gov. Andy Beshear’s budget office recently projected that state General Fund revenue will drop by 1.4% this fiscal year compared to revenue taken in last year — the first revenue decline in modern times in Kentucky not caused by an economic recession.

GOP not discouraged?

Some key Republican players in the legislature put no stock in that forecast, noting that actual revenues are up a bit through the first five months of this fiscal year. Kentucky’s economy remains healthy, state spending has been restrained, Kentucky’s emergency reserve fund is still well stocked, and Republicans seem as eager as ever to push ahead with their signature policy of income tax relief.

Rep. Jason Petrie, the Elkton Republican who chairs the House budget committee and sponsored the 2022 bill that set up a process that allows for gradual reductions in the income tax rate, said that because Republican supermajorities have budgeted “to needs versus wants” in recent years, the state can absorb the additional income tax cut.

“And we’ve got plenty of room to continue with the downward trend in the individual income tax rate and not have to raise in other places,” Petrie said.

And key Republicans still cling to a longer term goal of gradually dropping the income tax rate to zero — a half percentage point at a time.

House Speaker David Osborne, R-Prospect, said in a recent interview he still embraces that goal, despite a comment he made last spring.

The Lexington Herald-Leader quoted Osborne in late May as saying “I think we have to be realistic with the fact that growth will not carry us beyond 3% in the foreseeable future. … We’ve always known it would only carry us so far, which is why every other state that has gone to zero has dramatically increased sales taxes.”

In a recent phone interview, Osborne said that he meant only to emphasize that each ensuing cut is more difficult than the prior one, particularly with huge spending obligations for Medicaid and pensions.

In the recent interview with the Lantern, he said, “Assuming we control spending, I think the formula will get us there (to zero percent) eventually.”

But Jason Bailey, head of the progressive Kentucky Center for Economic Policy, said that the pending cut to a rate of 3.5% alone “is playing with fire when we see revenues forecasted to decline and now that the one-time pandemic economic stimulus is gone.”

Bailey said, “The budget is made up of critical investments needed to make all Kentuckians safe, healthy, educated and prosperous. Another cut will make our largest revenue source 30% smaller than it was just a few years ago, and nobody has put forward a plan … to address the harms that will inevitably come.”

If there was a shred of doubt that the next cut in the income tax rate would be approved in the 2025 session, that evaporated last month when Beshear said, “I believe with our booming economy that the next income tax cut is something we can do and still provide the services that are out there.”

Landmark policy shift?

The Republican Party seized control of Kentucky’s tax policy when it assumed control of majorities in the General Assembly beginning in the 2017 legislative session.?

In 2018 the legislature passed a tax reform bill that cut Kentucky’s top income tax rate from 6% to a flat 5% rate for all taxpayers. The bill also added the sales tax to many services, among other changes.??

The GOP’s power grew even stronger in later elections as Kentucky voters elected more Republicans to the legislature.

The onset of COVID in early 2020 triggered fear of economic recession. But after a few sluggish months, tax revenues in Kentucky — and other states — soared.

Aggressive stimulus measures taken by the U.S. Congress injected trillions of dollars into the economy. People spent that increased income on goods and services that resulted in big increases in sales and income tax revenue. As the effect of stimulus spending eased, the economy was socked by inflation which, while damaging to the personal pocketbook, invigorates growth in tax revenue.

Kentucky General? Fund revenue — which grows on average about 3% in normal times — grew by 10.9% in 2020-21 and by 14.6% in 2021-22. Those were by far the strongest growth rates since 1991 when revenues were boosted by hikes in the income and sales taxes to fund the Kentucky Education Reform Act.

On July 1, 2022 Kentucky had $2.7 billion in its Budget Reserve Trust fund, known as the “rainy day fund,” that in 2019 held only $129 million and was empty as recently as 2011.

House Bill 8?

Suddenly awash in money, most states responded with some form of tax relief.

Kentucky’s Republican legislators took the opportunity to achieve a long-sought goal — passing what they characterize as a “pro-growth” tax reform measure that would make Kentucky revenue growth more reliant on consumption (sales taxes) than production (income taxes.) A goal was to make Kentucky’s income tax rate more competitive with its neighbors.

HB 8 cut the income tax rate from 5% to 4.5% effective Jan. 1, 2023. And it allowed for future reductions of one-half percentage point whenever the state ends a fiscal year on strong financial footing. The bill specifies that two safeguards must be met before any future half-point rate cut can be made:

• The rainy day fund balance is at least 10% of what total General Fund receipts were in the fiscal year just ended.
• Revenue that year would have exceeded General Fund spending even if the income tax rate had been 1 full percentage point lower.

Those thresholds were met at the end of the 2021-22 fiscal year, which allowed the 2023 General Assembly to cut the income tax rate to 4%, effective Jan. 1, 2024.

Revenue did not exceed spending by enough in the 2022-23 fiscal year to meet the second requirement, so last year’s legislature was not eligible to consider another half-point cut.

But the 2024 General Assembly took steps that made it likely lawmakers could resume cutting the income tax this year.

In addition to passing a budget that restrained recurring spending below what Beshear and Democrats wanted, lawmakers changed the rules. They suspended the HB 8 law so that state spending of about $2.5 billion from the rainy day fund on infrastructure and other one-time expenses would not count as spending in the calculation of whether the law’s thresholds had been met — specifically, the requirement that revenue exceed spending even if the income tax rate had been 1 percentage point lower during the year.

Under the relaxed rules, the law’s two requirements were met at the end of the 2023-24 fiscal year, allowing the 2025 legislature to consider the half-point reduction to 3.5%.

Outlook sound or shaky??

Petrie agrees nothing is certain when projecting the future. But he notes the state has a stocked rainy day fund; a balance of $3.5 billion is anticipated at the end of the 2025-26 fiscal year even with withdrawals made in the current budget. That’s about 21% of annual General Fund revenue.

And he argues that Kentucky’s revenue boom was due to more than just the COVID stimulus. Actions taken by the Republican-controlled legislature — including its tax and spending policies — have made the state more attractive to job creators and are strengthening Kentucky’s economy, Petrie said. In 2017, the legislature weakened the power of labor unions by repealing the prevailing wage law and by making Kentucky a “right-to-work” state, meaning labor-management contracts can no longer require payment of union dues by workers who do not belong to the union.?

The COVID stimulus, Petrie said, “is not the singular effect of what’s happening in our revenues and our budget.”

Petrie also said, “There are a lot of safeguards built into what we’ve set up. … There is no set of circumstances under which some people will ever see that reducing taxes to constituents is a good thing. And I don’t need to convince them, nor do I seek to.”

But Rep. Lisa Willner, D-Louisville, says that the current budget is not meeting the needs of Kentucky families, and another income tax rate cut is bound to make the situation worse.

“The income tax was the most reliable and the biggest source of revenue for schools and all of so many other needs,” Willner said. “We already have a pretty fragile social safety net, and this rate cut will undermine our ability to fund those basic needs for years to come.”

Bailey said the pending income tax bill will permanently cut state revenue by about $650 million per year. “And no one has explained how they’re going to make up for the decline in revenue,” he said.

Moreover, Bailey’s nonprofit organization has long argued the income tax cuts are regressive. The savings from an income tax cut “go overwhelmingly to those people who need them the least,” according to an article posted on the group’s website last week. “Approximately two-thirds of income tax cuts in Kentucky flow to the wealthiest 20 percent of the people.”

More cuts to come?

HB 8 of 2022 has achieved its near-term goal of making Kentucky’s individual income tax rate more competitive with other states.

Osborne and Petrie each said in interviews that it is possible that both HB 8 conditions will be met at the end of the current fiscal year this summer and the 2026 General Assembly will be able to consider cutting the rate again — to 3%.

As for whether the rate will eventually fall to zero, Sen. Chris McDaniel, the Ryland Heights Republican who chairs the Senate budget committee, said the “solid and responsible” tax cutting process established by HB 8 will be the guide. “It’s hard to say.” McDaniel said. “We all realize that each half point we cut makes it just that much more difficult to cut the next half point.”

Petrie said, “Some said we could never flatten the tax. Some said we could never reduce the rate at all. Yes, we can get to zero as long as we stick with the budgeting philosophy of needs versus wants and we remember the proper role of state government being limited not unlimited.”