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Kentucky’s income tax will go down in 2023. Who does it help?

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In January, Kentuckians will start paying less in income taxes after the Republican-led Legislature passed a bill reducing rates from 5% to 4.5%. GOP leaders say they plan to cut the tax even further during next year’s lawmaking session, with hopes to totally eliminate the tax in the future.

Lawmakers voted to lower the income tax after the state brought in more tax revenue than expected in recent years, creating historic budget surpluses. But critics say the measure will blow a hole in the state’s revenue-generating mechanism and lead to higher sales taxes on essential items.

Rep. Steven Rudy, a Republican from Paducah who serves as House majority floor leader, says the policy will make the state more business friendly and encourage migration to the state.

“Everybody knows we need more workers and a greater population,” Rudy said. “You see most growth in the states that have low or no income tax, and that is our goal to get us to zero percent. But we can’t devastate the general funds or do it overnight, and that’s why a set of triggers have been set.”

Nine states have no income tax and two others will phase out the policy by 2025.

Kentucky lawmakers passed the income tax cut earlier this year, automatically reducing the rate to 4.5% starting Jan. 1, and allowing the Legislature to consider lowering it even further as long as the state continues to bring in more tax revenue each year.

Legislators paid for the cut, in part, by expanding the 6% sales tax to 35 previously untaxed services, ranging from cosmetic surgery to repairs on household items.

Jason Bailey, executive director of the progressive-leaning Kentucky Center for Economic Policy, called the move a “trickle-down fantasy.”

“The Legislature has two choices - either they slash spending and cut entire programs, or massively increase sales taxes on groceries. This would hurt low-income families, working class Kentuckians, the poor, seniors, but it would benefit the wealthy,” he said.

According to an official estimate, the bill will cost the state more than $1 billion every two-year budget cycle.

Critics say that money should go back into the state budget, restoring cuts made to public education and other services in the decade after the 2008 recession.

Democratic Rep. Josie Raymond from Louisville said the state should use the money to invest in social services.

“The great fear is that we will not have funds to fulfill the basic obligations of the government like public schools and Medicaid matches and prisons, police officers. It’s a real missed opportunity,” she said.

Rudy said the Legislature is ready to stop further cuts from taking place if another economic downturn takes place.

“We’ve built in a safety net, and it’s called having a savings account. We’re in a good place,” he said.

Kentucky currently has $2.7 billion in its Budget Reserve Trust Fund, more commonly known as the “rainy day” fund.

The state is projected to have another budget surplus this year.

Federal pandemic aid, record inflation boosted budget surplus

A massive influx of federal assistance during the coronavirus pandemic helped keep Kentucky’s economy afloat.

But the aid was temporary. And critics argue that as it phases out, the state won’t be able to rely on it to prop up the state budget.

Bailey said providing that aid helped the state maintain a healthy balance sheet.

“When people got those stimulus checks, expanded food assistance, they spent it in the economy, so that generated sales tax revenue which helped support employment. It had a multiplier effect over the whole economy,” he said.

Kentucky received about $2.4 billion from the American Rescue Plan Act of 2021, with an additional $1.6 billion going to city and county governments. Gov. Andy Beshear announced an additional $162 million in federal funding in June this year.

A large portion of the money was allocated for the state’s unemployment insurance program, drinking water and wastewater infrastructure projects.

But the money has to be allocated by the end of 2024 and spent by the end of 2026.

Bailey said lawmakers used federal funds as a short-term boost while offsetting revenue.

“Much of it has gone away, and will certainly go away in the next couple of years. To create a permanent tax reduction based on the fact that you have a one-time surplus through federal action is just ridiculous,” he said.

The Tennessee model

Republican lawmakers have justified the income tax cut by saying it will make the state more competitive with Tennessee, which has no income tax except for stock dividends and lending interest.

Rudy argues the move will help attract workers to the state.

“The shortage in teachers, in social workers is real, and part of it is because we don’t have enough people in Kentucky that are productive, working citizens, and that’s the goal of reducing the income tax – to get more people to move here,” he said.

But Tennessee also relies heavily on a 7% sales tax, and the lack of a broad-based income tax makes it the seventh most regressive revenue system in the country, according to the progressive Institute on Taxation and Economic Policy.

Raymond said there are other ways to increase workforce participation in Kentucky, like providing more protections for workers.

“We’ve seen in other states this rush to cut taxes in an ideological place that actually doesn’t play out as they promise with business and population growth. It’s very tricky. Let’s try offering paid leave instead and get native workers in Kentucky,” she said.

Kentucky’s next legislative session begins on Jan. 3.

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Divya is Kentucky Public Radio's Capitol Reporter. Email Divya at dkarthikeyan@lpm.org.