Kentucky’s Tax Cut Dilemma: Will Declining Revenue Spark a Crisis?
Despite a looming decline in state tax revenues, Republican leaders in Kentucky are doubling down on their push to slash income taxes.
Kentucky Senate President Robert Stivers made headlines this Saturday by declaring that the Republican supermajority’s top priority for the upcoming legislative session is to lower the individual income tax rate from 4% to an enticing 3.5%. This bold initiative was shared during his address at the Kentucky Farm Bureau’s annual meeting, underscoring a commitment to financial relief for hardworking Kentuckians.
Recent forecasts indicate that Kentucky’s general fund revenue is expected to take a hit, plunging by $213 million, or 1.4%, in fiscal year 2025. This gloomy outlook was outlined in a quarterly report released by the state budget director’s office on November 21.
This decline marks only the fourth instance in the last half-century where general fund revenue has dropped year over year, a stark contrast to data from Jason Bailey, executive director of the Kentucky Center for Economic Policy. The previous declines occurred in 2001 and twice during the turbulent years following the 2008 Great Recession.
What’s behind this shift? Following a period of robust state revenues fueled by pandemic relief funds, many states, including Kentucky, now face the reality of shrinking incomes as the government’s stimulus spending comes to an end.
According to a Pew research brief, the surge in state tax revenues saw an unexpected reversal a couple of years back. The brief noted that “annual inflation-adjusted state tax revenue fell in fiscal year 2023 from the prior year — marking the first time in over 40 years that real revenue has dropped outside of a recession.” This trend is echoed across more than three dozen states, with California experiencing particularly steep declines.
In light of these projections, state policymakers have been cautious, opting for temporary tax cuts and non-recurring expenditures instead of long-term commitments. Yet, Kentucky has chosen a different path, implementing permanent cuts to the individual income tax in both 2022 and 2023.
The budget director’s report attributes the majority of its revenue forecast reduction to upcoming tax credits set to take effect in 2025, stemming from a new pass-through tax paid in 2024. This misalignment has inflated FY24 collections, while expected FY25 revenues will take a significant hit.
In fiscal year 2024, Kentucky collected $15.571 billion in general fund revenue, but projections indicate a drop to $15.358 billion in the current fiscal year, with further reductions expected for 2025 that fall short of the state budget estimates.
The latest report indicates a modest 1.3% increase in general fund revenue collections during the first quarter. However, this growth was largely due to a spike in corporate income tax, which surged by $266.6 million, only to be nearly wiped out by a corresponding decline in individual income tax revenue.
While corporate tax contributions can be unpredictable, revenue from the state sales tax has seen a steady rise of 1.3%, reaching $1.5 billion in the first quarter of fiscal 2025. This uptick follows the 2022 legislative decision to expand the sales tax to include more services, a move designed to help offset the income tax cuts.
Senate budget committee Chair Chris McDaniel expressed cautious optimism regarding the anticipated revenue decline, labeling it as manageable. He reaffirmed the legislature’s commitment to enabling Kentuckians to keep more of their hard-earned dollars by advocating for an early 2025 bill to lower the individual income tax rate to 3.5%.
“We will closely track the latest revenue projections, but rest assured, we’ve crafted a conservative budget that can accommodate this planned tax reduction without jeopardizing fiscal integrity,” McDaniel stated. “This reduction would take effect in January 2026, ensuring it does not impact FY 2025 or the first half of FY 2026.”
Stivers also highlighted the “guardrails” established in the 2022 law, which set crucial fiscal benchmarks before the legislature can approve another half-percent reduction in income tax.
However, critics like Bailey argue that the legislature manipulated the guardrails by excluding billions of dollars in one-time spending from the fiscal benchmark calculations.
With his organization opposing the tax cuts, Bailey warns, “Reducing our most productive revenue source inevitably leads to a funding shortfall for essential services like education, healthcare, and public worker salaries.”
“No one has clearly articulated how they plan to compensate for the anticipated revenue decline,” he added, raising alarm bells about the financial future of vital public services.
While some in Kentucky’s Chamber of Commerce advocate for the gradual elimination of the state’s income tax, House Speaker David Osborne has cautioned against the feasibility of completely abolishing it without significant increases in the state sales tax.
Governor Andy Beshear, who vetoed the income tax cut bill in 2022, ultimately signed it in 2023 amid his reelection campaign, albeit with reservations about the legislature’s priorities, suggesting that lowering sales tax would have benefited more Kentuckians.
