Inflation is down by more than half of what it was last summer, unemployment remains surprisingly low, and the Federal Reserve opted not to raise interest rates earlier this month. Here in Kentucky, the state is expected to end the fiscal year with a billion-dollar surplus.
So the economy is doing great, right?
That depends. Inflation is still higher than consumers and economists would like, wage growth seems to have slowed, the Fed warns it still may raise borrowing rates, and some forecasters believe a downturn remains likely.
“We will hit a recession,” says Jason Bailey, executive director of the Kentucky Center for Economic Policy. “It’s a question of when, not a question of if.”
Bailey says America hasn’t seen these kinds of economic conditions – high inflation coupled with low unemployment – in five decades. He attributes the massive spike in inflation over the last two years to the double-whammy of the COVID-19 pandemic and the war in Ukraine. He says manufacturers and the global supply chains weren’t prepared for the sudden shift in demand from services to consumer goods when people isolated at home. As demand outpaced supply, prices increased. Some companies, according to Bailey, took advantage of the situation and padded their bottom lines by raising their prices even more.
John Garen, a professor emeritus at the University of Kentucky Gatton College of Business and Economics, says there was another, perhaps more important factor at play: The supply of money jumped when Congress approved multiple pandemic relief packages totaling some $6 trillion. As history shows, according to Garen, when there’s too much money chasing too few goods, inflation accelerates.
“The monetary theory of inflation has been around a long time and it works,” he says.
As the Fed raised interest rates and tightened the money supply, Garen says inflation has started to come down.
Bailey contends federal stimulus dollars didn’t cause inflation and says without that money the nation would have slipped into a depression. He argues inflation has decreased because manufacturing and supply chain issues have eased, allowing more goods to reach the market.
Employment and Wages
A goal of the Fed’s interest rate hikes is to slow down the economy by encouraging consumers to purchase less. But less demand for goods and services will likely also cause unemployment to increase.
So far, that hasn’t happened. Demand for labor has remained strong and workers have benefitted. Kentucky Chamber of Commerce President and CEO Ashli Watts says wages in the commonwealth have grown 6 percent in the past year across all sectors, with the mean hourly wage now at $25 an hour. She also says there are two open jobs for every one person seeking work.
“Employers are frankly pretty desperate for employees and they’re willing to pay more,” says Watts. “That kind of natural competition has driven up those wages.”
Demand is so strong that Watts says the Chamber is helping employers find workers in areas that have been under-utilized: retirees and individuals in recovery from addiction or recently released from prison.
Bailey is less sanguine about Kentucky’s workforce outlook. He says the fastest growing jobs are in the service sector, including fast food, hotels, retail, and elder and child care – jobs that traditionally aren’t unionized and don’t pay much. In fact, he says about 20 percent of jobs in Kentucky pay less than $15 an hour.
“We have a lot of jobs at the moment,” says Bailey. “We don’t have enough that pay a living wage.”
Another point of concern for the commonwealth is the workforce participation rate. For all Kentuckians 16 years of age and older, that rate is 57 percent. For those in the prime working ages of 25 - 54, the participation rate is 79 percent. Both of those numbers are below national averages, according to Watts, placing Kentucky in the bottom 10 of all states. Bailey says participation is actually above the national average in the state’s so-called Golden Triangle between Louisville, Lexington, and northern Kentucky. But he adds that it falls far below in rural areas that lack jobs, especially in eastern Kentucky.
Another issue affecting workforce participation is the state’s lack of affordable, quality child care. About half of Kentuckians live in child care deserts where the number of children needing daycare exceeds the capacity of existing providers. That makes it hard for working families to look after their children and hold jobs.
Bailey says that deficit could grow worse in the coming months as federal pandemic aid to child care centers ends. He says those dollars made it possible for centers to increase worker wages, improve facilities, and keep costs down for parents. Watts says the state now offers matching funds to companies that host employer-based child care sites, but Bailey says lawmakers must do more to help providers replace the lost federal moneys.
State Taxes and Budget
While these greater economic factors have played out, the General Assembly has pursued tax reforms that are shifting Kentucky from a reliance on income taxes to more consumption taxes. House Bill 8 in the 2022 legislative session created the framework to incrementally reduce the state’s individual income tax to zero as General Fund receipts and Budget Reserve Trust Fund balances hit certain milestones. That legislation added the state’s 6 percent sales tax to a wider range of goods and services to compensate for the reduced income tax receipts.
This year, the personal income tax rate dropped from 5 percent to 4.5 percent. As a result, state budget officials report that income tax revenues for the commonwealth this year have already fallen by $148 million.
“It should really not shock nor scare anyone that those numbers are going down,” says Watts. “It’s really going very much according to plan.”
Watts says income tax receipts are expected to decrease as the rate goes down. But she says that will be offset by higher sales tax revenues. Sales tax receipts have already increased by $40 million this year, according to state officials. Even with the lower income tax revenues this year, Watts says receipts for May still outpaced receipts for May of 2019, which she contends is a good sign.
But Bailey says income taxes are a fairer, more effective way of raising revenues for vital state services like infrastructure, public education, and health care. Consumption taxes, he contends, place more burden on low-income and working families. He fears the long-term implications of the tax shift, especially once the state no longer has pandemic relief dollars to bolster the Budget Reserve Trust Fund. Bailey says it’s troubling that state revenues have dropped while the national economy is so strong. If the U.S. does slide into recession, he says that would make it even harder for Kentucky to meet its revenue goals under the new tax system.
“The new sales tax on services is pennies, the reduction in the income tax rate is dollars. So what they’re doing is blowing a huge hole in the budget that’s not visible now because we have all this surplus revenue,” says Bailey. “The legislature is using a temporary opportunity to make permanent tax cuts… without any viable options to replace the revenue that we lost.”
Lawmakers in the Republican-controlled General Assembly have already tweaked the application of the state sales tax to help ensure it doesn’t become over-burdensome. Watts says legislators will continue to monitor that to make sure collections are adequate. Garen says such tweaks are common to tax overhauls.
“It’s hard to get this sweeping reform all at once,” says Garen. “Sometimes little by little is the way it goes.”
Kentucky’s individual income tax rate is already set to drop another half point to 4 percent next year. Further reductions are contingent on the state meeting the General Fund and Budget Reserve Trust Fund milestones mandated in HB 8.
“The triggers are really what makes the plan work – as long as long as they are adhered to,” says economics professor Chris Phillips of Somerset Community College.
Opponents of Kentucky’s tax overhaul point to how Kansas lawmakers had to reverse cuts they made to tax rates in their state after revenues dropped dangerously low. Phillips says Kentucky’s fiscal triggers should prevent that from happening here, but he says it still could happen if budget shortfalls became large enough.
Watts says Kentucky’s tax reforms have given the state a more competitive business climate and make sense for today’s service-oriented economy. But she adds that lawmakers need to guard against applying sales taxes in such a way as to hurt small businesses and service-based companies. She also says a complete elimination of the income tax in Kentucky may not be necessary.
“We could still be a really competitive state taxwise without getting to zero,” says Watts.
She says lowering the income tax to 3 percent combined with further reductions in business taxes and keeping the sales tax at 6 percent would make Kentucky very competitive.
