By many economic indicators, Kentucky emerged from the fiscal turmoil caused by COVID-19 pandemic in surprisingly good condition. Job growth continues, unemployment remains low, wages have increased for many, and the state has a budget surplus and healthy Rainy Day Fund.
“The way I like to describe Kentucky’s economy right now is essentially, it’s showing signs of normalization,” says Charles Aull of the Kentucky Chamber Center for Policy and Research.
Inflation remains higher than many would like, though, which could cause the Federal Reserve to raise interest rates once again. As the cost to borrow money goes up, the thinking goes, the economy should cool and inflation decline. But that could also bring an increase in unemployment. Aull contends the rate hikes so far have lowered inflation without dramatic impacts to employment or overall economic growth.
“Those are good indicators that we could be on the path to that type of soft landing where we maintain low unemployment while at the same time accomplishing our goal of lowering inflation,” says Aull.
Current interest rates, which are running about 5.5 percent, are at their highest in two decades. Jason Bailey of the Kentucky Center for Economic Policy fears further increases would bring negative consequences.
“The concern is that the Federal Reserve will act too quickly in raising interest rates and increasing the cost of borrowing and potentially push us into slower growth and get off that full employment path,” says Bailey. “That would be a bad track when we’re just now starting to see the benefits.”
Even as the state and nation enjoy a robust economy, the same isn’t necessarily true when you drill down to local and regional levels, according to state Sen. Chris McDaniel (R-Ryland Heights), the chair of the Senate Appropriations and Revenue Committee.
“Unfortunately, we kind of have a tale of two economies,” he says. “We still continue to see very troubling difficulties over in Appalachia. They are not enjoying a lot of the same benefits the balance of Kentucky has seen.”
The decline of the coal industry and related businesses continues to plague mountain communities. Devastating flooding last year added more hardship to an already struggling region.
“There are pockets that are really suffering,” says state Sen. Robin Webb (D-Grayson).
“The people are hungry for growth and to get their share of the pie back.”
Even though the state as a whole enjoys a low unemployment rate – about 4 percent as of August – Aull says Kentucky’s workforce participation rate remains stubbornly low at 57.6 percent. That places the commonwealth in the bottom 10 of all states for labor participation. Aull says Kentucky must take steps to move people back into the labor force and address the fact that the pool of workers between 25 to 54 years old is not growing.
Bailey contends the workforce participation rate is overemphasized. He says every Kentuckian not working in the commonwealth is either a student, a caregiver for family members, or is disabled. He argues that a closer look at the statistics indicates the state is on par with national averages for labor participation except for eastern Kentucky.
“It’s not there are all these job openings that people want to apply for,” says Bailey. “There are not job openings in that part of the state, so we need to talk about job creation.”
One thing that would help Appalachian communities, according to Bailey, is for the state to provide matching funds for federal infrastructure projects planned for the region. He contends that would help spur job growth there. Webb says low-paying service jobs aren’t enough to revive the revive the region’s economy. She says eastern Kentucky needs more development projects as well as job retraining programs around broadband internet opportunities.
McDaniel says job growth in eastern Kentucky and other struggling communities will continue to be a priority for legislators.
“The success or failure of any given region... ultimately impacts the balance of the commonwealth,” says McDaniel.
The March to Eliminate the State Income Tax
Thanks to House Bill 8 from the 2022 General Assembly session, Kentucky’s individual income tax rate is set to drop to 4 percent next year.
“By the end of 2024, these tax changes that we’ve put into place will have saved working Kentucky families over $1.8 billion,” says McDaniel. “That’s dollars going directly into Kentuckians’ pockets that they can choose to spend however they see fit.”
But a further half-percent decrease will not follow in 2025 because the state failed to meet both of the triggers that lawmakers built into HB 8 to protect Kentucky’s fiscal health. Those triggers require the state to have a Budget Reserve Trust Fund balance that is at least 10 percent of General Fund revenues. The state met that goal for 2025, according to state budget officials, but failed on the second metric of having General Fund revenues exceed appropriations plus the cost of a 1 percent cut in the income tax.
The goal of Republicans in Frankfort is to eventually eliminate the state income tax, which they argue will spur people and businesses to relocate to Kentucky. Aull says under the graduated approach implemented by lawmakers, the reduction would take at least 10 years, depending on how well the state meets the revenue triggers.
“We’re doing this very carefully, very diligently, and in a way that will ensure that we’re able to continue investing in key services while also slowly reducing the individual income tax rate,” says Aull. “This is something folks are going to have to accept will take time and that’s going to require a lot of patience.”
But even with this slow approach, opponents argue the state can’t afford to eliminate the income tax and replace it with more sales taxes, which they say disproportionately impacts poor and working-class families. Webb says she believes a more diversified tax portfolio is a wiser choice for generating state revenues.
“Even though I’m for cutting taxes, and the incremental plan might work, I still fear total elimination (of the income tax),” says Webb. “The revenue’s got to come from somewhere.”
The Kentucky plan is often compared to income tax cuts in Kansas. But both Bailey and Aull say what happened in Kentucky is different. Aull says Kansas lawmakers cut their tax too quickly. That ultimately forced legislators there to reverse course when state revenues collapsed.
Bailey says Kansas also implemented their plan during an economic downturn, which further exacerbated their revenue losses. On the other hand, Bailey says Kentucky implemented its tax cut when the commonwealth was flush with federal pandemic relief dollars. He says those surpluses have helped fund the tax cuts – for now.
“Folks who want to move down the path of a zero income tax have presented no plan or no option to replace nearly half of our state budget,” says Bailey. “It’s a very dangerous path to go on.”
Since income taxes comprise 41 percent of state revenues, Bailey says the only way the state can account for the loss of those dollars, especially in the event of an economic downturn, is to more than double the state sales tax. The other option, he says, would be dramatic cuts to government spending on crucial programs like public education, infrastructure, and health care.
“We have to have this diversified tax system, including an income tax, if we hope to have a chance at investing in the things that do create a thriving economy,” says Bailey. “There are a lot of good things that we’re just not going to be able to fund if we give away our best source of revenue.”
Finally, Bailey says the states that have the highest top income tax rate on wealthy individuals are faring better than states with no income tax. But McDaniel contends that raising taxes on entrepreneurs and job creators is counterproductive.
“The states that have decided to impose tax on their highest-income earners have also seen a tremendous flight of those high-income earners from their states,” says McDaniel.
The senator argues that the gradual drop in income tax revenues will be offset by economic and population growth the tax cuts will foster. Despite the failure to meet the tax cut triggers for a further reduction in 2025, McDaniel says he sees no push among lawmakers to override the criteria set in HB 8 and let the rate continue to drop.
Public School Funding Struggles to Stay Ahead of Inflation
Republican legislative leaders have touted record levels of per-pupil funding allocated to Kentucky’s public schools through what’s known as the SEEK formula. But education advocates say school appropriations haven’t kept up with inflation, and lawmakers have also failed to adequately fund student transportation costs.
That’s created a funding gap of nearly $4,000 per student between the state’s poorest and wealthiest school districts, according to a recent report from the Kentucky Center for Economic Policy. That report indicates the deficit is larger now than it was in 1980s, when a landmark lawsuit forced legislators to equalize school funding across the state. The result of that landmark court decision was the 1990 Kentucky Education Reform Act.
Bailey says public school transportation costs, which the legislature is required by state law to fully fund, hasn’t been at 100 percent since 2005. He says SEEK funding has struggled to keep pace with inflation over that same time period.
“The SEEK formula works if you fund it. But if you don’t fund it, then these inequities form,” says Bailey.
McDaniel says many people are unhappy with SEEK but he says lawmakers continue to abide by the per-pupil calculation.
“It’s a formula the General Assembly has followed with great precision over the last 30 years,” he says. “For right now I think that it’s doing what it’s intended to do.”
But McDaniel adds that a legislative working group is reviewing the SEEK formula. If the school funding disparities continue, Webb says the state could face another lawsuit like the one in 1989 that led to KERA.
“Under present conditions, I’d anticipate another court challenge,” she says.
Public Employee Pay and Pension Benefits
In the current state budget, lawmakers provided public employees with an 8 percent pay raise for the last fiscal year. They also allocated money for an additional 12.5 percent increase in the new fiscal year. Instead of an across-the-board pay bump, McDaniel says that money will be allocated based on greatest need, such as job categories that demand higher salaries to be competitive, or for employees working in regions that have higher costs of living. He says lawmakers will decide on the new pay raises after reviewing the results of a compensation study conducted by the Kentucky Personnel Cabinet, which he says is due soon.
Meanwhile, retirees in the state’s public pension systems are seeking cost of living adjustments, which they haven’t had in a dozen years. McDaniel says the state’s pension plans are slowly recovering after years of underfunding and he says Republican leaders will continue to make full funding of those plans a priority. As for COLAs for retirees, he says lawmakers are considering how that could be implemented, such as a percentage increase, a one-time lump-sum payment, or based on certain criteria such as the retiree’s age.
