The1st meeting of the Interim Joint Committee on Appropriations and Revenue was held on Tuesday, July 16, 2002, at 10:00 a.m., in Room 131 of the Capitol Annex. Senator Richard Sanders, Jr., Chair, called the meeting to order, and the secretary called the roll.
Members:Senator Richard Sanders, Jr., Co-Chair; Representative Harry Moberly, Jr., Co-Chair; Senators Brett Guthrie, Daniel Kelly, Alice Kerr, Robert Leeper, Vernie McGaha, Ed Miller, R.J. Palmer II, Dan Seum, Robert Stivers, Johnny Ray Turner, and Jack Westwood; Representatives Royce Adams, Rocky Adkins, Joe Barrows, Dwight Butler, Mike Cherry, Larry Clark, Jesse Crenshaw, Robert Damron, Bob DeWeese, Bob Heleringer, Joni Jenkins, Jimmie Lee, Mary Lou Marzian, Thomas McKee, Lonnie Napier, Fred Nesler, Charles Siler, Mark Treesh, Jim Wayne, Robin L. Webb, and Rob Wilkey.
Guests Appearing Before the Committee: Dr. Merl Hackbart, Member of Consensus Forecasting Group and Professor of Finance and Public Administration, University of Kentucky; Dr. Mark Berger, Member of Consensus Forecasting Group and Professor of Economics and Director of CBER, University of Kentucky; Manoj Shanker, Economist, Governor's Office for Economic Analysis; and John Scott, Tax Consultant, Governor's Office for Economic Analysis.
Guests: Tony Sholar, KY Chamber of Commerce; Eric Gregory, East KY Power Co-op; Lyle D. Cobb, STC; Judy Campbell, DPA; Mike Rodman and Wayne Johnson, KAHCF; Crystal Moore; NREPC; Bill Caylor, KY Coal Association; Marcia Morgan and Ann Gordon, CHS; Jack Couch, KY ADDS; Gary S. Cox, AIKCU; Darroll Hawkins, Louisville; and Randy Smith, PAC.
LRC Staff: Louis Pierce, Susan Viers Wobbe, and Kathy King.
Chairman Sanders asked members to take note regarding interim budget adjustments. He said he and Chairman Moberly agree that since there is not a budget in place that the committee cannot take any action on spending changes. He said the committee appreciates the information from the Executive Branch and asks to be kept informed in the manner, and on the schedule, normally followed for changes in appropriations and allotments.
Chairman Sanders recognized Dr. Merl Hackbart, Dr. Mark Berger, Manoj Shanker, and John Scott for reports on the national economy, Kentucky's economy, the performance of other state economies, and Kentucky's revenue receipts for FY 2002.
Dr. Hackbart said the national economy experienced unprecedented economic growth for a decade until the last two years. An economic recession, fluctuating stock market, and unforeseen shock effects have created instability and uncertainty and an environment where consumers are uncertain about their future. Businesses are also reluctant to invest until the future becomes clearer and the direction of the economy becomes more certain.
Dr. Berger said trends in the national economy over the last 12 fiscal years show that the U.S. experienced a recession in 1991, and in that entire fiscal year, there was no growth in real gross domestic product (GDP) adjusted for inflation. During the remainder of the 1990s, however, there was record-setting growth and expansion. The U.S. economy is now in another recession. Even though there was sizable GDP growth in the first quarter of this year, there was only about one percent growth over the entire year. Unemployment continued to rise after the 1991 recession and did not level off until 1993, so there is reason to believe that this trend is likely to occur when the current recession begins to recover.
Dr. Berger said U.S. industrial production was growing month-to-month from January 1998 until January 2001, when it started declining. The biggest rate of decline was around the September 11th incident. Although the rate of decline has slowed, it is still continuing to decline. Dr. Berger said industrial production growth is particularly important to Kentucky because of Kentucky's economic dependency on the manufacturing industry. Even though the decline has slowed, recovery is still very unstable due to consumer confidence. Some economic forecasters are predicting recovery for the 4th quarter of this year, but others are predicting that it may extend into next year. The stock market is a prime indicator of consumer confidence. NASDAQ peaked on March 10, 2000, which was at the very beginning stages of what we now know to be an economic downturn. Yesterday, NASDAQ hit a five-year low and was a little lower than what it was in September of last year. Indicators like the stock market determine consumer confidence, and businesses react in the same way.
Dr. Berger said the Consensus Forecasting Group met in January 2000 to make its forecast for FY 2002. The "Group" forecasted U.S. real GDP growth at 3.1 percent. Consumer confidence was still high at that time, but the "Group" felt that expansion was quite mature and could not continue at the same rate as it had been doing in the 1990s. The 3.1 percent growth rate was considered to be a very conservative estimate. Employment growth was forecasted at 1.2 percent for the U.S. and 1.9 percent for Kentucky, which again was lower than the growth rates experienced in the late 1990's. Because the state revenue forecast is based on the national economy, the Consensus Forecasting Group has had to make two downward revisions to its forecast since the January 2000 forecast.
Dr. Berger said the latest estimates are based on June 2002 numbers because all of the numbers are not in for FY 2002. The U.S. real GDP is 1.1 percent and growth in the employment rate for Kentucky is 0.1 percent; however, many of those jobs are in retail because of the decline in industrial production.
Mr. Shanker said economists look at the national economy to get signals that affect the state economy. When the Consensus Forecasting Group met in January 2000, the national economy was doing well, but the Kentucky forecasters agreed on a more conservative estimate at that time because they did not believe that the economy could continue to sustain the same kind of growth. Two broad indicators that economists always look at are personal income and nonagricultural employment. Following the 1991 recession, national data showed that Kentucky out-performed the national economy in personal income over the next five years. Mr. Shanker said the data was misleading because large, heavily populated states like California and New York were not doing well in personal income, and their lack of growth kept the national average down. From 1998 onwards, the national economy out-performed the Kentucky economy. The most recent data from the federal Bureau of Economic Analysis shows once again that Kentucky outperformed the U.S. economy in 2002. Economists and forecasters monitoring Kentucky's revenues and employment are skeptical of this data.
Mr. Shanker said nonagricultural employment is slightly more stable and easier to forecast because the data is not contaminated. In the 1991 recession, Kentucky had fairly strong growth in nonagricultural employment. In FY 2002, Kentucky just brushed by the zero mark while the national economy dipped just below zero. Kentucky did fairly well in retail sales and services, but most of Kentucky's personal income is from manufacturing employment and manufacturing employment has dipped significantly in 2002. Mr. Shanker said Kentucky's manufacturing employment has 28 percent more manufacturing concentration than the U.S. manufacturing economy. In the 1991 recession, Kentucky experienced only a slight decline of 0.8 percent in manufacturing employment. In 2002, it is down 5 percent.
Dr. Hackbart said U.S. Treasury receipts in FY 2002 are projected to be six percent, or $124 billion less than in 2001. Individual income tax filings are down $80 billion in FY 2002, but federal refunds are up by 23 percent. The total federal deficit for FY 2002 is now estimated to be $165 billion. This is the first time that the federal budget growth has turned negative since 1955. Other states, as well as Kentucky, are experiencing revenue shortfalls. Two weeks ago, 40 states had reported revenue shortfalls and had overestimated their revenues based upon the projected performance of the national economy and the performance of their own state economies. In the last two weeks, the number of states reporting revenue shortfalls has climbed to 45.
Senator Kelly said the data from June 2002 shows that Kentucky's personal income grew by 4.6 percent. The January 2002 data shows a 2.6 percent growth in personal income. He said this data does not appear to be correct. Mr. Shanker said national data is allocated to the states beginning with the larger states, and it is believed that the 4.6 percent estimate for Kentucky is incorrect. He said his office is checking into this anomaly further.
Dr. Hackbart said the total revenue shortfall for all states is currently estimated to be $50 billion. In 1992, the total shortfall for all states was $8 billion so the magnitude of this shortfall across the country is tremendous. California has a $23.6 billion budget gap, which is almost one-third of their state revenues. The recession has hit the states most severely with the income tax, which mirrors what is occurring at the federal level. States are dealing with their revenue shortfalls with budget cuts as well as revenue enhancements. The Federation of Tax Administrators did a survey of states to find out the most recent observations of their revenue performance. Twenty-nine states responded to the survey indicating that May collections across the country dropped by 13.6 percent. In the three-month period prior to May, collections fell by 14.3 percent. Most of the decline is in individual income tax collections, which was down 30.8 percent in May 2002, and down 28.4 percent for the three-month period. Individual withholding also declined by two percent, and sales tax receipts dropped by 0.4 percent. States are dealing with these revenue shortfalls in a variety of ways. Thirty states have raised cigarette taxes; 22 states used their rainy day funds; Wisconsin and other states borrowed from their tobacco litigation money; Minnesota closed its budget gap by delaying state aid to schools for a few weeks; and North Carolina borrowed $150 million from its $300 million hurricane fund. Dr. Hackbart said states have had to be innovative because the shortfalls have occurred in the last six months so the remedies are fewer than if they had had recognizable shortfalls earlier in the fiscal year.
Dr. Hackbart said 28 states reduced their budgets in 1991, because of that economic recession. Even though that year marked the recession's end, recovery in the states lagged behind, and in 1992, 35 states were forced to cut their budgets. Recovery depends on employment and it takes a while for businesses and corporations to reestablish their workforce until they are confident that the economy has recovered. Also, corporate tax receipts are delayed after a recession. A recent national study of states through recessions indicates that it takes states 12 to 18 months to recover after a recession is officially over. Dr. Hackbart said the fiscal impact of this current downturn is much more severe than the downturn of the early 1990s.
Representative Heleringer said all discussion has centered around states that are having budget shortfalls. He asked what the states without budget shortfalls did to avoid being impacted. Dr. Hackbart said the question raised has not been looked at in detail and requires further study. He said one explanation may be that the state has an energy sector, such as oil or gas, which would provide some stability. Another factor might be the tax and revenue structure that the state has in place.
Chairman Sanders asked if Texas has been added to the list. Dr. Hackbart said, "Yes." He said it was just recently announced at the National Governor's Association meeting that five additional states began experiencing revenue shortfalls during this last month. He said the number keeps growing because many states did not have a budget shortfall until the last part of this fiscal year.
Mr. John Scott said Kentucky has experienced a 1.4 percent decline in General Fund revenues for FY 2002. The last time Kentucky saw a decline in General Fund revenues was in 1954. There was a significant decline in individual income taxes because Kentucky paid more out in refunds and received less in pay returns. Withholding accounts declined slightly but the bulk of the shift was at the end of the year. Corporate income and license taxes had a significant drop of 25.7 percent. Mr. Scott said there was a decline in declaration payments from corporations and an increase in refund requests from corporations. He said corporations pay taxes by declaration payments, or by actually paying the money in, and that was reduced significantly because corporate profits were lower. Also, when corporate profits are lower, the corporation can file for a refund of taxes previously paid based on the net operating loss carry-back. Corporate net collections are the lowest since 1984. The other large tax is the sales and use tax and it did not decline. Its growth was smaller than what was expected but it was a steadying influence on the General Fund.
Representative Clark asked if LLCs are having any effect on the net collection of corporate income and licensing taxes. Mr. Scott said corporate taxes have dropped significantly and a substantial number of corporations have shifted to LLC status. An LLC does not pay corporate income tax, or a corporate license tax because it is no longer technically a corporation. He said the Finance Cabinet has been working with the Revenue Cabinet to collect data on the LLC phenomena.
Chairman Sanders said the recent tax study done by Dr. Bill Fox reports that Kentucky's nexus standard is outdated, and that corporations are paying taxes, but they are paying them in other states from business transactions conducted in Kentucky. He asked if Kentucky's nexus law has an impact on Kentucky's corporate tax collections. Mr. Scott said Kentucky has had the same nexus standard in place for quite some time and there is no doubt that it depresses year-to-year corporate tax collections compared to other states. Kentucky is the only state that requires a corporation to have physical presence in the state to collect corporate taxes. In most other states, the corporation is taxable if it derives income from that state.
Chairman Sanders asked why Kentucky has a June date for declaration of payments from corporations. Mr. Scott said the date has been in place for 40 years, or more. The rationale may be that it is easier for a corporation to calculate what it owes by June. In Kentucky, corporations pay one-half of expected declarations in June, and 25 percent in each of the following quarters. At the federal level, corporations pay four times.
Representative Treesh said the corporate income tax has a much smaller base. It is about one-seventh of the amount collected on either the sales tax, or the individual income tax so the same dollar difference is going to have a lot higher percentage difference. For example, a $10 million decrease will be a higher percentage of corporate income tax then it would be for the sales and use tax because the smaller base distorts the figures. Mr. Scott said the base does have an impact. The dollars are different but the percentage is larger. If a large corporation shifts from C-corporation status to LLC status, it changes the way their taxable income is calculated.
Representative Treesh said that when a company shifts from being a corporation to an LLC, it becomes nontaxable as a corporation, but it is still taxed as individual income. Qualifying corporations have the choice to be S-Corporations, which are pass-through entities, and the income that would otherwise be taxed as corporate income would pass to the individuals.
Representative Treesh said if Kentucky imposes the corporate license tax on LLCs, the fiscal impact would only be $1 million to $2 million so it is not just the license tax relying on the income tax return, it is the apportionment formula. Mr. Scott said that is correct. He said large corporations have competent tax counsel to tell them how to reduce their tax burden.
Representative Damron asked if there are certain corporations that pay the majority of the corporate income tax. Mr. Scott said the largest corporations do pay a disproportionately large amount of the corporate tax. Representative Damron said the committee needs more information before it starts modifying tax policy on the corporate community. Corporate profits are down and it is reflected in the stock market. He said it would be helpful to know the losses of the top 50 to 100 corporations that pay corporate income taxes and then factor that loss out to learn who is responsible for the decline in corporate taxes.
Representative Barrows said it is understandable that corporate license and income taxes have dropped for this year and last year, but they have been dropping for the last ten years during the best of economic times. He said there is something fundamentally wrong with this resource base. When the economy was good, corporations evidently did not pay their fair share, and now that the economy is bad, they can take advantage of the system through the loss carryback provision. Mr. Scott said corporate tax laws were adjusted and the rates were changed in the early 1990s to encourage corporations to contribute more to the KERA initiative. Corporate tax receipts went up the first year but have dropped downward ever since.
Dr. Hackbart said corporate income tax receipts alone were around $340 million in 1990-91. That number has dropped to just a little over $200 million for corporate income tax this year. Representative Barrows said corporate tax receipts have not reflected the good times. In 1985, the business corporate community promised to help support Martha Layne Collins' education reform. Corporate tax law changes were made at that time, but the support never reached the level of commitment.
Mr. Scott said revenue receipts are also down in the "other" account, which is primarily from declines in investment income, severance taxes on natural gas, and in some of the fees that are collected, such as court fees.
Mr. Scott said the Road Fund did not do well in the first year of the biennium, but it has done well in FY 2002. The motor vehicle use tax, which is the tax paid on a car, increased 8.2 percent in 2002. The motor fuels tax, or gasoline tax, posted a 5.1 percent increase. Overall, the Road Fund is up 5.2 percent for 2002.
Mr. Scott said the Consensus Forecasting Group made its forecast in January 2000, two and one-half years before the end of this current 2002 fiscal year. Nothing at that time indicated what the economy, or nation would go through in the next two years. Nearly every state has significantly overestimated, or found that their revenues underperformed their expectations. For Kentucky, the General Fund has underperformed the original estimate by 8.7 percent. The top three major taxes declined by significant percentages. The sales tax and the individual income tax are almost ten percent less than originally estimated, and the corporation income and license tax is 27 to 28 percent less than originally forecasted. The smaller taxes only had very small increases, and the coal severance tax is already seeing a decline and will probably drop back into a deficit situation within the next month or two.
Senator Kelly said there is $155.3 million less in receipts than what was presented to this committee in January 2002. He asked if the Consensus Forecasting Group will have to revise the base downward for FY 2003-2004, if the expenditures come in greater than anticipated. Mr. Scott said, "Yes." He said the Consensus Forecasting Group bases its forecast on actual dollars received, as well as national and state economic trends. If the economy is brighter or dimmer, they are both applied to the base. Dr. Hackbart said the economic forecast depends on the base of the previous fiscal year, economic factors and changes in tax structure, and the impact on the projected growth rate for the next fiscal year, or for the next biennium, depending on when the forecast is undertaken. The base will be analyzed to see if there are any adjustments to be made. The projected growth rate, which was around 3.3 percent for 2003, will have to be analyzed to see if that rate is still applicable, and even though the base will be solid, the growth rate could go up or down depending on national and state economic recovery. Dr. Hackbart said one of the most difficult issues is predicting when economic recovery will take place.
Senator Kelly asked when the Consensus Forecasting Group will make its next official forecast. Dr. Hackbart said he did not know. He said normally the Consensus Forecasting Group meets two or three months after the fiscal year has started to see how the economy and revenues are performing before estimating the projected growth rate for a forecasting period.
Senator Stivers asked how the Consensus Forecasting Group reached a 3.3 percent growth rate for 2003. Dr. Hackbart said the 3.3 percent growth rate was based on a growth rate of about 4.1 percent. Senator Stivers asked if it is likely that the projections for growth will be decreased.. Dr. Hackbart said the economy and consumer confidence are critical factors when projecting growth. In the past, Kentucky's economy and revenues had rapid growth coming out of a recession. In some circumstances, there were growth rates of 5.5 percent because of the demand for business services and housing. In this recession, the housing market has been very good, and new housing starts have been very strong. All of these factors need to be analyzed to determine when recovery will take place and whether it is a rapid recovery, or a more prolonged slow-growth recovery.
Senator Stivers asked if there is enough information to know if the growth rate will increase, or decrease. Dr. Hackbart said new, national economic forecasts will come out soon and it will be interesting to have their perspective on the strength of the recovery and to see how they have factored in recent economic changes, corporate investment plans, and consumer confidence. Once that information is available, forecasters can begin to try to analyze the impact of those national trends on Kentucky's economy. Dr. Hackbart said, historically, a 3.2 percent growth is a slow recovery so the growth rate probably will not change that much.
Chairman Sanders asked what a one percent growth rate would generate. Dr. Hackbart said it would be $65 million.
Chairman Sanders asked what the General Fund growth rate would have to be to meet the original forecast. Dr. Hackbart said it would need to be about 5.2 percent, or in that range.
Chairman Sanders said the 2000 forecast predicted investment income in the Road Fund at $16 million, but it is $32.2 million. Mr. Scott said Road Fund balances were quite large and the Cabinet is actively trying to spend them down. He said it takes time to bring a project on line, get it approved and then completed, and then make the pay out. As a result, balances have stayed larger than expected for longer than expected.
Secretary Dana Mayton and Charlotte Quarles, from the Revenue Cabinet, explained Administrative Regulation 103 KAR 1:050. Secretary Mayton said the Administrative Regulation deals with language in the statute that allows the cabinet to put all of its forms in one place in a forms manual and then to incorporate that by reference in the regulation. Secretary Mayton said taxpayers have access to the absolute latest version of any form. Chairman Sanders called for a motion to approve Administrative Regulation 103 KAR 1:050. The motion to approve was made by Representative Lee and seconded by Representative Siler, and the motion was approved by voice vote without objection.
With no further business, the meeting was adjourned at 11:38 a.m.