Tennessee tax system is hardly a perfect model

When discussing state tax reform, Kentucky executives and politicians often cite Tennessee as a model. But many people south of the state line would beg to differ.

What some tax reform advocates like about Tennessee is that it has no state income tax, which gives it a competitive advantage in attracting businesses and high-income workers. But Tennessee makes up for it with sky-high sales taxes.

While Kentuckians pay a 6 percent sales tax on most goods — and nothing on food — Tennesseans pay an average 9.35 percent in state and local sales tax on non-food items, the nation’s highest rate. Food is taxed at an average of 7.9 percent, the nation’s third-highest rate.

Taxing consumption more than income to spur economic growth makes sense philosophically. But things get complicated in the real world.

Tennessee’s tax system puts a greater share of the overall burden on poor and middle-class residents. High sales taxes also hurt small businesses and retailers, because Tennesseans often cross state lines or buy online.

Both Tennessee and Kentucky suffer from chronic budget shortfalls. They also spend less on health and social services than most other states do, which could help explain why both are in the bottom tier of state rankings of income, educational attainment and health.

The Tennessee General Assembly was concerned enough about the situation in 2002 to appoint the Tax Structure Study Commission. After two years of study, it recommended changing Tennessee’s tax system to be more like, well, Kentucky’s.

The commission recommended creating an income tax that would make it possible to lower Tennessee’s total sales tax rate to 6 percent, with food taxes falling to 4 percent. The income tax would have four tiers ranging from 3.5 percent to 6 percent, and families would not hit the top bracket until they made $100,000. (Kentucky’s income tax structure, a relic from the 1950s, tops out at 6 percent for people making more than $8,000 a year, which is virtually everyone.)

Like various tax reform plans in Kentucky, the Tennessee commission’s recommendations and similar proposals since then have gone nowhere politically. But they are worth keeping in mind, especially since Kentucky Senate President David Williams, who is running for governor against incumbent Steve Beshear, has Tennessee-style tax reform on his agenda.

Two state representatives — Democrat Jim Wayne of Louisville and Republican Bill Farmer of Lexington — have long proposed competing visions for Kentucky tax reform.

Wayne would recalibrate income tax brackets to reflect modern incomes. He also would tax some services used mostly by wealthy people. Farmer would eliminate most sales tax exemptions — except for food — and add taxes on most services.

He thinks that would generate enough revenue to lower the sales tax rate below 6 percent and eliminate the income tax. While in previous years Farmer estimated that could generate enough revenue to eliminate income taxes and lower the sales tax rate below 6 percent, the version of the bill he filed for this legislative session calls for raising the sales tax rate to 7 percent. (See followup blog post.)

The solution probably lies with some combination of those proposals, especially the ideas about taxing services, eliminating many exemptions and updating income tax brackets.

What Kentucky needs is an equitable, “business friendly” tax structure that promotes economic growth without shifting too much of the tax burden to poor and middle-income people; and one that provides enough tax revenue to meet Kentucky’s needs, even as the economy evolves. The devil, of course, is in the details.

As lawmakers consider tax reform, here are a few other things to think about:

■ Economists say Kentucky, compared to other states, under-taxes real estate. Low property taxes are a legacy of political pressure from property owners and 1979 legislation that capped annual property tax increases at 4 percent, despite the fact that property values have often risen much more than that.

■ Kentucky’s coal severance tax, which has been 4.5 percent for more than 30 years, is the lowest among major coal states. The tax is 5 percent in West Virginia and 7 percent in Wyoming. In addition, the citizens group Kentuckians For The Commonwealth estimates that Kentucky taxpayers provide more than $97 million in annual subsidies to the politically powerful coal industry.

■ Lawmakers have in recent years raised cigarette taxes from ridiculously low levels. But Kentucky’s 60-cent per pack tax is still less than half the national average of $1.45.

■ Kentucky’s tax code is riddled with exemptions, few of which have been analyzed to see if they provide any overall economic benefit to the state. A comprehensive analysis is long overdue.