The Kentucky General Assembly once again faces a challenging budget session in which projected revenue cannot meet the rising costs of Medicaid, pension obligations, and jail crowding. As we saw during the 2018 legislative session, where the budget faced similar constraints, self-interested observers have begun digging for potential revenue options, usually in the hopes of keeping some other government program or loophole intact. Such attempts virtually never yield good tax policy.

Two years ago, the General Assembly responded to arguably an even more severe fiscal challenge by taking a holistic approach to tax policy, rather than a piecemeal one. This approach resulted in the most substantial update to Kentucky's tax code in more than eight decades, the largest jump in economic competitiveness in Kentucky history, and, ultimately, budget surpluses during the biennium.

The 2018 Tax Reform package shows the benefit of a holistic approach. It also provides a warning against shortcuts that will ultimately damage Kentucky's economy even if they provide short term revenue benefits. The conversation surrounding Kentucky's historical racing machines, on which some have suggested a more than doubling of the current tax rate, provides a perfect case study in which policymakers could make a decision that damages one of Kentucky's signature industries and has ripple effects across the state's economy.

What Impact Would Increasing the Tax on Instant Racing Have?

Proponents of increasing the tax on historical racing machines have suggested more than doubling the tax rate from 1.5% to 3.5% and have estimated that such an increase could equal $60 million in tax revenue for the state. Putting aside the minimal impact that this would have on the projected $1.8 billion shortfall in Kentucky's budget, such estimates have failed to properly account for the effects on historic wagering, the horse industry in Kentucky, and the state as a whole.

Are Potential Revenue Estimates Correct?

Research by the University of Louisville found that an increase in the tax on historical racing machines would not have a proportional increase in tax revenue, as such projections wrongfully suppose. In fact, because of the elasticity of demand between gaming and taxes, which is the subject of a great deal of literature, the proposed doubling could lead to a decrease in the overall handle by as much as 20 percent. However, revenue estimates referenced in media stories do not appear to have calculated for this economic reality and should, therefore, be treated with caution by lawmakers.

According to University of Louisville researchers looking at an estimate made by the Kentucky Center for Economic Policy, "an increase in the tax on instant wagering will raise more tax revenue, but not as much revenue as projected by KCEP if an assumption of proportional tax revenue increases are assumed. For the Fiscal Year 2019, which just ended June 30, 2019, KCEP estimates would project tax revenues of around $71 million on handle of slightly over $2 billion. Yet, using an elasticity of demand of 5, the tax collected would be more like $64 million on total handle of around $1.8 billion."

The researchers also noted that, "[a]t some point below a certain level of revenues, establishments will have to cut back operating hours or jobs as plunging revenues harm profitability."

Our calculations agree with these assessments, which assume a fairly conservative elasticity. A tax increase may lead to more revenue in the short term, but are far off from the estimates of $60 million in additional potential revenue some have proposed. Increases also carry high long term costs, including the loss of jobs and a decline in economic investment, which other estimates have not accounted for.

Historical Racing Machines Aren't Exactly Like Slot Machines-

Additionally, such a projection fails to account for the differences between traditional slot machines and the historic instant racing machines operating in Kentucky. Because machines in Kentucky operate through the pari-mutuel system, approximately 91.2 percent of every dollar put into a machine is returned to bettors in the form of winnings. Of the remaining dollars, 18 percent is paid in taxes, and approximately 13 percent is paid out in purses, equally an approximately effective tax rate above 31 percent. This rate is already higher than the effective tax rates on slot machines in Indiana and Missouri and nearly on par with Ohio and Illinois. To more than double the tax rate, as has been suggested, would equal an effective tax rate of 53 percent, surpassing West Virginia, Illinois, Ohio, Indiana, and Missouri, and rendering Kentucky completely uncompetitive.

When compared to individual casinos in neighboring states, the effective tax rate on Kentucky machines is already higher than many facilities Kentuckians might be familiar with. For example, Horseshoe Casino in Southern Indiana has an effective tax rate of 29.5 percent. Belterra Casino in Indiana has an effective rate of 26.12 percent. Harrah's Metropolis in Illinois, just a short drive from Paducah, only has an effective tax rate of 23.35 percent.

These rates are already favorable in the absence of an increase, meaning that such a change would lead to a rate that would significantly dwarf any regional competitor. Raising the tax on historical racing machines would, through uncompetitiveness and elastic demand, stifle the growth of Kentucky based facilities, ultimately placing limitations on revenue to the Commonwealth and provide a significant competitive advantage to neighboring states. The ripple effect on Kentucky's horse industry and economy would be even more significant.

Would a Tax Increase Hurt the Horse Industry?

Every metric indicates that a tax increase would significantly damage Kentucky's horse industry. This is particularly noteworthy at a time where the industry at large is vulnerable. Despite this, Kentucky has developed a revenue base that protects the horse industry and allows for economic growth.

Presently, the horse industry employs 80,000 people in Kentucky and contributes $1.6 billion to the state's GDP. The total indirect and induced effects of the horse industry are approximately $5.2 billion — nearly three percent of the state's entire GDP. The Kentucky Derby and Kentucky Oaks alone have an economic impact of more than $350 million a year for the Commonwealth. The Breeders Cup, which will take place at Keeneland in Lexington, Kentucky in 2020, will bring an estimated economic impact of more than $70 million.

Historic racing is allowing this impact to grow. During the 2019 Spring Meet, at Churchill Downs alone, purse sizes increased by 45 percent, including a $1 million increase in the Kentucky Derby purse which helps ensure it remains America's most prestigious race, all of which led to larger average field sizes (8.4 in 2019 vs. 7.6 in 2018) and an astonishing 14 percent increase in the overall handle. An increased handle, meaning more people placed bets on Kentucky races, means more tax revenue. The larger fields mean more trainers, breeders, and owners investing in Kentucky, more Kentucky bred yearlings being sold and far-reaching economic benefits from the industry itself, real estate, retail, legal services, and beyond.

It is too soon to gauge the full impact that historic racing machines will have, but the early indicators are arguably the most positive development for Kentucky's horse racing industry in a generation.

So, What Should Lawmakers Do?

The horse industry is central to Kentucky's economy and Kentucky's culture. It is estimated that one in every three Kentuckians is engaged with horse racing either as owners, participants, or spectators. Increasing taxes on the industry will have disastrous economic implications, which cannot be justified by the relatively small revenue available from such a change.

The 2018 tax reform package, which was expanded upon during the 2019 legislative session, provides a positive blueprint for tackling Kentucky's pressing fiscal challenges. Lawmakers should seek tax changes that evenly distribute the tax burden through the lowest possible rates on the broadest possible base, and pursue tax policies that do the least amount of harm to Kentucky's economy. Proposals to increase taxes on historical racing machines are economically misguided and fail to achieve this ambition.

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