From Foresight, Vol. 8, No.3
published 2001
Demographers and budget analysts have been warning policymakers for years that the coming wave of retiring Baby Boomers will wash away projected budget surpluses and erode existing spending priorities. While expenditures for various entitlement programs are expected to increase dramatically, it is already estimated that over half of federal domestic spending outside of interest goes to people 65 and older.(1) Likewise, the revenue side of the ledger will be affected as an increasing percentage of the nation’s population reaches retirement age and becomes eligible for various tax breaks. While much has been written about this issue from a federal perspective, the impact at the state and local levels has not been studied as thoroughly.
It is clear, however, that state and local governments will be affected. For example, individuals over 65 years of age tend to spend less money in general and tend to concentrate more of their expenditures in nontaxed areas such as health care services. As a result, sales and use tax collections, which comprise around 33 percent of the state’s total general fund receipts, will be affected as the population ages.
Moreover, while many elderly will continue to work, they will get the bulk of their income from nontaxable (or virtually nontaxable) sources, like pensions and Social Security. This will affect future income and occupational tax collections, which comprise about 42 percent of the state’s general fund receipts and more than a quarter of local tax revenue, respectively.
Finally, the Homestead Exemption on real estate for the 2001 and 2002 tax years now exempts from taxation the first $26,800 of a property’s assessed value for property owners who are at least 65 years of age.(2) The property tax is the main source of local tax revenue in Kentucky, accounting for nearly 54 percent of local tax revenue in 1999. As the Homestead Exemption shields some property owners from taxation, it exposes others to potentially higher levels of taxation and under some circumstances could lower total property tax receipts.
In the sections that follow, we briefly examine the demographic data on Kentucky’s aging population and then discuss in detail how the income, occupational, sales, and property tax could be affected. We conclude with a discussion of how future expenditures might be impacted.
There are at least two important factors regarding the manner in which Kentucky’s population is aging. First, Kentucky’s population is aging faster than most. Second, some regions of the state will have a much higher concentration of elderly than others. In short, the much-feared aging of Baby Boomers, which will be felt nationally, will be felt more acutely in Kentucky. The Census Bureau ranked Kentucky 28th in 1995 among the 50 states and the District of Columbia in terms of its population 65 and older. By 2025, however, the state is expected to rank 14th.(3) Kentucky’s 65 and older population is predicted to increase by almost 9 percentage points, from around 12.6 percent to 21.3 percent (see Table 1). From 1975 to 2000, Kentucky’s 65 and older population looked similar to that of the nation as a whole. However, from 2005 until at least 2025, Kentucky is expected to pull away from the U.S. average.
Table 1: 65 and Older Population Shares, US and KY, 1970-2025
The anticipated shift in Kentucky’s population toward more elderly can also be seen in the changing distribution of who heads Kentucky’s households. By 2020, individuals 65 and older will be the predominant household in Kentucky (see Figure 1). As we will discuss, this rapid increase in the number of households headed by individuals 65 and older is important because they tend to pay less tax.
Figure 1: Household Projections by Age of Head, Kentucky
While the whole state is aging, it is not aging uniformly across Kentucky. Some counties have (and will have in 2020) a higher percentage of elderly. For example, as shown in Figure 2, counties in the western and south central part of the state have a much higher percentage of their population in the 65 and older category. Consequently, these counties might begin to feel the effects on their tax bases sooner than others.
Figure 2: Percentage of Population 65 and Older, by County
The sales tax accounts for the largest portion of Kentucky’s combined state and local tax revenue, almost 37 percent.(4) Since older citizens tend to spend less money overall and less on taxable items, future sales tax collections will be affected. Table 2 illustrates these points. As can be seen in the row titled “Average Annual Expenditures,” households that are headed by individuals 65 and older tend to spend, on average, thousands of dollars less each year than younger households. The one exception is households that are headed by someone under age 25. Moreover, as previously noted, older households tend to spend more money in nontaxed areas, such as heath care. The oldest households spend an estimated 12.2 percent of their total expenditures on health care compared to 2.6 to 7.2 percent for the other households. Also, older households tend to spend relatively less at restaurants and entertainment, which are taxed.
Table 2: Older Citizens Spend Less Money Overall and Less on Taxable Items
As a consequence of these spending patterns, the state receives less sales tax from the average household that is headed by someone age 65 or older. We estimate, in fact, that the typical 65-and-older household pays about $500 annually in sales tax—the lowest amount of all age groups (see Figure 3).(5) Thus, assuming that the elderly of the future adopt spending habits similar to those of today’s elderly, total state sales tax collections will be lower than they otherwise would be.
Figure 3: Estimated Annual Sales Tax Paid, by Age Group
The income and occupational taxes account for the second largest portion of Kentucky’s combined state and local tax revenue, about 33 percent.(6) Since older citizens get most of their income from Social Security and pensions, which are effectively untaxed, future income tax collections will be affected. Consumer Expenditure Survey data show, for instance, that households where the head is 65 or older receive the majority of their income from “Social Security, private and government retirement” as opposed to wages, salaries, or some other taxed source (see Table 3). In Kentucky, state tax is not paid on Social Security income or the first $35,000 of private pension income. The net result is that the majority of individuals drawing Social security or pension income pay no state income tax. Moreover, since the labor force participation rate declines with age (see Figure 4),(7) the local occupational tax will be affected as the population ages.
Figure 4: Civilian Labor Force Participation Rates by Age, 1950 to 1998 and Projected, 2015 to 2025
The property tax is the third largest source of Kentucky’s combined state and local tax revenue, accounting for around 17 percent.(8) In reality, it constitutes a small portion of state tax revenue, around 5 percent, and a large part of local tax revenue, just over 50 percent. As we have already discussed, the Homestead Exemption on real estate for the 2001 and 2002 tax years now exempts from taxation the first $26,800 of a property’s assessed value for property owners who are at least 65 years old. As the population ages and more citizens become eligible for the exemption, the property tax burden will gradually shift to other property owners. Moreover, local governments will be likely to seek other revenue sources, such as the occupational tax and insurance premium taxes.
For a variety of reasons, the elderly pay fewer taxes (see Table 4), and as their ranks increase, state and local government revenue receipts will be affected. At the same time, an aging population will exert increased, reciprocal pressure on the expenditures side of the ledger.
Table 4: Older Citizens Pay Less State and Local Tax as a Percentage of Their Total Income
The projected growth in spending on Medicare, Medicaid, and Social Security dominates the long-term federal budget outlook. If current policies at the federal level remain the same, spending on these three programs is likely to grow significantly faster than the economy as a whole over the next few decades. By 2040, the Congressional Budget Office (CBO) projects, spending on these three programs could account for about 17 percent of gross domestic product (GDP), which is more than double the current 8 percent.(9) And if proposals to increase benefits in any of these programs are adopted, spending will grow even more rapidly, which will result in an even greater share of the gross domestic product going to these programs.
Anticipated increases in health and retirement spending are due to three factors. First, as the Baby Boom generation retires, spending for Social Security and Medicare will increase considerably simply by virtue of the increase in numbers of recipients. Second, Americans are living longer and spending more time in retirement, thus increasing the time during which they are dependent upon these programs. Third, the cost of health care is expected to continue rising steadily and thus increasing costs for Medicare and Medicaid.
Moreover, the demographic changes projected over the coming decades will significantly alter the ratio between retirees and workers and thereby affect both sides of federal, state, and local government ledgers. According to CBO, “In 1960, 5.1 workers supported each beneficiary in the Social Security Program; today, the ratio is about 3.4 to 1, and in 2040, it is projected to fall to just 2.1 workers per beneficiary.”(10) Thus, the growth of federal outlays for Social Security and Medicare will increase rapidly while the growth of revenues from taxes that largely fund these programs will slow.
Kentucky’s older population, which is expected to be larger than that of many states, will almost certainly increase demand for public services at the state and local, as well as the federal, level. A significant portion of the cost of Medicaid, three quarters of which is spent on nursing home or adult day care for older recipients, is paid for by the Commonwealth. Indeed, Medicaid has been the fastest rising public cost in the state of Kentucky for a number of years. Moreover, Kentucky’s older citizens have historically been disproportionately poor and thus more likely to rely heavily on a combination of federal and state programs for support. We also know that a significant percentage of Kentuckians will depend on Medicare and Social Security in their retirement.
In a collaborative project with the University of Kentucky Sanders-Brown Center on Aging, the Kentucky Long-Term Policy Research Center has surveyed Kentucky citizens 45 years old and older to determine the extent of their current and anticipated reliance on these programs.(11) We find that respondents rely or plan to rely heavily on Medicare for health care in retirement; 76 percent say it is or will be a major source of health care (see Table 5).(12) If Medicare provisions remain unchanged, this portends fiscal strain on state Medicaid budgets, as Medicare provides limited coverage of nursing home care, and employer-provided health care, which 43 percent of respondents say is or will be a major source of their health care in retirement, may not provide long-term care coverage. Concerning Social Security, a significant percentage of Kentucky’s retirees list it as the most important source of their retirement income (44 percent), and about one third (31 percent) of those not yet retired believe Social Security will be the most important source of income in their retirement (see Figure 5).(13)
What is true in Kentucky is true across the country: current and future retirees will depend heavily upon Medicaid, Medicare, and Social Security. The heavy reliance many Americans have and will have on these programs will cause their aggregate share of the budgetary pie to increase substantially as the Baby Boomers retire.
Many economists believe the increased burden the Baby Boomers will place on the federal government will in turn create a heavier burden for state and local governments.(14) According to C. Eugene Steuerle, an economist with the Urban Institute who recently chaired the Technical Panel advising the Social Security Administration on its methods and assumptions, “There will be extraordinary pressure upon states and localities to self-finance much of what they want to do in the near future.”
According to the National Association of State Budget Officers (NASBO), “The share of total state spending financed by federal funds declined from 26.3 percent in fiscal 1996 to 25.8 percent in fiscal 1997. Federal aid to states is expected to continue on a downward trend for the foreseeable future.”(15) Indeed, the percentage decreased to 25.2 percent in fiscal year 1999.(16) As Baby Boomers begin to retire in large numbers, it will become increasingly unlikely that this downward trend will reverse course. This means, of course, that the state’s financial burden could become heavier in the future. In turn, it is likely that governments will look increasingly at its system of state and local taxation to ensure it will have sufficient revenue to provide expected services.
* Michael T. Childress is the Executive Director of the Kentucky Long-Term Policy Research Center. Return to text.
1 Rudolph G. Penner, “Tax Benefits for the Elderly, The Retirement Project, The Urban Institute, Washington, 5 (April 2000). Return to text.
2 Kentucky Revenue Cabinet, “Homestead Exemption Increases to $26,800,” press release, 14 Dec. 2000, 19 Oct. 2001 http://revenue.state.ky.us/pressreleases/pr121400.htm. Return to text.
3 “Kentucky’s Population Projections: 1995 to 2025,” U.S. Census Bureau Web site (2000), 17 Nov. 2000 http://www.census.gov/population/projections/state/9525rank/kyprsrel.txt. Return to text.
4 This includes the general sales tax and selective sales taxes. Selective sales taxes include alcoholic beverage taxes, amusement taxes, insurance premiums taxes, motor fuels taxes, pari-mutuels taxes, public utilities taxes, tobacco sales taxes, and other selective sales taxes. This is an estimate for 1999. The data were downloaded from the U.S. Census Bureau http://www.census.gov/govs/estimate/9918ky.html on 4 October 2001. Return to text.
5 We use the U.S. Department of Labor, Bureau of Labor Statistics, Consumer Expenditure Survey (CES), South Region data, to estimate the amount of sales tax paid by age of household head. We asked personnel at the Kentucky Revenue Cabinet to examine each CES category and indicate whether sales and use tax is applied in part or in total. We then estimated how much sales tax would be garnered from each category. Return to text.
6 This is an estimate for 1999. The data were downloaded from the U.S. Census Bureau Web site http://www.census.gov/govs/estimate/9918ky.html. Return to text.
7 Howard N. Fullerton, Jr., “Labor Force Participation: 75 Years of Change, 1950-98 and 1998-2025” Monthly Labor Review, Dec. 1999, 24 Oct. 2001 http://www.bls.gov/opub/mlr/1999/12/art1full.pdf. Return to text.
8 This is an estimate for 1999 using data from the U.S. Census web site. Return to text.
9 Congressional Budget Office (CBO), The Long-Term Budget Outlook (Washington: Author, Oct. 2000), CBO Web site, 25 Oct. 2000 http://www.cbo.gov. Return to text.
10 CBO. Return to text.
11 Refer to Michal Smith-Mello, et al., Challenges for the New Century (Frankfort: Kentucky Long-Term Policy Research Center), Appendix E for information about the Kentucky Retirement Survey. Return to text.
12 Michal Smith-Mello and Amy Watts, “Anticipating Future Needs for Long-Term Care,” Policy Notes, Frankfort, Kentucky Long-Term Policy Research Center, 4 (June 2001). Return to text.
13 Michael T. Childress, “Are Kentuckians Financially Prepared for Retirement?,” Policy Notes, Frankfort, Kentucky Long-Term Policy Research Center, 5 (Aug. 2001). Return to text.
14 C. Eugene Steuerle, untitled speech, Kentucky Long-Term Policy Research Center Annual Conference, “Challenge for the Next Century,” Covington, Kentucky, 14 Nov. 2000. Return to text.
15 National Association of State Budget Officers (NASBO), NASBO Web site, 7 Nov. 1998, 19 Nov. 2000 http://www.nasbo.org/pubs/exprpt/serexec.htm. Return to text.
16 NASBO. Return to text.