Kentucky faces multiple pressures in budget season

Kentucky's government is facing pressure from weak revenues, federal budget cuts and increased tariffs as it starts to prepare its biennial budget.

"Unlike recent years, when pandemic-era stimulus created robust revenue growth, lawmakers are facing a serious budget crunch due to the loss of federal funds, a weakening economy and falling revenue because of state income tax cuts," said the liberal Kentucky Center for Economic Policy last week.

In the first six months of the fiscal year, July through December, state general fund revenues were down 0.7% year-over-year without adjusting for inflation. The national inflation rate in 2025 was 2.7%.

In mid-December the Consensus Forecast Group, Kentucky's revenue forecasting body, predicted general fund revenue will decline 1.3% in the current fiscal year, in part due to a cut in the individual income tax rate to 3.5% from 4.0% on Jan. 1, 2026. In addition the effects of the tax cut, collections to the corporate income and limited liability entity tax are projected to decline by $430 million from the previous fiscal year.

The state legislature started its session last week and is expected to complete a proposed budget by the end of March.

"Lawmakers must put a halt to the effort to reduce the state's individual income tax, which overwhelmingly benefits the richest residents and depletes the resources needed to make key investments," the Kentucky Center for Economic Policy said in December.

Joseph Krist, publisher of Muni Credit News, said revenue statistics for July to November showing a 0.1% increase and the revenue projections for a 1.3% decline in the fiscal year concerned him "only somewhat.

"The cuts to income taxes are producing unsurprising results. The question is ? how do they manage going forward?" he said.

"The cutting of tax rates usually has a lagged effect," said John Mousseau, vice chairman and chief investment officer for Cumberland Advisors. Rate cuts will inevitably cut revenues. Over time, any positive impact of the rate cut on the economy will lead to, at best, small improvements to revenues over time.

Kentucky Senate Budget Committee Chair Chris McDaniel said the revenue numbers through December don't concern him. For a few years around the pandemic the state had strong revenue growth and now the growth rates will settle into a more "normal economic pattern," McDaniel, a Republican, said.

The December declines in revenues from those a year earlier included a drop of $25 million from public service company property taxes and $14 million from pass-through entities. The declines also included an $86 million decline in corporation income taxes.

Individual income and sales and use tax revenues were up in December, McDaniel said. The decline in property tax collections was largely due to a timing issue with the public service companies account. The tax on pass-through entities (limited liability companies), was only in its second fiscal year, he said.

Karen Ribble, senior director at Fitch Ratings, noted there were significant one-time payments in fiscal year 2025, which led to year over year declines in fiscal 2026. "Ongoing revenues have continued to increase, albeit very slowly, in light of the tax rate reduction."

Continued tax rate cuts in Kentucky could lead to negative rating action, Ribble said. Fitch rates Kentucky AA with a stable outlook.

Republicans control both chambers of the legislature but Gov. Andy Beshear is a Democrat.

The federal One Big Beautiful Bill Act, which Republicans passed this summer, includes cuts to Medicaid, the Supplemental Nutrition Aid Program and other programs that benefit Kentuckians.

In Beshear's proposed budget and his state of the commonwealth speech, the governor called for the state to add money to prop up SNAP and to introduce a pre-kindergarten education program. Beshear called for $100 million to be added to state Medicaid spending to maintain coverage. He also called for $125 million for rural hospitals.

"Backfilling federal cuts is often exhausted in the short term," said John Hallacy, president of John Hallacy Consulting. "Longer term it may be necessary to reconsider what level of services will be provided and is affordable from a state budget perspective."

Mousseau said, "Federal cutbacks clearly hurt Kentucky with fund reduction for public health grants and community health centers and treatment programs could also deteriorate financially. Balancing state budgets while facing the loss of federal dollars is challenging enough. But it's harder in states with lower wealth demographics."

Krist said, "The cuts to Medicaid and SNAP will drive pressure. I see support for healthcare and SNAP as a more likely outcome vs. expanded pre-kindergarten." Krist wondered if the federal cuts might be restored after the 2026 midterm elections.

McDaniel said the federal cuts will mainly affect state financing in the costs of SNAP administration, which he said would require an extra roughly $50 million per year. The state government must also work to reduce SNAP error rates or it will cost the state about $130 million per year, he said.

Medicaid cuts to hospital reimbursements could indirectly affect the state government's finances, the senator said. He said the government was keeping an eye on the issue.

Overall, the federal government cuts will not be a "huge hit" to the state government, McDaniel said.

Beshear has called for the state's budget reserve trust fund, which currently is equal to 24% of annual spending, to be drawn down to 17%.

McDaniel said he agreed generally that the trust fund should be drawn down some. He said any use of the funds should be for one-time projects and not continuing needs. He said he hadn't yet analyzed Beshear's budget closely enough to say whether the governor's proposal met that condition.

"Drawdowns for recurring expenses tend to get a raised eyebrow from the rating agencies so at some point they may have to consider cutting expenses or raising revenues or a combination of both," Mousseau said.

Krist said, "Given all of the uncertainty from federal cuts, the use of some reserves is almost unavoidable. I believe that many states will draw down reserves to some extent as fiscal year 2027 will potentially serve as a bridge year if the midterms see big changes that restore funding."

S&P Global Ratings Director Anne Cosgrove said, "As the upcoming biennial budget gets finalized, we will look to see the structural nature with this new revenue level [following January's tax cut.] A draw on the budget trust stabilization fund could occur but we expect it to remain at healthy levels." S&P rates Kentucky A-plus with a stable outlook.

"The governor's proposed use of the budget reserve trust fund appears to be one-time, while retaining the balance above the threshold noted in our published negative rating sensitivity," Ribble said.

"The state has had improved fiscal discipline over the last several years and has been funding in excess of actuarially determined contributions for pensions," Cosgrove said. "The budget trust stabilization fund has been healthy and is expected to remain well above 10%."

Kentucky's is rated Aa2 by Moody's Ratings with a stable outlook. The state doesn't have any general obligation debt outstanding and all three agencies rate its highest-rated appropriation-backed bonds one notch lower.

After the legislature reconciles the two chambers' versions of the budget and passes a budget it is transmitted to Beshear. In Kentucky Beshear will be able to issue line-item vetoes as well as veto the whole budget.

If there are any vetoes the budget would go back to the legislature, which can override the governor with simple majority votes. McDaniel said this process should be complete by sometime in April.

In June Moody's said Kentucky imports a greater share of its GDP than any other state in the country. It is also a top exporter among states. These facts make it more vulnerable to the higher tariffs imposed by the federal government and the counter-tariffs imposed by some other nations on U.S. goods.

The press office of Beshear didn't respond to a request for comment.