WEDNESDAY, FEBRUARY 5, 2003 - 7:00 p.m.

President Williams, Speaker Richards, and members of the General Assembly, members of the Judiciary, and other constitutional officers, my fellow Kentuckians.

I once again thank the people of Kentucky for selecting me to serve as their governor these past seven years.  I thank the members of the Kentucky General Assembly for the privilege of working with you.

Iíve served in the best of times - and the worst of times.  And now is the worst of times. 

With the benefit of hindsight, itís now clear that, beginning in about July of 1994, the economy of the nation and Kentucky began to boom.  State revenue increased dramatically in fiscal year 1995.  In fact, state revenue for six consecutive years was abnormally high.  Virtually every other state experienced this same phenomenon. 

The boom is now over.  Real revenue growth is practically non-existent.  Most of our sister states are experiencing the same situation.  The states are, as a whole, in the midst of the greatest fiscal crisis since World War II.  In Kentucky, for the first time since 1954, revenue actually declined from one year to the next.  Weíre well into our third year of historically slow growth.  The prospects for recovery are dismal at best.  There is no light at the end of the tunnel.

It is indeed our darkest hour Ė and it can be the greatest opportunity to gain on our sister states during my administration.  My fundamental goal as Governor has been to set Kentucky on a path to achieving a quality of life and a standard of living above the national average by the year 2020.  Because some states are allowing this nationwide fiscal crisis to take them backwards, those states which donít cut back on their commitments can make a quantum leap in their effort to gain competitive advantage.  Kentucky has that opportunity - if we have the wisdom and the strength.

Yes, we have severe budget problems, but weíre not alone.  Forty-eight other states are experiencing, or have experienced budget shortfalls.  Virginia has a 10 percent budget shortfall; Massachusettsí is 15 percent; California, 20 percent.  The average nationwide is ten percent.    Ours is about 6 percent. 

How we and our sister states handle this crisis will determine where weíll be relative to each other economically and socially twenty years from now.

Some states have taken the easy road and cut education, social services and public protection programs; stopping progress and, in fact, going backwards. 

A few states have rejected these cuts and increased taxes to keep their vital services functioning.  What will Kentucky do?  Thatís what youíre assembled here in Frankfort to decide. 

Before I get to our immediate problem, let me review for a moment our past. 

While Iíve been governor, we have moved Kentucky forward.  We saved the Kentucky Education Reform Act.  We made new commitments to postsecondary education.  We addressed adult education and early childhood development. 

We improved the environment in the Commonwealth.  We cut our welfare rolls in half.  We created 180,000 new jobs.  Weíve committed to rebuilding our farm economy and that of the coal-producing regions of the Commonwealth. 

Weíve made Kentucky safer, making dramatic improvements in our juvenile justice system.  We have better trained police officers, better-equipped State Police, and 5,401 new jail and prison beds with 900 more on the way.

Weíve cut the state payroll by over a thousand employees and weíve made government more efficient by 572 million dollars through our Empower Kentucky initiative.

We put some of the excess revenue of the boom years into our Budget Reserve Trust Fund, about 280 million dollars and we had over 400 million dollars in reserve in other Dedicated Use funds.

We refunded 287 million dollars of taxes which had been collected and spent by previous administrations under laws which have been declared unconstitutional by the courts.  We made 600 million dollars of cash investments in infrastructure that will improve the economy and the quality of life of Kentuckians in the years ahead.  And we returned much of this excess revenue to our citizens as tax cuts; 26 different tax cuts.  Over 2 billion dollars so far.  Almost 500 million dollars in fiscal year 2004. 

Thatís the reason that the percent of personal income Kentuckians are devoting to government has gone down 7 percent since I took office. 

Iím proud of the fact that weíve reduced the amount of our peopleís income that theyíre devoting to government; but I also realized that this is the genesis of our current problem. 

Let me frame the fundamental issue of the debate that confronts us.  Corporate support for state government is about 350 million dollars below what it should be compared to what it was in 1990. 

We in Kentucky have historically had low corporate taxes, generally providing about 10 percent of the General Fund.  Thatís what it was in 1990 when Corporate Kentucky lead the way for education reform. 

By 2002 corporate support of the General Fund had decline to 5 percent, 50 percent lower than it was in 1990 Ė half as much.  Individuals are now paying for 21 percent more of the General Fund than we were paying in 1990. 

That shift in whoís paying the cost of state services is the fundamental issue in this debate.  This shift in relative tax burden brings up an even more fundamental question.  Should corporations doing business in Kentucky and using the services of state government pay any taxes at all?  If so, how much? 

The fact is that large national and international businesses operating in Kentucky donít have to pay corporate taxes if they donít want to!  All they have to do is to operate in Kentucky as a limited liability business!

Perhaps we should first define the term businesses.  There are two fundamental types of business structures.  One is businesses owned by one or more individuals who assume all the responsibility of gain or loss of the business and pay Individual Income taxes on the profit.

The other is limited liability businesses; one or more people investing to conduct business on a scale that they are not wiling to do as individuals if it means risking all they have.  To make these kinds of investments, their liability for losses must in some way be limited.  The corporation has historically been the business structure used to achieve these ends.  These type businesses have historically paid taxes to the governments that granted them limited liability protection and, of course, their owners also pay taxes on the income they receive as dividends.  This issue of double taxation is at the center of the present debate. 

Thereís lately emerged a new business entity, the Limited Liability Company, which is a partnership and isnít required to pay taxes directly. Its income is passed directly to its owners and the owners pay the taxes.  This type business entity enjoys the limited liability protection of a corporation but avoids the burden of double taxation. 

In 1994 Kentucky authorized limited liability companies.  Eight years later, we have over 33,000 of these companies doing business in the Commonwealth.  Most major corporations operating in Kentucky are conducting at least some of their business with limited liability companies.  Their stockholders live all over the world.  Only those stockholders who are legal Kentucky residents, pay Kentucky taxes on the corporate profits they receive as dividends.  Typically Kentuckians would own less than 2 percent of a large, national corporation.

Therein lies the essence of the debate about corporate support for state government.  Should corporations pay anything for services such as the education of their workforce; the protection of their property; the use of the stateís infrastructure?   Until recently, in Kentucky and all other states, the answer has been yes.  Today, in Kentucky, that answer is, only if they want to. 

If all the owners lived in Kentucky and paid Kentucky Individual Income Tax, this probably wouldnít be an issue.  But what if the owners live in Tennessee?  Or Florida?  Or France?  Shouldnít they pay something when they profit from our tax money?

The way I see it, unless the current laws are changed, there will be virtually no direct corporate support for state government in the very near future because I donít know too many businesses who are going to continue to pay taxes they donít legally have to pay.  We need to decide, once and for all, should corporations operating in Kentucky under any organizational structure pay taxes.  We need to make that decision now; in this session.

When making any decision of this nature, we need to look at what our neighbors are doing.

All our close neighbors have higher corporate taxes than Kentucky and some of them are making them even higher as they look for ways to deal with their budget shortfalls. 

If we look at our neighbor to the south, we find that Tennessee, according to the United Statesí Census Bureau, gets 15.3 percent of its tax receipts from Corporate Income and License taxes.  They also had an 8.2 percent budget gap and they raised taxes 933 million dollars, including an additional 127 million dollars on corporations, to solve their problem.  And now I understand that the new governor of Tennessee is calling for more taxes. 

Illinois gets 10.8 percent of its revenue directly from corporations.  They also raised taxes 370 million dollars and still have a 592 million dollar budget shortfall. 

Indiana gets 7.1 percent of its revenue as Corporate Income and License taxes.  They raised taxes a billion dollars even though theyíre getting a quarter billion dollars from Kentuckians who like their riverboats.

Ohio gets 15.3 percent of its revenue directly from corporations.  They raised taxes 797 million dollars including 216 million dollars from corporations. 

I read just last week where Governor Taft was calling for more tax increases to plug another 720 million dollar budget gap for next year.  In calling for that tax increase, Governor Taft said to a joint session of the Ohio legislature, ďThe actions Iím asking you to take will be painful, but the consequences of inaction are unacceptable.Ē  I make that same statement to the members of the Kentucky General Assembly. 

Governor Huckabee of Arkansas said to a joint session of his legislature,  ďAnd if you deem that all new revenue sources, your proposals or mine, are dead on arrival, then youíll be saying that teacher pay increases are dead, scholarships are dead, medicine for the elderly is dead, that long (prison) sentences are dead, and that weíll have to have a massive early release of thousands of inmates from the system.Ē  He went on to say, ďTo be blunt, our problems arenít that simple and the answers arenít either.Ē 

Again, I echo that message to the Kentucky legislature and the people of the Commonwealth.

We in Kentucky have yet to permanently address our problem.  That is the challenge presented to the Kentucky General Assembly.  I hear your opposition to new taxes.  I donít like to have to even talk about them myself.  But do we know something that our neighbors donít know?  Does someone in the General Assembly have a silver bullet I havenít found?  If you do, share with me; and the people of Kentucky.  Our administration solicits your advice. 

Weíve dealt with this budget shortfall for over two years.  Since November of 2001 weíve managed shortfalls of 872 million dollars!   Weíve made dramatic cuts in the administrative cost of state government.  Weíve reduced payroll.  Weíve reduced vehicles; weíve cut travel.  Weíve reduced the use of personal service contracts. 

So far, there have been very few programmatic reductions.  Our people have yet to feel the pain of their government not living up to its commitments; with the single exception of the consequences of an underfunded Corrections budget. 

As I review my administrationís handling of this crisis, I think weíve done pretty well.  I think our job is to keep our people from feeling the pain.  But we can no longer shield our citizens from this crisis.

You adopted a very progressive budget for Fiscal Years 2001 and 2002 in the 2000 legislative session.  But the budget shortfall for 2001 was 185 million dollars.  We tightened our belts and absorbed that shortfall without cutting services.  In 2002 the budget shortfall was 687 million dollars, 9.4 percent of the budget.  I cut our postsecondary education and our Medicaid program two percent and all the rest of government 5 percent Ė but I didnít cut our elementary and secondary schools; the education of our children is too important.

In the 2002 session I proposed a continuation budget for this year and the next, based on a budget for last year which had already been cut 5 percent in every area of state services except education and Medicaid.  That budget had no expansion of services, no real raises for our teachers or state employees, no operating increases to cover inflation.  When rent went up, we told our agencies to reduce space.  When utility bills went up, we told our managers to turn down the thermostat.  Last December we announced other cost-saving measures which will save over 30 million dollars more without cutting services that affect the average Kentuckian.  But we can no longer avoid the inevitable.  We must now restore the 500 million dollars a year that weíve returned to the people in tax cuts while Iíve been governor or; drastically cut services.

By the first of July, all our reserves will be gone.  Weíll be almost 400 million dollars short of what it takes to fund the 2004 budget I proposed last year.  Weíll need another 103 million dollars to prevent more cuts in Medicaid and to keep all our convicted felons behind bars until theyíve served their time. 

If weíre going to really restore the financial health of the Commonwealth, weíll need another 92 million dollars to rebuild our reserves and continue to invest 6 percent of our revenue in our schools and communities.

Thereís no doubt that you can take 400 million dollars out of the budget I proposed last year.  Thereís no doubt you can force even more cuts in Medicaid.  I donít see how you can refuse to fund our prisons.  But you can certainly refuse to rebuild our Budget Reserve Trust Fund and stop our infrastructure investment program.  Thereís no doubt that you can push a lot of the problems off on the next governor and the next General Assembly.  There is no doubt that you can adjourn without addressing the problem.  There is no doubt you can pass a fictitious budget.  But you, I, or the people of Kentucky cannot escape the fact that we either restore the revenue lost when we cut taxes in 26 different ways or we reduce the teachers in our classrooms or increase college tuitions or cut more people off Medicaid or let more felons out of prison or reduce our services to neglected children or let the weeds grow in our state parks or let our infrastructure deteriorate; or lose a lot of dedicated state employees; or a combination of all of the above.  Those are the choices we face.

Iíve made my choice.  Iíve already experienced the trauma of releasing felons from prison before theyíve paid their debt to society.  Iíve seen them go out the very next day and abuse the good people of Kentucky.  Iíve faced the reality of depriving Kentuckians of essential health care.

Iíve been to the mountain of cutting the very heart and soul out of government; and Iíve returned sickened, saddened and resolute.  I can stomach no more.

If that is to be the future of Kentucky, that future will be your legacy Ė not mine. 

And so I propose to you tonight a budget which doesnít expand our government Ė but it does live up to our existing commitments.

And I propose to address one of the fundamental problems we face, the structure of our tax laws.

I propose to revise our tax code to make it more fair, to keep us competitive for economic expansion, to make our revenue stream more stable, to make it grow more closely with the growth of our society and to make it adequate to meet our current commitments.

I propose 17 specific changes which will close loopholes and raise some taxes and cut others.  The net increase in state revenue will be 573 million dollars.   

But the centerpiece of my proposal is to close the biggest loophole of all, the loophole that permits huge multi-national corporations to operate in Kentucky while paying practically no taxes to pay for the government services they use everyday. 

Iím not here to criticize the businesses that make our economic prosperity possible.  Iím here to criticize a corporate tax code that has become dysfunctional.

All I want to do is change the way we tax these corporate citizens to make it more fair to all our businesses.

In 2000, 37,000 corporations filed corporate tax returns in Kentucky.  Two of them paid 10 percent of our Corporate Income Tax.  Eleven of them paid 10 percent of our Corporate License Tax.  That canít be fair.   

These kinds of inequities are possible because we have a corporate tax code that has so many loopholes that it enables a corporate citizen to organize itself in ways so as to legally reduce its tax liability to practically nothing.  Again, I want to emphasize that this is not a criticism of corporate Kentucky.  Our large corporations have every obligation to their stockholders to pay only their legally binding tax obligations.  The criticism is of us, the elected leaders of Kentucky who made this possible.  We have created these loopholes.  We have every reason to expect our corporate citizens to use them.

In 1990 we increased taxes by todayís equivalent of one and a quarter billion dollars a year to pay for an educational program that we didnít know for sure would work.  Surely we will increase taxes half that much to pay for it after we know it does work.  For my part, Iím there. But the decision is not mine.  The decision is yours, the 138 men and women elected by your peers to decide on their behalf, the future of Kentucky.

I realize that corporations, like individuals, pay a lot of different taxes like sales tax and property tax.  As far as I know the relative amount of these taxes corporations pay hasnít changed.  Tonight I will concentrate on those taxes that are paid only by corporations and those taxes paid only by individuals and point out how the distribution of the tax burden has shifted since 1990. 

There arenít many loopholes in the Individual Income Tax laws that the average Kentuckian can take advantage of.  Our corporate tax laws are full of loopholes.

Our present corporate tax system allocates a portion of a national corporationís total income to Kentucky based on three factors Ė payroll, sales and capital employed in Kentucky.  My proposal uses these same three factors to determine a corporationís fair share of support for state government.  It just applies them in a different way.

The present system is so full of loopholes, a corporation can almost wipe out its tax liability legally. 

Closing those loopholes is the objective of replacing the Corporate Income Tax with the Business Activity Tax.  This is based on a companyís payroll and sales in Kentucky.   

This tax will apply equally to every business operating in Kentucky which enjoys the protection of limited liability except professional partnership; doctors, lawyers, engineers, accountants and other professional services.  It does not apply to sole proprietorships or general partnerships.  This change is not intended to affect the tax burden of Kentuckians who own a business which passes its income through to its owners. 

Any Business Activity Tax thatís paid by a Subchapter S Corporation or by any company that passes its income directly through to its owners; that tax is taken as a direct credit on the Individual Income Tax of that owner.  Now I want you to listen to that statement very clearly.  Any Business Activity Tax paid by a pass-through company is deducted dollar for dollar from the Individual Income Tax owed by the owner.  Most Kentucky companies owned by Kentuckians are pass-through companies.  This change should have no effect on a Kentucky-owned business thatís already paying its fair share of the cost of state government. 

I also propose to increase the Corporate License Tax from 21 to 41 cents per $100 of capital employed in Kentucky and extend it to apply to these same businesses.  What weíre trying to do is create a level playing field where all businesses, large or small, are playing by the same rules, paying the same taxes, and helping to keep our education programs improving.  Weíre also maintaining the ability of all Kentucky business owners who are presently avoiding double taxation by the use of pass-through companies to maintain that savings. 

In 1990, corporate leaders like John Hall, David Jones, and Oz Nelson led the businesses of Kentucky as they came to you and said ďgive us better schools Ė raise our taxes to pay for them.Ē  And you responded.  Since 1990 the taxes that individuals pay have gone up 123 percent!  The taxes corporations pay have gone down 9 percent. 

And let me emphasize one more time, I am not criticizing our business community.  Iím criticizing our corporate tax code which is fundamentally flawed. 

The limited liability company loophole was created in 1994.  Few people realized what the changes did.  Some corporate executives are just now beginning to understand how to reorganize a company and virtually eliminate state taxes.  Thatís whatís causing the stampede to the Secretary of Stateís Office to file the papers to establish limited liability companies; the vehicles to tax-free heaven.  I know this subject is complicated.  Itíll require a complicated solution.  If you want to know more, itís all right here in this ďhot off the pressĒ document, Securing Kentuckyís Future. 

Weíve sent a copy to every legislator.  Itís available on the web to anyone whoís interested.  It documents in detail my proposal and my reasoning.  I urge every Kentuckian to read it. 

Itís my responsibility to execute the programs the legislature has mandated so long as we have the money in the bank; and we still have money in the bank.  Itíll run out about July.  I will then have no choice except to make cuts that will upset people more than the early release of felons.  Then you and the people of Kentucky will see what an emasculated government really looks like.  I already know. 

You must now decide.  If we raise no taxes, weíll put Kentucky back a generation.  If we raise taxes a little, itíll be like a narcotic; mask the pain but not cure the disease.

If we address the fundamental problem and restore the revenue we didnít need during the good economic times, we can move Kentucky forward during the next administration and beyond and surpass those other states whose political leadership is more interested in the next election than they are in the next generation.

I think Iíve proven that I understand how important businesses are to the people of Kentucky. 

I would never do anything to hurt the business climate in the Commonwealth.  Thatís why I wonít support cutting education.  Providing good schools is the single most important thing we can do to make Kentucky more business friendly.

The other side of this coin is to cut my budget to fit existing revenue.  I am not going to participate in cutting government services anymore.  Weíll leave that up to the people who say we donít need more revenue.  They must draft the budget with no new revenue.

The people have the right to see a budget with no new revenue.  I know what it looks like and itís ugly.  Itís cruel.  Itíll destroy all the progress weíve made these last seven years.  I will not support it.  I will oppose it.  I will not put my name on it.  It will be your budget.

Iím proposing a sound budget.  A budget that funds our current commitments.  A budget that restores our fiscal integrity, protects our bond rating and begins to rebuild our budget reserves.  My budget will fully fund our commitment to Basic SEEK for next year at the level of 3,234 dollars for every student in average daily attendance in our schools; it will fully fund the current estimated cost of the Medicaid program with no more cuts beyond those weíve already begun to initiate.  And itíll fully fund our Corrections Department so there will be no more early release of felons.

And my budget will continue our policy of investing 6 percent of our income in our infrastructure; the framework around which our economy grows.  Iíve said it before and Iíll say it again.  No matter how bad things get, we must continue to invest in the future, just like those who came before us.  Itís especially important to invest now because interest rates may never be lower.  And if we stop growing our infrastructure, weíll stop growing our economy.

I heard the story of the farmer who decided to economize so he slowly reduced the feed to his mule; just a little bit less everyday.  After a month his neighbor asked him how his economizing effort was going.  ďWell, it was going great,Ē the farmer said.  ďI had him completely weaned from food and then the darn thing died!Ē 

Well, thatís what happens when a society stops investing.  Itís just about the same as eating your seed corn. 

We have a simple choice.  Pay now or pay later.  Statesmen will step up to the plate and pay now.  Politicians will make the people pay later.

Our colleges and universities are our future, so my budget will fund the new health services campus at the University of Louisville and the Biological Sciences Pharmaceutical Complex at the University of Kentucky.  Itíll fund the Business Technology Center at Eastern; the Old Science Building Renovation at Northern; the Student Center Restoration at Morehead; the Science Building Replacement at Murray; the Thompson Science Complex replacement at Western; and the renovation of Hathaway Hall at Kentucky State. 

Itíll fund new KCTCS buildings at Henderson and Madisonville and Ashland.  Itíll fulfill the promise of 100 million dollars made two years ago to our schools for new buildings, and promises another 100 million dollars for the next biennium; and it funds Bucks for Brains. 

We must continue to grow our economy and have plenty of land set aside for businesses to locate and expand, so my budget will fund the new business park in the Purchase and one in Hopkinsville as well as finish the convention center there.  Itíll pay off the loan on the Glendale industrial sight in Hardin County and provide the Economic Development Cabinet the ED bonds they must have to keep our economy growing. 

And itíll fund our 2020 rural water initiative and keep us on track to reach our goal of providing every Kentuckian with access to high quality water by the year 2020. 

And it finishes the six new golf courses you authorized in 2000. 

And it funds the new executive office building which will let future administrations get on with the job of restoring and preserving our beautiful State Capitol building. 

And I support and urge you to support the judicial branchís efforts to construct the 23 new courthouses in rural Kentucky. We absolutely must continue this program to provide every court in the Commonwealth with state-of-the-art facilities. 

And my budget recognizes the importance of our major urban areas to all Kentuckians.  My budget begins the multipurpose activities center in Northern Kentucky and finishes Rupp Arena and keeps our Kentucky State Fairgrounds in the first tier of large convention centers in America!!!

My budget is a responsible budget; a humane budget; a budget that keeps our commitments.

Those who canít see my vision for Kentucky can have the ugly budget of no new taxes.  If you canít see very far, ugly doesnít look too bad.  If you can see to the horizon, you see a sunrise; you see the future. 

To the people of Kentucky, I ask you to study my budget and the comprehensive tax reform needed to fund it.  Donít greet the mention of increased taxes with a knee-jerk reaction. This Business Activity Tax, in all likelihood, wonít affect your pocketbook one dime.  It will most assuredly affect the schools in your communities, the social services of your neighbors, the safety of your streets.  If you agree with me, call your state senator and state representative.  They really want to know your views.  All theyíre hearing from now are the uninformed or the selfish special interests that only care about today Ė and themselves. 

The flat earth, no new taxers will scream cut spending, cut spending and then theyíll scream donít let felons out of jail.  But keeping criminals off the street is where weíve increased spending 65 percent.  Room for 5,401 new inmates; and 900 more beds on the way.  Thatís one reason the crime rate in Kentucky has dropped 10 percent. 

Weíve increased spending on Medicaid by 63 percent and now Iíve had to cut Medicaid 250 million dollars and the cut spenders are calling my office demanding that we not cut the reimbursement rates of their friends in the health care field. 

Weíve increased spending on education 29 percent but our teachersí salaries have already dropped from 27th to 34th in the nation.  And the cut spenders scream, donít cut education. 

Since Iíve been governor, inflation has caused costs to go up 19 percent but the increased costs of all the rest of state government has increased by only 13 percent, only two thirds as much as the average increase in costs in our nation as a whole.

My friends, the politicians can demagogue new taxes.  But they offer no solution.  I have but ten more months to serve.  I have but one more challenge to meet; - to turn over to my successor a state government that has a balanced state budget, a sound fiscal position, and the ability to meet its existing commitments.  I canít do that by myself.  I need your help; you here in the legislature and you out there in Kentucky.

For seven years, Iíve tried my best to do and advocate what was right for the long-term welfare of all the people, not the short-term gain of the special interests.

I have supported Labor when I thought Labor was right.  I have opposed Labor when I thought Labor was wrong.  The same goes for business.

Iíve tried to be the advocate for the people.  Thatís the role I play tonight.  I believe history will prove me right.

Goodnight, God bless you, and God bless America.