In 2012, Koch-bot governor Sam Brownback led a radical Tea-Publican legislature to enact the “Kansas experiment” out of blind faith in trickle-down economics. They enacted “a tax cut that eliminated state income taxes entirely for pass-through entities — such as sole proprietorships and limited liability partnerships — which are taxed at the owner’s individual income tax rate. The law also lowered individual income tax rates, cutting the top rate to 4.9 percent from 6.4 percent.” Kansas Tried a Tax Plan Similar to Trump’s. It Failed.
The tax package reduced state revenue by nearly $700 million a year, a drop of about 8 percent, from 2013 through 2016, according to the Kansas Legislative Research Department, forcing officials to shorten school calendars, delay highway repairs and reduce aid to the poor. Research suggests the package did not stimulate the economy, certainly not enough to pay for the tax cut. This year, legislators passed a bill to largely rescind the law, saying it had not worked as intended.
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[C]ongressional Republicans and President Trump are trying to take the experiment with pass-through preferences national, beyond Wichita and Topeka to cities with residents who measure incomes in seven, eight or nine figures.
The Republican tax rewrite unveiled this month aims to jump-start economic growth in part by establishing a 25 percent tax rate on small businesses and other firms that operate as pass-through entities, a cut from the top rate of 39.6 percent that such business owners pay now.
But the abandoned experiment in Kansas points to how a carve-out intended to help raise growth and create jobs instead created an incentive for residents, particularly high earners, to avoid paying state income taxes by changing how they got paid.
“It caused a lot of budget instability,” said State Senator Jim Denning, a Republican who led the effort to repeal the pass-through exemption this year. Mr. Denning, who earns pass-through income from his interest in a commercial real estate firm, said he had personally benefited from the exemption, but the state’s economy had not.
The pass-through exemption was responsible for $200 million to $300 million of that annual shortfall, according to budget researchers at the Tax Foundation in Washington. Between 2012 and 2015, the total number of Kansans claiming pass-through income grew 20 percent, to about 393,000 from about 330,000. A team of researchers from the University of South Carolina and other institutions who studied the impact of the tax change found the top 2 percent of Kansas earners reaped the largest gains from shifting income to pass-throughs.
Participation at the federal level could be far more dramatic — with tax benefits dwarfing those enjoyed in Kansas. The top income tax rate in Kansas before the 2012 law was 6.4 percent. This year, it will be 5.2 percent, growing to 5.7 percent in 2018. The top federal rate is 39.6 percent, offering a significantly bigger incentive for tax avoidance if pass-throughs are taxed at 25 percent. Already, 70 percent of pass-through income flows to the top 1 percent of American income earners, Owen Zidar, an economist at the University of Chicago Booth School of Business, has found.
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“The experience of Kansas shows that lawmakers should be cautious about taxing income from pass-through businesses at different rates than wages and salaries,” said Scott Greenberg, a senior analyst at the nonpartisan Tax Foundation in Washington, which models tax proposals’ likely effects on the economy. A pass-through cut, he added, would probably produce less growth than many other, less expensive tax policy changes.
Republicans say they will erect guardrails to prevent workers from reclassifying themselves as contractors to exploit the lower rate. But their plan does not provide specifics, and tax experts say it will be difficult to restrict high-income individuals from diverting income through a pass-through.
Pass-throughs have long been favored by small businesses such as dental offices and family farms, but their use has expanded to include many financial and real estate firms. Mr. Trump’s business empire is largely run through hundreds of pass-through companies. [Trump would personally benefit from his tax plan].
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Using a random sample of state tax returns, Jason DeBacker of the University of South Carolina Darla Moore School of Business, Bradley Heim and Justin M. Ross of Indiana University, and Shanthi Ramnath of the Treasury Department isolated the number of workers in Kansas who routed income through pass-through entities after the law passed, even though they continued to earn that income from the same source. They found more than 2,200 Kansans had done so, about 0.2 percent of workers in the state.
If the rest of the country saw the same reclassification trend as Kansas, Mr. DeBacker said, nearly 250,000 Americans would use the technique to lower their tax bills. He cautioned that the number could be larger, because the gap between the top tax rates on labor income and pass-through income would be substantially wider than it was in Kansas, and because tax professionals would have greater incentive to specialize in helping wage earners form pass-throughs.
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Mr. Rosenberg and two colleagues estimate that such shifts could reduce federal revenues by at least $41 billion a year. Most of that, $39 billion, would come from existing pass-through owners paying lower taxes. The rest would come from wealthy individuals routing income through pass-throughs to minimize taxes.
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Defenders of the “Kansas experiment” say that the state’s budget woes came from lawmakers’ unwillingness to impose spending cuts alongside the tax cuts, and that it was never realistic to expect the tax cuts to produce enough growth to pay for themselves.
Whaaa? That’s the whole basis of trickle-down tax cuts, that they pay for themselves and are revenue neutral.
“Those are effusive political hopes — that’s not economic analysis,” said Dave Trabert, the president of the Kansas Policy Institute, a free-market think tank. “It’s pretty common for people to hope that something is going to have a tremendous, I think Governor Brownback’s phrase was, ‘shot of adrenaline.’ That’s not how economies work.”
“Clap your hands and say, ‘I believe in tax fairies!'” isn’t how economies work.
Dinah Sykes, a Republican member of the Kansas state senate, writes at the Washington Post, A message to Congress: Don’t make the same mistake we did in Kansas:
In 2012, Republicans in Kansas enacted a “revolutionary” tax overhaul promised to be a “shot of adrenaline to the heart of the Kansas economy.” With the benefit of hindsight, we can say with certainty this promise was unfulfilled. In the following five years, Kansas experienced nine rounds of budget cuts, stress on state agencies and the inability to effectively provide the core functions of government for our citizens.
As Republicans in Congress begin working to modify the federal tax code, I worry that tax reform done poorly could lead to similar failure. I hope federal lawmakers learn from mistakes made at the state level.
This year, the Kansas legislature — including many Republicans like me — voted to partially restore income-tax rates and to repeal a provision that allowed independent business owners to pay almost no state taxes on their income. We also overrode our governor’s veto, who opposed rolling back the tax cuts he championed.
Critics of our vote claim that Kansas didn’t cut spending enough to accompany the tax cuts. In reality, we cut our budget through across-the-board cuts, targeted cuts, rescission bills and allotments. Roughly 3,000 state employee positions were cut , salaries were frozen, and road projects canceled . We delayed payments to the state employee retirement system and emptied our savings accounts. Even as we issued more than $2 billion in new bonds to float our debt, Kansas received three credit downgrades, making that debt costlier.
In Kansas, we understand the allure of tax-cut promises. We want to believe promises of amazing growth or outcomes. In 2012, traditional budget forecast models accurately predicted the devastating effect the tax breaks would have on state revenue. Proponents of the plan used dynamic scoring predicting incredible economic growth and supporting their own preconceived ideas. Today, we know which forecasts were correct.
Across the state, citizens may have been paying less in income taxes, but those decreases were offset by increases in sales taxes, property taxes and fees. These changes alone were not enough to put the state on the right path. Education and infrastructure, key investments necessary for strong economic growth, were treated as the enemy. As we went through our 2017 legislative session, the “shot of economic adrenaline” still showed no signs of materializing. Our state functioned as though the Great Recession had never ended.
Kansas should serve as a cautionary tale illustrating the damage done when the normal order is shortchanged. America’s founders and countless generations of leaders embedded deliberative procedures into our legislative process for a reason. But in 2012, the governor’s tax proposal looked very different from the package he signed. A dispute between House and Senate versions should have gone to conference committee; however, the House cut short debate and rammed through a motion to concur with the Senate instead. I watch now as lawmakers in Congress use similar tactics, and I worry that backroom dealing and circumvention of process will lead to similar results.
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There is a real temptation to let our frustration turn into anger. In our increasingly polarized world, we see what happens when we retreat to our ideological trenches. The antidote, it would seem to me, is listening carefully to those we disagree with and seeking common ground as a starting point. (We should also note that failing to listen to constituents while blindly holding to ideology can have consequences: About a third of Kansas legislators became ex-legislators in 2016.)
Hopefully, finally, this same accountability moment will come for Tea-Publicans in the Arizona legislature and the Congress who worship the golden idol of the false religion of trickle-down economics.