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Kansas Tax Problems Loom Large in Federal Tax Reform

Posted on October 17, 2017 by Maria Koklanaris

Kansas, which many on the coasts would call “a flyover state,” is suddenly the talk of Washington.

On October 10 The New York Times published a story titled “Kansas Tried a Tax Plan Similar to Trump’s. It Failed.”

“The state’s experiment with tax cuts on so-called passthrough entities did not heat up its economy — but did help some very rich people,” the paper said.

On October 16 President Trump sent a tweet citing Arthur Laffer, who was one of the architects of Republican Gov. Sam Brownback’s tax plan, which drastically cut taxes and eliminated them altogether for passthrough businesses in Kansas.

“Art Laffer just said that he doesn’t know how a Democrat could vote against the big tax cut/reform bill and live with themselves!” the president said on Twitter.

That fired up the social media machine. “The same Art Laffer who helped construct Kansas’s failed tax plan? Weak growth and drastic cuts to K-12 education,” the House Democrats tweeted in response.

“Economist who wrecked the Kansas economy very excited for Trump’s tax plan,” tweeted Judd Legum of the liberal group Think Progress.

“The next time you hear conservatives call for tax cuts on the wealthy and corporations, remind them about what happened in Kansas,” tweeted former Clinton administration Labor Secretary Robert Reich.

What happened in Kansas was that the promised growth and booming economy that was supposed to come from the Brownback plan never materialized. Five years later, staring down a huge budget deficit and a state supreme court order to fund the schools, even many Republicans in the Legislature had had enough. Working late into the night June 6, the Legislature mustered the votes to override Brownback’s veto of their previous vote that all but dismantled the tax plan. That included getting rid of one of the most controversial parts of the package — the zero income tax rate for partnerships, limited liability companies, and other passthrough businesses.

Trump and House Republicans do not plan to take the passthrough rate to zero. But at their proposed rate of 25 percent, it would be a nearly 15-point gap between the passthrough rate and what is now the top individual income tax rate of 39.6 percent. If the top rate came down to 35 percent, it would still be a gap of 10 percent. By contrast, the gap in Kansas was only 4.6 percent from its top rate to the zero passthrough rate.

And that is the question for policymakers, experts said. Does the Kansas experience, which happened in a state with fewer than 3 million people (according to July 1, 2016, Census data), translate to a federal experience?

“Translate might be a little bit strong,” said David Gamage, professor of tax law and healthcare at the Indiana University Maurer School of Law. “But certainly there are lessons to be learned.”

Not really, according to members of the Kansas delegation in Congress, all of whom support the Republican framework.

“While some may try to compare this tax reform framework to what was tried in Kansas, the truth is these two reforms could not be more different,” Rep. Lynn Jenkins, R-Kan., said in a statement. “Under our framework, everyone pays a lower rate. In terms of pass-through businesses, Congress will lower the rate to 25 percent, not zero percent.”

But Gamage and others cited the large number of businesses in Kansas that structured themselves to take advantage of the opportunity to pay no income tax. When Brownback was touting the plan, the state said 191,000 businesses would take advantage. The actual number was 330,000. Gamage said it is reasonable to expect that the Kansas scenario would replicate itself, on a massive scale, if the federal government sharply lowered passthrough rates.

Gamage used himself as an example, saying it might be challenging for him to reclassify as a professor, but that he would have little trouble doing it for his consulting business. “I find it hard to understand the motive behind this lower rate to begin with,” Gamage said. “Why would anyone want to make that easy for me and others like me? If you want to encourage entrepreneurship, I find this a very poor way to do it.”

Darien Shanske, a tax professor at the University of California, Davis, said he sees similarities in the promises being made. In Kansas, and now on the federal scale, proponents have said the plans will stimulate growth and fire up the economy.

“It’s really hard to figure out how that is a boon, how that is going to create more jobs,” Shanske said of cutting passthrough rates. “In addition to not accomplishing goals of the framework, it is adding to the deficit.”

Michael Mazerov of the Center on Budget and Policy Priorities said that comparing Kansas and the federal government “is a question of magnitude.” Otherwise, he said, “I think a top rate cut is a top rate cut, and similar to Kansas, I think you’ll see a real rush at the federal level” to reclassify to become a passthrough.

Federal policymakers have discussed plans to try to mitigate those effects, including a “70-30” proposal. Under such a plan, proposed by then-House Ways and Means Committee Chair Dave Camp in 2014, wages (70 percent) would be taxed at the top rate, presumably at 35 percent. Profits (30 percent) would be taxed at the 25 percent rate.

“That is not a satisfactory answer,” said Chye-Ching Huang, also of CBPP. “That is not helping small businesses.”

In an October 16 Tax Analysts blog post, Chief Economist Martin Sullivan wrote that such a plan “just means all passthrough profits earned by high-income owners are taxed a weighted average 32 percent rate. Passthroughs hate that idea. Perhaps the net resulting rate is too high. Perhaps they know that (as with transfer pricing) with good consulting, they can likely get a better deal.”

John Buhl of the Tax Foundation said there are similarities but also significant differences between the Kansas experience and the framework. He said it is important to view the plans as a whole, and a big problem with Kansas was that the state did not broaden its tax base, Buhl said. By contrast, he said, with the framework, “there’s certainly an intention to broaden the tax base.”

But that too remains in question, Buhl said. While elimination of the deduction for state and local taxes paid would be a significant element toward broadening the tax base, officials including Trump have in recent days expressed doubts about whether it is a good idea.

“It’s problematic,” Buhl said. “We can’t fully judge this yet.”