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Oct. 28 — The impact of tax changes on the state level could provide valuable insight for Hillary Clinton and Donald Trump as they flesh out their own proposals.
Analysts agreed that lessons learned from state changes should be taken into consideration. “Often at the federal level people talk about states being labs for democracy to try and figure out what works and what doesn’t work” said Kim S. Rueben, a senior fellow in the Urban-Brookings Tax Policy Center at the Urban Institute. Rueben directs the State and Local Finance Initiative.
What they didn’t agree on was what those lessons are.
Rueben sees Republican presidential candidate Trump’s individual and business income tax proposals going the way of Kansas, where some argue that recently imposed tax cuts have had a negative impact on the economy. What Trump is proposing “looks really similar to what Kansas did,” she said. The state’s tax cuts have reduced income tax revenue by millions of dollars.
Stephen Moore, a Trump tax adviser and a distinguished visiting fellow for the Project for Economic Growth at the Heritage Foundation, argued that those cuts have actually been successful. Moore, who was one of the architects of the Kansas tax changes, said if anything, people should be looking at states where high tax rates have had an adverse effect. He compared Democratic presidential candidate Clinton’s tax proposals with taxes in Connecticut, New York and Illinois, where he said tax increases have been a “catastrophe.”
Kansas Gov. Sam Brownback (R) made tax cuts a central focus during the state’s 2012 legislative session. In 2012 and 2013, he enacted legislation that would reduce the top individual income tax rate to 3.9 percent from 6.45 percent by 2018. The legislation also eliminated income tax on passthrough entities like LLCs, S corporations, partnerships and sole proprietorships.
The changes have resulted in significant tax revenue loss for Kansas. In fiscal year 2012—before the tax cuts became effective—individual income tax revenue totaled $2.91 billion, according to Kansas Department of Revenue statistics.
That number rose in FY 2013 to $2.93 billion, but in FY 2014—the first full year that all the tax changes were in place—individual income tax revenue plummeted by 24 percent, to $2.22 billion. In FY 2015, there was a slight 2.7 percent increase to $2.28 billion, followed by a drop in FY 2016 to $2.25 billion.
Like Kansas, Trump’s plan would enact significant tax cuts. He would reduce the top individual income tax rate to 33 percent from 39.6 percent, and would lower the business tax rate to 15 percent from 35 percent. At the same time, he would modify rules for passthrough entities, which under current law don’t pay income taxes themselves. Instead, they pass their earnings to their owners, who are taxed at their individual tax rates. Trump has proposed letting those businesses pay a 15 percent rate on their income.
Also similar to Kansas, the revenue losses from Trump’s plan would be substantial. The conservative-leaning Tax Foundation estimates that the Trump tax plan would reduce federal revenue over a 10-year period by between $4.4 trillion and $5.9 trillion on a static basis, and between $2.6 trillion and $3.9 trillion using a dynamic model that takes macroeconomic effects into consideration. The Tax Policy Center’s static estimate is a $6.2 trillion reduction and its dynamic estimate is only slightly smaller at $6 trillion.
House Republicans have proposed similar cuts in a tax blueprint under their “A Better Way” initiative, with some key differences.
The GOP blueprint, published in July, proposes lowering the corporate tax rate to a flat 20 percent. Active business income of sole proprietorships and other passthrough entities would be taxed—not at the lower 33 percent top individual income tax rate adopted by the blueprint, but at a maximum rate of 25 percent.
Kansas has had to pay for the revenue losses from its tax cuts with reductions in spending on education and government services, said Martin B. Dickinson, the Robert A. Schroeder distinguished professor emeritus of law at the University of Kansas School of Law.
The Brownback plan has “really diminished government services generally in Kansas,” he said. People are especially unhappy with cuts in education spending for kindergarten through 12th grade, he said.
In the last months of FY 2015, Brownback implemented a 4 percent expenditure reduction to Kansas’ state general fund for certain agencies, including the Kansas Department of Education and the Board of Regents, which governs state-run higher education institutions. These spending reductions were carried forward for the same agencies in the approved FY 2016 and FY 2017 budgets. The reductions are anticipated to achieve savings of $32.8 million in 2016 and $33.4 million in 2017, according to the state’s 2016 Comparison Report. With the reductions, education expenditures still comprise more than 60 percent of the state general fund.
A March 2014 blog post from the liberal-leaning Center on Budget and Policy Priorities said the Kansas tax cuts that year cost the state about 8 percent of the revenue it uses to fund schools, health care and other public services.
Dickinson said he envisions a similar problem occurring with the Trump plan in which government services become the bill payer for large revenue losses. “If you crack those business rates down to 15 percent, that revenue loss has to be huge,” he said.
Moore said the tax cuts in Kansas have been a success, contrary to the picture of economic crisis that has been painted by local media outlets. “If you look at Kansas’ records on jobs, it’s one of the best in the Midwest. Our tax cut worked there,” he said.
Since the tax cuts took effect, the seasonally adjusted unemployment rate in Kansas dropped to 4.4 percent as of September, from 5.5 percent. During that same time period, however, the nationwide unemployment rate decreased to 5 percent from 8 percent, a proportionally sharper reduction.
Between January 2013 and September 2016, Kansas added—on a seasonally adjusted basis—32,900 private-sector jobs, a growth rate of about 3 percent. That is less than half the national average of 8 percent growth in private-sector employment during that same period. From September 2015 to September 2016, Kansas lost 6,300 private-sector jobs, according to a recent Kansas Department of Labor news release. Critics of the tax cuts argue that even though there has been some overall job growth, it’s not quite the growth that Brownback promised.
James Franko, vice president and policy director at Kansas Policy Institute, provided a different view. “Jobs numbers show early signs of increasing Kansas competitiveness,” he said in an e-mail to Bloomberg BNA.
“It is not enough to simply accept reported jobs numbers at face value. Instead, they should be examined with perspective and context alongside a host of other indicators of state economic vitality,” the institute said in an Aug. 6 blog post.
The disparity between the individual income tax rate and the business tax rate in Trump’s tax proposals has raised concerns that taxpayers will try to shift their earnings from wage and salary income to business income. The 18 percentage point differential between the top rate on passthrough business income and wages “would create a strong incentive for many wage earners to form a pass-through entity that provides labor services to their current employer instead of taking compensation in the form of wages,” the Tax Policy Center said in its recent analysis of the plan.
Moore conceded that in Kansas a lot of people have shifted their income from wage and salary income to business income. “So you’ve got a lot of lost revenue from people scamming the system and declaring their wage income as business income so they could avoid paying income tax,” he said.
Dickinson provided Bloomberg BNA with an example of the strategy being employed in Kansas. Bill Self, head coach of the University of Kansas men’s basketball team, makes more than $4 million per year. However, his 2012 contract shows that he is directly paid an annual salary of just $230,000. The coach then receives at least $2.75 million annually for “professional services rendered” that Kansas Athletics Inc. pays to BCLT II LLC, of which Self is the owner.
The bottom line is that by simply structuring the payment to go through a limited liability company, Self is able to avoid taxes on the majority of his income, Dickinson said. “I have no doubt that if Trump’s plan went through, lots of folks would do exactly that.”
“We learned from that” in the Trump plan, Moore said. Trump’s proposal would prevent those abuses because a business only gets to use the 15 percent tax rate if it reinvests the money back into the business, he said.
“If the money is taken out of the business in the form of a dividend or some kind of payment to the owners, it’s taxed as individual income. If it’s reinvested in the business to hire more workers or to build a new plant or purchase a new truck or something like that, then you only pay a 15 percent tax,” he said.
“You’re not going to get that kind of arbitraging that went on in the Kansas plan,” Moore said. “It’s not like the Kansas tax cut in that sense.”
Regarding the idea that under the Trump plan employees would turn into contractors, Moore said that “employees can convert into businesses, but if they take the money out of the business like a wage or salary the money is still taxed as individual income.” The same rules would apply as with payroll taxes today, he said.
The Trump campaign didn’t respond to several Bloomberg BNA requests for comment.
Barbara Angus, the House Ways and Means Committee’s chief tax counsel, recently said the different tax rates between corporations, passthrough businesses and individual brackets in the GOP’s tax blueprint are being looked at to minimize gaming.
Alan Cole, an economist with the Center for Federal Tax Policy at the Tax Foundation, said if the reinvestment provision is part of Trump’s proposal, then the Kansas comparison isn’t fair. “The Kansas critique applies only when there’s a single layer of taxation at sub-ordinary-income rates. But at times I think I’ve heard the Trump folks say that ‘small’ pass-throughs might get that single 15 percent rate,” he said in an e-mail to Bloomberg BNA.
However, Cole said, “this entire area of Trump policy is unclear, which opens them up to critiques about potential abuse that might not be valid if they would actually specify what’s going on in a clear written statement.” The Trump tax platform online says that the 15 percent rate is available to all businesses—large and small—"that want to retain the profits within the business,” but that is the only hint at Moore’s reinvestment provision.
“If you’re proposing a plan in which it seems obvious that you’re setting things up that people can take advantage of, I think you have to give an answer for how you’re going to make sure” abuse doesn’t occur, Rueben said. The best option for preventing abuse would be to raise the business tax rate, she said.
Rueben’s colleague Joseph Rosenberg, a senior research associate at the Tax Policy Center, said if there is indeed a reinvestment provision in the Trump tax plan, then it would be fair to say that there is less incentive to avoid taxes under his plan than there is Kansas. However, it would be difficult to stem all abuse with the disparity between the two rates remaining at the current level.
“It would be tough to write rules that the IRS could credibly enforce when the tax rate differential is so large,” Rosenberg said. “We have problems in the current tax system with high-income business owners reclassifying wage income to avoid the 2.9 percent payroll tax.”
When comparing the presidential candidates’ tax plans to changes on the state level, Moore likened Clinton’s plan to tax changes in states like Illinois, where tax hikes have had an adverse impact.
In January 2011, Illinois lawmakers imposed a record income tax increase that temporarily raised the rate on individuals to 5 percent from 3 percent, and on corporations to 7 percent from 4.8 percent. The Tax Foundation notes that the business rate increase is actually 9.5 percent because of an additional 2.5 percent property replacement tax imposed on corporate income. The rates in Illinois have since fallen.
The tax changes resulted in some residents moving across state borders to avoid the high rates. A recent poll by the Paul Simon Public Policy Institute at Southern Illinois University Carbondale found that 47 percent of Illinois residents said they wanted to move. Taxes were the most significant driver, with 27 percent of respondents citing that as their motive for wanting to depart. The poll also found that working-age adults and millennials are most interested in leaving.
The outflow has accelerated to record rates in recent years, the Illinois Policy Institute said in a recent blog post. In 2015, the most recent year of data, Illinois sustained a net loss of 105,000 people, the worst year on record, the think tank said. “Illinois is losing people at a rate of one person every five minutes,” it said. The tax increases haven’t done much to better the state’s financial situation. Illinois’ unpaid bills and pension debt continue to pile up, and out-migration worsens those problems.
Clinton has proposed three individual income tax increases on high-income households: a 4 percent surcharge on adjusted gross income in excess of $5 million ($2.5 million for married couples filing separately); a minimum tax of 30 percent of AGI phasing in between $1 million and $2 million of income; and a 28 percent limit on the tax benefit from specified deductions and exclusions, apart from charitable contributions. Clinton’s plan wouldn’t change the corporate income tax rate, but she has offered several proposals aimed at discouraging multinational corporations from avoiding taxes by moving their headquarters overseas.
The Clinton campaign didn’t respond to Bloomberg BNA requests for comment.
While analysts noted that the complexity of Clinton’s tax plan makes it difficult to compare to changes made on the state level, Cole said the “bulk of long-run evidence” supports the assertion that high rates typically reduce growth. “For example, over the very long run, it’s pretty obvious that high tax rates result in lower hours worked throughout the economy,” he said, pointing to research conducted by Edward C. Prescott, the 2004 Nobel Laureate in economics.
Rueben of the Tax Policy Center said the comparison between Clinton’s plan and the tax changes in Illinois is “somewhat misleading,” at least as Illinois’ current tax rates stand. “Illinois’ economy is in trouble largely due to high spending and low taxes and not meeting its obligation most notably about its public pensions,” she said.
Rueben noted that there are proposals in Illinois to introduce higher income tax rates on very high-income individuals, which would parallel Clinton’s plan.
“I think it is worse for Illinois to introduce much higher rates on its top earners while cutting taxes on everyone else given its existing obligations because it is relatively easy for people to move,” she said. Rosenberg said the out-migration issue would probably be less of a concern on the national level because people are less likely to move to another country or change their citizenship to avoid taxes.
California or New York would be a more appropriate comparison for the Clinton plan “to learn from given they are larger economies (as is the nation as a whole) and while there are definite long term issues they have more capacity to respond,” Rueben said. California and New York have some of the highest income tax rates in the country, though the latter recently reduced its business rates.
“We haven’t seen a lot of exodus from either state due to their higher tax rates,” Rueben said.
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