Trump Tax Plan Haunted by Kansas Tax Experiment

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By Christopher Brown

Does President Donald Trump’s recently released tax framework rely too heavily on the ideas behind the controversial Kansas experiment in tax cuts over the past five years?

A growing chorus of critics, among them members of the U.S. Senate, think-tank experts, and editorial pages from around the U.S., say the answer is “yes.”

But supporters of the Republican tax framework say lawmakers writing the new tax bill in the House Ways and Means Committee are well aware of the mistakes made by Kansas tax cutters and are writing key provisions to avoid repeating them.

Kansas Gov. Sam Brownback’s (R) 2012 tax cut package was heralded when enacted as an experiment in supply-side economics that would provide a needed jolt to the state’s economy, but was rolled back earlier this year amid a growing feeling that the experiment failed.

The Kansas experience is “highly relevant” to the Trump tax framework, said Chye-Ching Huang, deputy director of federal tax policy at the Center on Budget and Policy Priorities. Huang told Bloomberg Tax that the Kansas plan used “the same theory and even the same designers” as the Trump framework.

Now there are questions of who would benefit from the Republicans’ proposed tax cuts and whether they would lead to economic growth.

Five-Year Experiment

The Kansas 2012 package lowered tax rates, simplified the state’s system of tax brackets, and created a complete tax exemption for income from passthrough entities—a category that includes most small businesses and sole proprietorships, but also many larger enterprises and partnerships owned by wealthy taxpayers.

Critics both inside and outside the state said the result of the cuts was a precipitous drop in tax revenue, a turmoil-ridden budget process that dominated state politics for the next five years, and no real evidence of economic benefit to balance the harm caused. Criticism became so widely accepted inside Kansas that the cuts were repealed over Brownback’s veto by a Legislature that was still firmly in Republicans’ control.

The problem with the Kansas experiment was twofold, according to William Gale, co-director of the Urban Institute and Brookings Institution Tax Policy Center: It was built on a shaky foundation of supply-side economics, and its tax exemption of passthrough income was an invitation for taxpayers to game the system through recharacterization of income.

“The most important thing to remember about the Kansas experience is that tax cuts in no way guarantee economic growth,” Gale told Bloomberg Tax. “When it comes to the tax code and economic growth, it seems that policy makers can’t help themselves—they keep going back there. But there’s no solid evidence that this stuff works.”

Kansas has consistently undershot projections both in tax revenue and job creation since the tax cuts were passed. Kansas was one of two states that lost nonagricultural jobs over the past year, according to data maintained by Arizona State University’s Seidman Research Institute.

Passthrough Income

The Kansas tax cuts reduced state revenue by an estimated $800 million a year, which supporters justified with projections of increased economic activity that would generate a compensating increase in tax collections even at lower rates. But the state was forced to make punishing cuts in services and investments while waiting for the promised economic boom to materialize, Huang said.

Because the framework cuts are at the federal level and are correspondingly bigger as a share of each taxpayer’s income, they have the potential to “do even more harm,” Huang said.

For example, the Republican tax framework proposes lowering the tax rate on income from passthrough entities from the current top rate of 39.6 percent to 25 percent.

Supporters of the Kansas exemption for passthrough income said it would boost small businesses, most of which are passthrough entities, but critics said it was an invitation for taxpayers to adopt the form of a passthrough entity without any real change in business activity.

‘Far From Ideal’

Jared Walczak, a senior policy analyst at the Tax Foundation, told Bloomberg Tax that a special rate for passthrough income “is far from ideal public policy.” The Tax Foundation promotes tax reform on the basis of a “broad base and low rates” and typically is critical of special carve-outs, he said.

“The classifications of businesses into different forms—C corporations, S corporations, LLCs, and so forth—should be driven by economic factors, and not by tax policy,” he said. “But special treatment for passthrough income tempts taxpayers to seek benefits through the tax code rather than by focusing on the growth of their business.”

But Walczak disputed the contention that the Kansas experience undermines the argument that well-designed tax cuts can boost economic growth.

“Eighteen states have cut individual income tax since 2008, and 15 have cut their corporate tax rates,” he said. “Many of these are thriving and are more competitive than their peers.”

Kansas stands out for the “unusual and unbalanced manner” with which it carried out its cuts and for encouraging tax arbitrage by exempting a category of income from taxation, he said.

Supporters of the Republican framework’s passthrough proposal have defended it against the Kansas comparison by pointing out that the framework retains taxation of passthrough income, although at a reduced rate.

But Gale said that the incentive to recharacterize income remains under the framework proposal, even with taxation at a 25 percent rate. “The issue is the difference between the top individual income tax rate, which would be 35 percent under the framework, and the 25 percent passthrough rate,” he said. “That’s a 10 percent difference, which is actually larger than the benefit offered by the Kansas exemption.

Safeguards

Rep. Peter Roskam (R-Ill.), the tax policy chairman on the House Ways and Means Committee, said in a statement provided to Bloomberg Tax: “There’s no connection between what happened in Kansas and what we’re proposing. We have always agreed that strong guardrails are needed in the federal tax code so that people do not cheat the system, but by separating business and personal income we are able to provide massive tax relief to main street businesses. Millionaires will not be able to avoid paying their fair share.”

Rep. Lynn Jenkins (R-Kan.), who sits on the House Ways and Means Committee, said in an op-ed that the architects of the Republican tax framework were aware of the Kansas experience and have made changes to avoid problems with the Kansas tax cuts, in particular the issue of recharacterization of income.

“Congress is well aware of this loophole and has worked hard at crafting safeguards to ensure that the federal passthrough rate is not exploited in similar ways,” Jenkins said.

Jenkins didn’t offer specifics in the op-ed, but a congressional staff member working on the bill, who spoke on condition of anonymity, told Bloomberg Tax that “three or four” proposals were under consideration. The staff members declined to offer details on the proposals.

Walczak told Bloomberg Tax that the bill writers have several options, each of which would attempt to separate a taxpayer’s wage or salary income from return-on-investment income. These include limiting the passthrough rate to a defined portion of a taxpayer’s passthrough income, possibly 30 percent; limiting the lower rate to the income attributable to the return on capital investment of the passthrough entity; or having the IRS employ reasonable-compensation rules to define as wage income a portion of a taxpayer’s passthrough income.

Strict Rules

Walczak said that the bill’s scoring process could provide the bill writers an incentive to include strict rules.

“If there are no guardrails in the bill to prevent redefinition of income, then the Joint Committee on Taxation, which scores the bill, will anticipate a shift of income to get the lower tax rate, which would then put a squeeze on other parts of the bill,” Walczak said. “They have a lot of different priorities for this bill, and if the passthrough cut takes up too much, they won’t have room elsewhere.”

Beyond the scoring process, Huang expressed skepticism that guardrails would work. “We’ve seen this already in the federal tax code where people have recharacterized their income to a tax advantage of a couple of percentage points in the payroll tax,” she said.

“And that doesn’t even address the issue that most of the benefit from this cut will go to hedge-fund investors and real estate investors, and not to small businesses,” she added. “There aren’t any guardrails that I’ve heard about that will address that.”

Gale sounded a similar note. “There’s no magic here,” he said. “If there were easy ways to write these things, the armies of tax attorneys out there—some of the finest minds in the country—would have written them already.”

To contact the reporter on this story: Christopher Brown in St. Louis at ChrisBrown@bna.com

To contact the editor responsible for this story: Jennifer McLoughlin at jmcloughlin@bna.com

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