The matter with Kansas

Earlier this year, while Oklahoma lawmakers were adjourning their legislative session without a final agreement on Governor Fallin’s top priority of cutting the income tax, Kansas Governor Sam Brownback was celebrating his state’s adoption of major income tax changes. Governor Brownback has since referred to the tax plan adopted by the Kansas legislature as a “real live experiment.” While some will be pushing hard to replicate the experiment in Oklahoma, the Kansas example should instead give us pause.

The tax plan approved in Kansas, HB 2117, had four main components:

• Lowering income tax rates, with the top rate dropping from 6.45 to 4.9 percent and the bottom rate dropping from 3.5 percent to 3 percent, and reducing the number of tax brackets from three to two;
• Eliminating tax credits that benefited low- and middle-income households, including the Food Sales Tax Relief credit, Child and Dependent Care Credit, Homestead Property Relief Credit for renters, adoption credit, and others;
• Raising the standard deduction for married couples and heads of household;
• Exempting all “pass-through” business income from tax.

Other than the exemption for pass-through income, the legislation bears a close resemblance to the major proposals that were introduced this year in Oklahoma, which similarly would have lowered the top income rate and offset part of the lost revenue by eliminating key exemptions and credits that reduce taxes for low- and moderate-income Oklahomans. The similarities are not surprising in that tax cut proposals in both Kansas and Oklahoma were largely based on recommendations by economic consultant Arthur Laffer.

As a result of these tax cuts, Kansas is expecting large budget shortfalls. In FY 2014, the first year the new tax provisions will be fully implemented, the tax cut will result in nearly $850 million in lost tax revenue, according to the official estimates of the Kansas Legislative Research Department. By 2018, the tax cuts will lead to cumulative budget cuts approaching $2.5 billion, two-thirds of which are likely to affect public schools and colleges. In July, Kansas budget director Steve Anderson told state agency directors to prepare budget proposals that assume a 10 percent across-the-board cut. Already some agencies are implementing cuts in anticipation of budget reductions. Last month, the Commerce Department announced it was cutting 18 jobs and ending its Kansas Main Street program, which provided money and support for communities to help preserve small downtown businesses.

The Kansas tax plan also provides disproportionate benefit to wealthier households while providing minimal benefits or tax increases to lower-income families. Eliminating the Food Sales Tax Rebate, which offsets the sales tax some low-income families pay on food, will result in a family of four with $17,000 of income paying $294 more in taxes. Only three other states, Alabama, Mississippi, and South Dakota, tax groceries without offering a low-income rebate or credit. Overall, the tax changes will raise taxes for the bottom fifth of Kansans by an average of $148 per year, while lowering taxes for the wealthiest 1 percent of households by over $20,000, according to the Institute for Taxation and Economic Policy. Oklahoma proposals, which would have eliminated the Sales Tax Relief Credit, Child Tax Credit, and Earned Income Tax Credit to partly offset cuts in the top income tax rate, would have had similarly regressive consequences, as we discussed here and here.

The final element of the Kansas plan – eliminating taxes on income from ‘pass-through’ entities such as limited liability corporations, ‘S’ corporations, and sole proprietorships – is  the most unusual. As a result of the differential treatment of income under the new law, a partner in a law firm won’t have to pay any tax, while his or her junior associates, secretaries, and clerks will be fully taxed, as a recent news article noted. Even the reliably conservative Tax Foundation opposes this provision, stating that ” the exemption creates an incentive for businesses to structure as pass-throughs for tax reasons, even if it might be unwise to do so for non-tax reasons.” In addition, while the measure is touted as a boon for small business, the Tax Foundation notes that most pass-through revenue is generated by large businesses, those with revenues above $10 million.

Speaking recently to the Tulsa Metro Chamber, Oklahoma Senate Pro Tem Brian Bingman indicated that “he does not favor a general tax cut, saying he did not want a situation such as the one in Kansas.” At a time when Oklahoma’s economy is outperforming most states, yet our schools and other critical services are struggling with years of reduced and flat funding, such caution is justified. Oklahoma does not need to be the next laboratory for Kansas’ radical tax experiment.