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Sights and Sounds from Kansas as they Consider Bill to Eliminate Pass-through Carve-out

3 min readBy: Scott Drenkard

Yesterday, I testified in Topeka to the Kansas House Committee on Taxation on HB 2444, a bill that would eliminate the state’s rather infamous exemption of all income earned by pass-through entities (like LLCs, S-corps, and sole proprietors). We’ve been critical of the provision since its passage back in 2012, and this was an opportunity to voice some of our concerns. From my remarks:

The pass-through exemption encourages taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. avoidance without generating desired growth

My judgement, which is shared by my colleagues, is that the pass-through exemption is the reason for this revenue underperformance. When the exemption was passed in 2012, it was projected that 191,000 entities would take advantage of the provision. As more and more people have realized the very sizeable tax advantage of being a pass-through entity in Kansas, that number ended up being 330,000 claimants, over 70 percent more than was anticipated.

It’s important to note here that while decreasing taxes is generally associated with greater economic growth, the pass-through carve out is primarily incentivizing tax avoidance, not job creation.

If they passed a provision like this in Washington, D.C., where I live and work, I would go to my employer the next day and ask them to start paying me as an independent contractor. I would still be doing the same job and contributing the same value to the economy, I just wouldn’t be paying any income taxes.

The individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. is one of the largest instruments in the Kansas revenue toolkit. Exempting pass-through income substantially narrowed the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. of that instrument, and in a haphazard and unpredictable way.

There may be some on this committee that are interested in getting rid of the individual income tax entirely, and see the pass-through exemption as a first step to getting there. It is not a good one, and broader, more predictable overall rate cuts are a much more straightforward way of getting there.

Feelings of legislators on the Kansas pass-through exemption are mixed. Some share our concerns, but some view it as a hallmark feature of Kansas’ 2012 tax package, and now that it has a sizable constituency of claimants, they don’t want to vote to remove it. Others would consider removing the provision, but only if in a revenue-neutral fashion. Still others don’t want to pass anything on tax issues until the next round of elections, with a new governor (that, of course, is two years away).

Rep. Mark Hutton (R-Wichita), the bill’s sponsor, has managed to pull together a group of notable legislators around the bill, including Rep. Adam Lusker (D-Frontenac), Sen. Jim Denning (R-Overland Park), and Senate Vice President Jeff King (R-Independence). Yesterday, after I testified, over a dozen Kansans from different walks of life testified about their concerns with the carve-out. Some of them are beneficiaries of the provision, but have watched as the exemption has encouraged restructuring activity and created revenue shortfalls in recent years. Some good coverage is here and here.

It’s hard to impress how much damage has been done by Kansas’ failed attempt at tax reform in 2012. It has forced the state to raise taxes elsewhere, draw down its cash reserves, and compromise its bond rating. As I mentioned in my testimony, the Kansas fiasco also has garnered national attention; and I watched it contribute to the 2014 shelving of a tax reform proposal in Nebraska that I thought was very balanced.

Read the full testimony here.

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