Kansas May Drop Pass-Through Exclusion After Revenue Projections Miss Mark Again

April 30, 2015

In 2012, Kansas enacted a tax cut package that reduced income tax rates while completely eliminating income tax on pass-through entities like LLCs, S corps, partnerships, farms, and sole proprietorships. At the time, we warned that the pass-through exemption had no economic justification and “will encourage economically inefficient, though tax-reducing” restructuring activity. We also warned that the “tax reductions, while producing positive economic benefits, would cost revenue and ultimately need to be paid for either by cutting spending or increasing taxes elsewhere.” In 2013, I said the pass-through exclusion is “an incentive to game the tax system without doing anything productive for the economy.”

Tragically for Kansas, our predictions have proven true. In 2013, as revenue dropped by $700 million (and $300 million more than predicted), spending was only cut $150 million. For a $6 billion budget, those numbers are huge. New fiscal estimates calculate a $422 million gap between revenues and expenses for the fiscal year beginning July 1, 2015, and a $600 million gap for the year after that. These estimates are upward revisions of earlier estimates by hundreds of millions, which has been a disconcertingly common practice since Kansas enacted its tax cut package in 2012.

The pass-through exemption is why. Earlier this year, Bryan Lowry of the Wichita Eagle dug into the numbers and found that 280,737 entities were taking advantage of the tax carveout in 2013, far above the state’s projection of 191,000. Further, another 53,000 farmers took advantage and weren’t even counted initially, boosting the unexpected revenue loss to $200 million annually. While the Brownback administration has pointed to a few thousand new brick-and-mortar businesses in Kansas, the vast majority of this activity spurred by the pass-through carveout is creative accounting.

In 2012 and 2013, Brownback predicted instant economic growth to cover the gap. Some economic activity has occurred, but not enough to offset the revenue drop. Brownback continues to insist on retaining the pass-through carveout, although he now concedes the state is running out of cash and some action needs to be taken to balance the budget. He has proposed suspending further tax cuts, drawing down the state’s reserve funds (a one-time “source” of revenue), raising cigarette taxes, and eliminating income tax deductions for things like mortgage interest. Tackling deductions is a good idea on its own merits, but none of these ideas address the structural problem: the pass-through carveout that is wreaking havoc on the state’s ability to project its revenues with any accuracy, by letting people who can game the system pay zero tax, while other people engaging in economically identically income-creating activity have to pay full freight.

Two key Kansas Republican legislators said yesterday that it’s time for the state to revisit the state’s income tax exemption for all pass-through business income. It is.


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