Kansas tax cuts don't work, leave state in hole

Kansas officials can't seem to put out a tax forecast that's pessimistic enough, with tax collections in June falling short again, this time by more than $33 million.

Not collecting as much revenue as expected is becoming routine in Kansas, just one aspect of an "I told you so" story that is clearly delighting left-leaning observers. That's because everybody who follows tax policy knows Kansas is the outstanding example of a state government fully committed to reducing taxes to boost economic growth. So far it's a story of failure.

The challenge is to look closer and see what really went wrong here. Maybe it's not so much that policymakers slashed taxes as how they did it, all the while ­failing to realize just how much people would change what they did with their money once tax laws changed.

There's a lesson in this for Minnesotans, too. Here, advocates of a 9.85 percent top income tax rate have had to argue that it doesn't really have much effect on the choices high-income Minnesotans make. Yet can Minnesotans be more irrational than people are in ­Kansas? Incentives in the tax code really do matter.

If you've read about Kansas in the last couple years, it's probably been about its fiscal problems. For the year that just ended, income tax collections again fell short of the official estimate, although the $111 million shortfall could almost be pitched as good news. It's been a lot worse.

While sales, cigarette and other taxes have been boosted to help close the gap, a perennial shortfall in income tax collections has affected the state budget in an entirely predictable way. There have been spending cuts, one-time shifts and the draining of the ­highway fund.

The most recent snapshot of the Kansas economy, an analysis of 2014 inflation-adjusted personal income growth, had Kansas narrowly avoiding being ranked dead last among the states. For the administration of Gov. Sam Brownback — who once predicted that lower taxes would be like a "shot of adrenaline" — evidence of economic sluggishness gets attributed to national headwinds and such slowing industries as oil and gas production and ­aircraft manufacturing.

Others aren't buying that explanation.

"There are other areas of the state that don't have oil and gas, don't have aviation and don't have agriculture, particularly Johnson County [in suburban Kansas City], and there's something going on there, too," said Bernie Koch, a longtime lobbyist for the Wichita Metro Chamber of Commerce now with a group called the Kansas Economic Progress Council. "The employment growth hasn't been that great" and sales tax collections in this affluent suburban area have actually slid.

"The tax cuts didn't work," said Duane Goossen, a fiscal policy analyst and blogger in Kansas who had previously served both Republican and Democratic administrations as the Kansas budget director. "It's about that simple."

Individual income tax rates were cut in a 2012 reform package, but Goossen said what pushed Kansas into uncharted policy territory was eliminating taxes on individual business income.

The form of business that was taken completely off the hook for paying state income taxes is commonly called a pass-through entity, so called because business profits are "passed through" to the ­owners. While some pretty big companies can be organized as a subchapter S corporation or limited liability company, it's mostly small business owners who set one up.

What it means is that in Kansas, people who make their living from a business don't have to pay state income taxes. Their employees, working for a wage, still do.

"It was even a little broader than that, exempting things like rental income, farm income, just about any kind of business income an individual would have," Goossen said. "Just a major, dramatic turn in tax policy. And that [impact] is awfully hard to estimate."

When the tax cuts went into effect in 2013, individual income tax revenue declined by more than $700 million, or roughly $307 million more than had been predicted. That's an awfully big miss for a roughly $6 billion general fund.

That isn't the only estimate that the state got very wrong. Policymakers thought the number of pass-through entities taking advantage of this provision would be around 191,000.

Then the realization grew in Kansas of just how advantageous it was to get the money collected for work somehow classified as business income. That's why the number of claimants for this tax exemption has since climbed to more than 330,000, as described in legislative testimony this spring.

Maybe the original estimate just wasn't accurate, or there could have been a burst of entrepreneurial activity. Or, as seems mostly likely, there's been an unprecedented burst of paperwork filing to change how to get paid.

It's easy to imagine how, too. At a technology consulting firm, for example, the five senior consultants could decide one day to form their own business and then sell their services back to their old boss.

If the boss agrees that this is a fine idea, great, but not much will change. There will be details to work out, such as Social Security and Medicare taxes, but the five consultants-turned-business-owners now get a chance to call what they get paid business income.

Now only the firm's salaried office manager will pay income tax to the state of Kansas.

This strikes some business owners as fundamentally unfair, Koch said, and one reason the current tax policy has split the Kansas business community. One business owner, of an information technology service provider, made a news splash in June by publicly announcing his intention to leave Kansas, and its "destructive" policies, to set up shop across the border in Missouri.

Advocates for stay-the-course haven't been silent, of course, including citing a study that showed recent income migration the other way, from Missouri into Kansas as evidence Brownback's tax policy is working.

Because this is probably the income of business owners who pay no income taxes, it's not clear why this was cause for much celebration.

lee.schafer@startribune.com • 612-673-4302