What's Wrong with Kansas' Tax Reform?

According to finance experts from the left and right, it's the worst reform measure passed by a state in the last two years.
by | April 11, 2013
 

At a recent Urban Institute forum, two policy analysts who follow state and local finances were asked a simple question: What's the worst and best tax bill a state passed this past year? Without hesitation, both Nick Johnson, an economist with the left-leaning Center on Budget and Policy Priorities, and Joseph Henchman, a lawyer with the right-leaning Tax Foundation, gave the same answer. Kansas, they said, was the worst.

The tax reform measure, passed by the Kansas legislature last year and signed by Gov. Sam Brownback, slashes the top two individual income tax rates, as well as rates for corporations. It also exempts all pass-through business income -- the first state tax law to do so.

But other states have cut tax rates too, so why is Kansas' so bad? I put this question and others to Johnson and Henchman. Here's an edited version of their comments.

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Why don't you like the tax bill Kansas put into effect last year?

Joe Henchman (JH): Good tax reform broadens the tax base and lowers rates. That's what Gov. Brownback wanted to do. But the legislature took out the "broaden-the-base" part. They just passed a tax cut, which can be justifiable if you want to reduce the size of government or expect other revenue sources to go up. But they didn't cut spending and they don't expect revenue to grow, so it's just a hole. With the exemption for pass-through entities, if you're a wage earner, you're taxed at the top rate, which is currently 4.9 percent in Kansas. If you're a partnership, an LLC or any form of recognized business entity with limited liability that's not a corporation, you're income is taxed at zero percent. That's an incentive to game the tax system without doing anything productive for the economy. They think things like the pass-through exemption will encourage small business, and to be fair, it might. But they are doing it in a way that violates the tax principle of neutrality.

Nick Johnson (NJ): The law fails almost every test of good tax policy, starting with adequacy, affordability and sustainability. It fails both vertical and horizontal equity tests. Vertically, it's beneficial to high-income taxpayers and harmful to low. It doesn't do much for the middle either. Horizontally, its exemption of pass-through entities creates inequities and tax avoidance, which of course then goes back to sustainability because it balloons cost.

The point of [economist Arthur] Laffer, [who was a consultant for the tax plan], is that the whole idea of the tax bill is to jump-start the economy. But evidence suggests that there's no goose to the economy from this or, if there is one, it will be small. The real big problem here is that because it costs so much money, it will make it harder for Kansas to make other kinds of investments that are important to a strong economy like education and infrastructure. People don't understand the scale of what's been enacted -- it's jaw dropping. I'm hard-pressed to identify another state that has ever passed a larger tax cut package overall to its budget.

Is it leading the way in the movement toward getting rid of state income taxes?

JH: That's the goal. But it's a lot of money, so a state has to find a way to get from here to there. The last state to do it was Alaska in 1980. Louisiana [and North Carolina] is looking at it; Louisiana's income tax is one of the smallest shares of revenue -- between 14 and 17 percent. Most states are between 25 and 40 percent. In North Carolina, income taxes are 40 percent.

NJ: For all the frustrations with the income tax, it is perceived as fairer than existing alternatives, and its more broad-based. It's easy to say you want to get rid of the income tax, but there's a real devil in the detail. Nebraska pulled together a proposal to implement big income tax cuts -- the first step toward repeal. They were going to pay for the cuts by repealing exemptions in sales taxes, but were forced to pull it. Business liked the repeal of income taxes, but did not want sales tax exemptions going away. But there's also some backlash: Some states point at Kansas as [the model of] what not to do because of the pay-for-it issue: How do you sustain funding for a top-quality school system when you don't have the tax dollars to do it?

So what state had the best tax reform?

JH: There were several good efforts. Rhode Island's a state where there's high unemployment, several municipalities have gone bankrupt and the state doesn't have a lot of private employers. It's recognized that something has to change. The legislature pushed through revenue-neutral income tax reform that's very good. The governor is talking about lowering corporate tax rates by taking away targeted incentives. These are good moves that are not getting a lot of attention.

NJ: Among the most impressive proposals is Massachusetts'. It proposes to raise additional revenue by making the state tax system modestly less regressive by getting new revenue from those families, businesses and corporations that are already doing well. Then, it will put those revenues into spending areas that seem likely to pay off for the state's economy -- investing in children, families and infrastructure. All of these things are tied to what business leaders want from a state's economy: a trained workforce and sound infrastructure. There's a clear contrast between the investment-oriented approach of Massachusetts versus the less investment approach of Kansas. You need revenue to make those investments and that will be Kansas' problem.

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