The state’s experiment with tax cuts on so-called pass-through entities did not heat up its economy — but did help some very rich people.
WICHITA, Kan. — In December 2014, the University of Kansas agreed to pay David Beaty $800,000 a year, plus incentives, to be the football program’s head coach, but with an interesting structure: More than two-thirds of that pay would be channeled to an organization called DB Sports L. C.
DB Sports is what accountants call a pass-through entity, and it pays all of its profits directly to Mr. Beaty. As the result of a tax law that Kansas lawmakers passed in 2012, ostensibly to benefit beleaguered small businesses in the state, that contract structure allowed Mr. Beaty to avoid paying about $37,000 a year in state income taxes, nearly enough to fund a first-year teacher’s salary in the Wichita school district.
With the state hemorrhaging government revenue, Kansas lawmakers rolled back the tax law this year, but congressional Republicans and President Trump are trying to take the experiment with “pass-through” preferences national, beyond Wichita and Topeka to cities with residents who measure incomes in seven, eight or nine figures.
The Republican tax rewrite unveiled this month aims to jump-start economic growth in part by establishing a 25 percent tax rate on small businesses and other firms that operate as pass-through entities, a cut from the top rate of 39.6 percent that such business owners pay now.
But the abandoned experiment in Kansas points to how a carve out intended to help raise growth and create jobs instead created an incentive for residents, particularly high earners, to avoid paying state income taxes by changing how they got paid.
In 2012, Kansas lawmakers, led by Gov. Sam Brownback, a Republican, enacted a tax cut that eliminated state income taxes entirely for pass-through entities — such as sole proprietorships and limited liability partnerships — which are taxed at the owner’s individual income tax rate. The law also lowered individual income tax rates, cutting the top rate to 4.9 percent from 6.4 percent.
The tax package reduced state revenue by nearly $700 million a year, a drop of about 8 percent, from 2013 through 2016, according to the Kansas Legislative Research Department, forcing officials to shorten school calendars, delay highway repairs and reduce aid to the poor. Research suggests the package did not stimulate the economy, certainly not enough to pay for the tax cut. This year, legislators passed a bill to largely rescind the law, saying it had not worked as intended.
“It caused a lot of budget instability,” said State Senator Jim Denning, a Republican who led the effort to repeal the pass-through exemption this year. Mr. Denning, who earns pass-through income from his interest in a commercial real estate firm, said he had personally benefited from the exemption, but the state’s economy had not.
The pass-through exemption was responsible for $200 million to $300 million of that annual shortfall, according to budget researchers at the Tax Foundation in Washington. Between 2012 and 2015, the total number of Kansans claiming pass-through income grew 20 percent, from about 330,000 to about 393,000. A team of researchers from the University of South Carolina and other institutions who studied the impact of the tax change found the top 2 percent of Kansas earners reaped the largest gains from shifting income to pass-throughs.
Participation at the federal level could be far more dramatic — with tax benefits dwarfing those enjoyed in Kansas. The top income tax rate in Kansas before the 2012 law was 6.4 percent. This year, it will be 5.2 percent, growing to 5.7 percent in 2018. The top federal rate is 39.6 percent, offering a significantly bigger incentive for tax avoidance if pass-throughs are taxed at 25 percent. Already, 70 percent of pass-through income flows to the top 1 percent of American income earners, Owen Zidar, an economist at the University of Chicago Booth School of Business, has found.
Republicans are considering lowering the top individual tax rate to 35 percent, but Mr. Trump has said he would maintain a higher rate on top earners in an effort to keep the income tax structure as progressive as it is now.
“The experience of Kansas shows that lawmakers should be cautious about taxing income from pass-through businesses at different rates than wages and salaries,” said Scott Greenberg, a senior analyst at the nonpartisan Tax Foundation in Washington, which models tax proposals’ likely effects on the economy. A pass-through cut, he added, would probably produce less growth than many other, less expensive tax policy changes.
Republicans say they will erect guardrails to prevent workers from reclassifying themselves as contractors to exploit the lower rate. But their plan does not provide specifics, and tax experts say it will be difficult to restrict high-income individuals from diverting income through a pass-through.
Pass-throughs have long been favored by small businesses such as dental offices and family farms, but their use has expanded to include many financial and real estate firms; Mr. Trump’s business empire is largely run through hundreds of pass-through companies. The structure is also popular among consultants and other high-earning independent contractors; former President Bill Clinton, for example, receives payment for speeches through a pass-through entity.
Using a random sample of state tax returns, Jason DeBacker of the University of South Carolina’s Darla Moore School of Business, Bradley Heim and Justin M. Ross of Indiana University and Shanthi Ramnath of the Treasury Department, isolated the number of workers in Kansas who routed income through pass-through entities after the law passed, even though they continued to earn that income from the same source. They found more than 2,200 Kansans had done so, about 0.2 percent of workers in the state.
If the rest of the country saw the same reclassification trend as Kansas, Mr. DeBacker said, nearly 250,000 Americans would use the technique to lower their tax bills. He cautioned that the number could be larger, because the gap between the top tax rates on labor income and pass-through income would be substantially wider than it was in Kansas, and because tax professionals would have greater incentive to specialize in helping wage earners form pass-throughs.
“I’m not going to go through the hassle of reclassifying myself just to save $10,” said Joseph Rosenberg, a senior research associate at the Tax Policy Center in Washington. “I’m only going to do it if there’s a payoff, and the 10 percentage points would make a difference for me.”
Mr. Rosenberg and two colleagues estimate that such shifts could reduce federal revenues by at least $41 billion a year. Most of that, $39 billion, would come from existing pass-through owners paying lower taxes. The rest would come from wealthy individuals routing income through pass-throughs to minimize taxes.
Defenders of the Kansas experiment say that the pass-through cut led to more new businesses forming, while modestly raising growth at a time when the state’s key industries — aerospace, agriculture and energy production — were faltering.
