Former Senior Vice President, Economic Policy Division, and Former Chief Economist
June 22, 2017
In the grand American tradition of states experimenting with new policies, Kansas has done the nation a great service by offering itself up to test certain propositions in tax reform. Congress and the administration should digest such lessons as the nation prepares for a sprint to enact comprehensive, pro-growth tax reform at the federal level.
Kansas’ story actually began in 2013 when Governor Sam Brownback pushed through the largest tax cuts in the state’s history, including a zero percent tax on business income. Lowering tax rates on business income is certainly a sound approach to strengthening job and income growth, whether of a state or a nation, but the Kansas plan did not turn out as the governor hoped.
Instead of an economic boom, Kansas got booms in tax avoidance and deficit spending. The tax avoidance problem was simple enough to see coming. If tax rates on sole proprietorships and partnerships are set much below the rates on wage and salary income, then taxpayers have an obvious incentive to convert their salary income into business income by cutting their salaries.
The taxpayer-owner receives the same amount of pre-tax income either way as business net income rises by the amount of salary reduction, but the tax burden is much lower when facing a large difference in tax rates. As Congress considers a substantial tax rate cut on passthrough businesses, tax writers are acutely aware of this issue and are working toward solutions to prevent a repeat of the Kansas experience.
Partly as a result, Kansas then experienced a string of massive budget deficits. Was Kansas economic growth stronger as a result of the tax reform? Probably, but the differences were too small yet to tell, and certainly too small to generate the revenue feedback needed to reduce let alone eliminate the budget deficits.
Finally, the Republican-dominated state legislature could no longer stand by and watch the state’s fiscal picture deteriorate into Illinois’ near junk-bond rated class. A few weeks ago, the state legislature voted for a substantial tax hike largely wiping out much of Governor Brownback’s tax reform. The governor vetoed the bill, but the Kansas Senate voted 27-13 and the Kansas House voted 88-31 to overturn his veto. Both chambers are dominated by Republicans.
As Washington policymakers gear up for federal tax reform, they should take a few lessons from the failed Kansas tax reform experiment. For example, effective pro-growth tax reform will produce a stronger economy and stronger revenues, but there are limits to revenue feedback effects.
Also, tax cuts on either a static or dynamically scored basis must be considered in context. If the federal government were running a tidy surplus, or even small deficits, one might consider combining a big tax cut with big tax reform, but instead President Obama left the nation with a dangerous deficit projected to rise rapidly in coming years. This fact cannot be ignored just because it’s inconvenient. If federal tax reform becomes a big Kansas-style tax cut, the one certainty is that the reforms won’t stick. Within a few years Congress will have to reverse course and hike taxes, just as Kansas did. Don’t expect a lot of additional growth from such a reform.
Pro-growth tax reform can do more for economic growth than any other policy reform available, but only if it’s done sensibly. We cannot afford to miss this opportunity for bold, effective, lasting reform.
About the authors
Dr. J.D. Foster is the former senior vice president, Economic Policy Division, and former chief economist at the U.S. Chamber of Commerce. He explores and explains developments in the U.S. and global economies.