President Trump’s tax plan doesn’t have a lot of details yet, but Treasury Secretary Steven Mnuchin gave us one big clue: a proposed 15% business tax rate, a big drop from the current 35%.
But ask some Kansans and you’ll learn how that kind of tax cut can have some serious unintended consequences.
In 2013, as part of the state’s largest-ever tax cuts, Kansas slashed its business tax rate down to 0%. It was supposed to spur economic growth. After all, if businesses have more money in hand, they can theoretically hire more people and invest in making new products.
Instead, researchers from a number of institutions say it turned more into a “tax avoidance” program, rather than encouraging investment. A lot of white collar workers like law partners, accountants, and doctors stopped taking salaries and instead started claiming the profits of the business. For them, state income tax essentially went from a maximum of 4.6% to nothing. This has led to an ongoing budget crisis.
“Kansas has been an unmitigated budgetary disaster,” says Dr Lori McMillan, a tax law professor at Washburn University told Business Insider. “It was a very messy, blunt club when a scalpel was needed.”
The economic growth from the tax cuts never materialised. Kansas was saddled with an almost instantaneous budget hole, leaving schools and pensions drastically underfunded. Infrastructure repairs were put on hold. And to deal with a $US700 million drop in revenue — almost twice what was predicted — Kansas raised its sales tax, hurting all residents, but especially lower income Kansans.
Kansas has some peculiarities, but the lessons still apply nationally. In the state, the zero per cent tax only applies to so-called “pass-through” businesses, which send their profits directly to the companies’ owners. Before this law, those owners would just pay Kansas’s individual tax rate. The 2012 law effectively created a new category just for them, where they pay nothing.
Nationally, 90% of US companies are pass-throughs, according to the Tax Foundation, so it’s possible Trump’s tax cut would have similar effects. It could also encourage some higher-income workers to become independent contractors rather than remain companies’ employees.
“The logic is simple,” Joseph Rosenberg and Leonard Burman of the Tax Policy Center write in a report. “If wage income is taxed at 33 per cent but business income is taxed at 15 per cent (as under President Trump’s campaign proposal), taxpayers may reduce their tax liability by more than half if they can effectively recharacterize their wage income as business income.”
In other words, someone might stop taking a traditional salary, and instead effectively become a one-person business to save on taxes.
It wasn’t supposed to be this way.
Kansas governor Sam Brownback pushed hard for this tax break. He bet it would help the state’s economy. But the bigger than expected budget shortfall has had drastic ripple effects.
It’s exacerabed a school funding crisis. The state’s supreme court in March even called the low level of funding unconstitutional.
Despite widespread criticism, including from within his own party in the legislature, Brownback has mostly resisted reversing the tax cuts. The state’s budget director, Shawn Sullivan, who’s appointed by the governor, says that might be changing.
“The goal is to be pro-growth,” Sullivan told Business Insider. “The governor believes the current plan is best, but as the legislature deals with the current situation, he is willing to compromise.”
Sullivan also refutes the validity of some of the economic studies of Kansas completed by the Tax Foundation and academics, saying, “they’ve extrapolated conclusions not borne of the data.”
But the state is still facing massive budget deficits — as much as $US1.1 billion through the middle of 2019. Instead of changing the tax cuts on business and personal income, the lawmakers have raised sales taxes.
“When you pick winners and losers in your tax policy, you only shift the burden of funding the government to others who may be less able to pay,” says McMillan.
Kansas now has one of the highest sales tax rates in the nation at 6.5%, the cigarette tax was recently raised by 79 cents to $US1.29, and a new tax was put on vapour products as well, according to the Tax Foundation.
Bernie Koch of the Kansas Economic Progress Council isn’t sure how long that level of sales tax can last.
“The sales tax wasn’t meant to handle that load,” says Koch. “It’s become the largest slice of the pie for Kansas. More than the income tax. I don’t think the legislators ever thought ‘can the sales tax handle this?'”
Kansas lawmakers are now working to repeal the pass-through tax exemption as part of a larger tax overhaul. In February a state legislature-approved bill was sent to Governor Brownback’s desk where he vetoed it.
“I am vetoing it because the legislature failed to fulfil my request that they find savings and efficiencies before asking the people of Kansas for more taxes,” the Governor said in a statement. “I am vetoing it because Kansas families deserve to keep more of their hard-earned cash.”
Following the veto, the credit-rating agency Moody’s issued a negative outlook for the state.
Even though people are changing the way they file and are going out of their way to get the tax cut, they’re within the bounds of the law.
A Trump plan
Trump’s team says its plan might work differently.
At a White House briefing, Mnuchin said the administration “will make sure that there are rules in place so that wealthy people can’t create pass-throughs and use that as a mechanism to avoid paying the tax rate that they should be on the personal side.”
But the big question is: how does he do that? What legal rules can the administration come up with so that tax lawyers and accountants can’t find legal loopholes.
“Kansas is a teaser for how hard it is to budget this kind of tax cut,” McMillan said.
Details of the Trump plan are currently being negotiated with Congress.
Meanwhile, some are wondering if Kansas’s schools will open in the fall. Following the supreme court’s ruling, legislators must pass some form of tax reform to properly fund the schools.
“I’m optimistic something will get done,” Koch said. “Mostly because if the schools close, there will be riots in the streets.”
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.