Kansas’ Pass-through Carve-out: A National Perspective
In 2012, Kansas enacted a tax cut package that reduced income tax rates while completely eliminating income tax on pass-through entities like LLCs, S corps, partnerships, farms, and sole proprietorships. At the time, we warned that the pass-through exemption did not have good economic justification and would “encourage economically inefficient, though tax-reducing” restructuring activity. We also warned that the “tax reductions, while producing positive economic benefits, would cost revenue and ultimately need to be paid for either by cutting spending or increasing taxes elsewhere.”
In 2013, revenue dropped by $700 million ($300 million more than predicted). Spending that year was only cut $150 million. These numbers are quite large for a $6 billion general revenue fund. The state delayed a planned cut to the sales tax, weakened the generosity of itemized deductions, and drew down reserves to make ends meet. FY 2015 had a significant cash deficit, masked by draining the rainy day fund and beginning balances, and helped by very slow spending growth (only 1.1 percent from the previous year).
The pass-through exemption encourages tax avoidance without generating desired growth. The pass-through exemption is the reason for this revenue underperformance. When the exemption was passed in 2012, it was projected that 191,000 entities would take advantage of the provision. As more and more people have realized the very sizeable tax advantage of being a pass-through entity in Kansas, that number ended up being 330,000 claimants, over 70 percent more than was anticipated.
Tax reform is about broadening tax bases and lowering tax rates. This state has lowered tax rates, but the pass-through exemption significantly narrows tax bases, and the wheels are coming off because of it. We have an opportunity here to staunch the bleeding. I’m hopeful that we are on the way to a productive conversation about how we can do that best.