What Happens When You Eliminate Taxes on Small Businesses

What Happens When You Eliminate Taxes on Small Businesses

In 2012, Kansas Governor Sam Brownback pushed for and signed a tax reform act that was the fancy of every supply-side economist. The reform took three marginal income tax brackets of 3.5, 6.25, and 6.45% down to 3.0% and 4.9%. It also completely eliminated taxes on non-wage business income. The goal was to revitalize the economy by encouraging small business to increase investment. Overall, the plan was expected to slash tax revenue but compensate for part of that in GDP growth. However, in years since, Kansas’ tax revenue has been dropping in greater volume than was expected. This has caused a panic within the state legislature, problems with the budget, and a downgrade of Kansas’ credit rating. After the Governor vetoed emergency tax increases in June, a coalition of Democratic and Republican lawmakers overrode the veto with a two-thirds majority, raising a projected $1.2 billion over two years towards an $889 million budget shortfall.

What went wrong in the first place? Most publications point to the use of “pass-through” loopholes for tax avoidance. A pass-through entity is a business in which their income is passed through to the owners. Therefore, tax will be paid at the personal income tax margins rather than a corporation. This includes income reported on Schedule C and E of a 1040 (1040 is the form every tax-paying individual person must file with the Internal Revenue Service (IRS) each year). Schedule C filers are sole-proprietors or contractors where all income goes to one individual. Schedule E filers are partnerships or S-corporations where income passes through to multiple owners. Businesses that report to Schedule E and C are consistently small firms, attributing 50% of all business income in the United States. About 30% of all individuals in the United States report some form of pass-through income on their personal tax returns, according to the IRS.

CPAs (Certified Public Accountants) are always looking to help their clients pay the least amount of tax as appropriately possible. What is often considered a mundane career is reinvigorated after a government entity passes tax reform. The large federal tax code on top of every states’ and municipalities’ means there is a lot of black ink when it comes to taxes, leaving plenty of room for loopholes. Since the inception of the IRS in 1862, the federal tax code has grown to be 187 times its original length. While most people find doing their taxes a tiresome burden, CPAs have built a career on it. For CPAs, tax reform means a new tax code that almost certainly overlooked some aspect of itself.

In the case of Kansas, it is believed that Governor Sam Brownback opened up a lucrative loophole with his tax plan. When Brownback and the Kansas legislature cut taxes across the board, they cut one particular tax a little too much. Brownback’s emphasis on small business growth led him to completely eliminate taxes on small businesses. While this could have promoted economic growth , in reality, it provided an outlet for the middle and upper classes to escape their state income taxes. Kansas CPAs had one rule for the states’ doctors, lawyers, engineers, and other highly paid individuals – incorporate.

Many believed that the incorporation rush which allowed individuals to reap the benefits of pass through taxation, was the main cause for Kansas’ financial stress. However, further research suggested that that was not necessarily the case. A study conducted by the government officials in the treasury department of the United States and Kansas as well as academics from Kansas’ universities uncovered three important observations:

  1. There is a small 2% increase of the probability of reporting income from self-employment as well as no statistically important change in the reporting of income of any other pass-through entities
  2. No significant evidence was found that amount of reported pass-through income was impacted.
  3. A small amount of wage income may have been reported as self-employment income in order to receive preferential tax treatment.

The evidence from this studygiven by the Internal Revenue Service can lead us to conclude that Kansas’ financial problems are almost certainly not due to some grand avoidance scheme.

Regardless, Governor Brownback’s policies did not stir the growth in small businesses that he was expecting. Additional data from the aforementioned study found no overall increase in spending for “inputs to production” in Schedule C filers. Increase in these types of expenses would indicate greater investment by small firms and contractors. A study by Giroud and Rauh at the National Bureau of Economic research found that C-corporations (medium and large sized companies, not pass-through entities) were more sensitive to changes in income taxes than pass-through entities. Kansas’ situation proves these findings. Tax cuts are less likely to spur as much growth in small pass-through firms as they might in large corporations.

It would be unanalytical to blame Kansas’ massive revenue tax decrease on a massive tax avoidance scheme. Out of the $496 million decrease in tax revenue, only 2% or $8.6 million can be attributed to this loophole aspect of the reform. Statehouse Democrats and Republicans are united in blaming the deficit on tax avoidance to repeal this tax reform. This could tell us two things: one, these politicians have failed to understand the root cause of the problem or two, they have an underlying goal. Brownback’s proposed budget cuts targeted all government sectors, including departments like education which have major ties to powerful lobby groups like the teachers’ unions. It is no coincidence that establishment politicians in the Kansas statehouse would want to keep control of major spending in order to retain their influence and power. Supply-side economics may have not worked out in Kansas, but state legislators might have repealed these policies for their own reasons as well.

 

Sources:

Flows, Capital. “Debunking The Myth Of Tax Avoidance In Kansas.” Forbes, n.d. https://www.forbes.com/sites/realspin/2017/06/13/debunking-the-myth-of-tax-avoidance-in-kansas/.

Henchman, Joseph. “Kansas Pass-Through Carveout Repealed After Legislature Overrides Gov. Brownback’s Veto.” Tax Foundation, June 6, 2017. https://taxfoundation.org/brownback-pledges-veto-kansas-tax-bill/.

“Kansas Had a Mass Tax-Fail in 2012 – Business Insider.” Accessed August 23, 2017. http://www.businessinsider.com/trump-tax-plan-kansas-2017-4.

“Ksbrownbackanalysis.Pdf.” Accessed August 17, 2017. https://itep.org/wp-content/uploads/ksbrownbackanalysis.pdf.

“Sam Brownback Calls on Donald Trump to Mimic His Kansas Tax Plan – WSJ.” Accessed August 17, 2017. https://www.wsj.com/articles/sam-brownback-calls-on-donald-trump-to-mimic-his-kansas-tax-plan-1482489006.

“What Trump Can Learn From Kansas’ Tax Troubles – POLITICO Magazine.” Accessed August 23, 2017. http://www.politico.com/magazine/story/2017/05/04/what-trump-can-learn-from-kansas-tax-troubles-215103.