Why Tax Cuts Worked for Russia, But Not Kansas
Donald Trump may lose the presidential election, but the idea of major tax cuts as a way of boosting the economy is likely to remain a central tenet of Republican ideology long after he's gone. Opponents say that if you want to see why such programs don't work, you need look no further than Kansas, where the Republican governor, Sam Brownback, put in place radical tax cuts four years ago.
To a Russian visitor like me, though, that's not a persuasive narrative. The most effective economic initiative undertaken by President Vladimir Putin in his 16 years in power was to replace a progressive tax scale with a 30 percent top rate in favor of a 13 percent flat tax. Putin's 2001 tax reform saved the Russian budget from chronic underfunding and a woeful dependence on high-rate borrowing. Brownback told me that the experience of Russia and other Eastern European countries with low, flat taxes, contributed to his decision to try the same medicine in Kansas.
Some of the same economists who worked on Brownback's plan also advised Trump on his tax proposal, notably Arthur Laffer, a former economic aide to Ronald Reagan.
"The Trump tax plan is the Brownback tax plan," says Duane Goossen, the state's former budget director. Under a Trump administration, "what's happening here would happen to the whole country."
To the supporters of Hillary Clinton, who wants to raise taxes on the wealthy, Kansas's problems -- a big budget shortfall and anemic growth -- are the natural result of any broad tax-cutting strategy.
And it's true that this approach hasn't quite worked in Kansas, where Brownback has cut the top tax rate from 6.45 percent to 4.6 percent since 2012 and exempted small businesses from income taxes. But that doesn't necessarily mean it's fair to say tax cutting will never work for U.S. states or the U.S. as a whole. It's a matter of realistic goal-setting, execution and timing. In Kansas, none of the three worked out correctly.
Thanks to improved compliance, Putin's reforms immediately increased personal income tax revenue to 2.9 percent of gross domestic product in 2001, from 2.4 percent the previous year.
By contrast, Brownback's tax reform immediately deprived the Kansas State General Fund of $800 million a year, when revenue had been just $6.17 billion in the 2013 fiscal year, the last before the cuts took effect.
The resulting shortfalls have caused Brownback's administration and legislators to scramble for extra revenue. Since the income tax cuts, Kansas has raised its sales tax twice. Combined local and state sales taxes are now higher here than in New York or California. The state has also plundered the highway construction fund to pay other bills and used every legal opportunity to defer payments. The state's budget director, Shawn Sullivan, looked in dire need of sleep when I saw him in Topeka: His is probably one of the most thankless jobs in U.S. government today.
Russia avoided a similar predicament because Putin was trying to solve a specific, narrow problem. In a country where tax evasion was a way of life, he was trying to give Russian employers an incentive to pay salaries legally rather than under the table. This benefited the budget, businesses (the tax environment became clearer and more stable) and the workers -- suddenly, they had official income that allowed them to take out bank loans, creating a credit boom and speeding up growth.
Kansas didn't have Russia's compliance problem. Brownback's goals were different and perhaps overly ambitious, while the tax cut was far less drastic: The governor told me he was mainly concerned with his home state's population outflow to other states and the subsequent loss of Kansas's political power. "Bob Dole got elected from the sixth congressional district," Brownback says. "Now there are only four. Do you want to keep going down that road?"
The governor's analysis of the migration flows gave him the idea that Americans were fleeing to states with lower taxes.
"We were getting in-migration from California and losing lots of people to Texas," Brownback says. "It was the vibrant economy and the zero income tax. That's what tracks. We are generally losing people to lower income tax states and gaining people from higher income states."
The tax cuts did little to change that. Brownback points to a sharp increase in net migration from neighboring Missouri, which still has a 6 percent tax rate. That's somewhat misleading, though: Kansas lost almost 6,000 people to outward migration last year, many of them to higher-tax states. Brownback couldn't have solved the problem, and I think he understands why. "I don't have oceans and I don't have mountains," the governor told me. "Just got mountains of grain."
Another motive for the tax cuts was to boost the economy and create jobs. At the time the reform was adopted, Brownback wrote it would be "a shot of adrenaline into the heart of the Kansas economy," a phrase he now regrets. "I used too robust a terminology," he told me.
Brownback wanted to contribute to economic expansion by stimulating the growth of small businesses. That's why Kansas did something no other U.S. state does: It eliminated income tax on earnings from pass-through businesses such as limited partnerships. That exemption has cost the state about $250 million a year, but it may have helped increase the number of new businesses in Kansas. In 2015, 17,298 were set up, an all-time record and a 15 percent increase compared with 2012.
The economy, however, hasn't shown any stellar growth. Kansas’s gross domestic product grew 4.8 percent from the end of 2012 through the first quarter of 2016, less than half the national rate. Nor have the cuts resulted in a job boost. Non-farm employment in Kansas is down so far this year. In 2012, before the tax cuts went into effect, it increased 0.7 percent.
"Our economy is stuck in neutral," says Mike O'Neal, who was speaker of the house in the Kansas legislature when the tax cuts were passed and who now heads the Kansas Chamber of Commerce.
Brownback has taken the blame: Under his tenure, the public sector has been shrinking and bleeding jobs. He's not the real culprit, though. The biggest contributor to this year's job losses is the mining sector, which includes the oil and gas industry.
According to Sullivan, oil and gas and agriculture combine for 10.5 percent of Kansas's economic output, compared with 5 percent for the U.S. as a whole. That's not the degree of commodity dependence Russia has to deal with -- its gross domestic product is about one-fifth oil and gas and about 4 percent agriculture -- but the commodity price bust since 2014 still has hurt Kansas more than Brownback's many opponents are willing to admit.
Much of the state's industry is tied to agriculture: It produces machinery, equipment and biological material for farmers. Kansas's farm income hit a 30-year low last year, plummeting to less than $5,000 from almost $129,000 the previous year, so farmers have had to cut down on investment. State sales tax receipts have dropped the most in the countries where energy and agriculture form the basis of the economy.
"Every 1 percent drop in farm commodity prices costs us $7.7 million in sales tax receipts," Sullivan says.
In Russia, the oil bust has obliterated much of the positive effect of Putin's early fiscal reforms. There, low energy prices mean lower revenue across the board -- for equipment makers, retailers, media owners and real estate developers. The oil and gas money trickling down to every other sector was the fuel for Russia's explosive growth in the 2000s. Without it, the Russian economy is in recession.
But at least Russia had its fat 2000s. Brownback cut taxes in 2012: His timing was unlucky in the extreme.
Both Russia and Kansas now have major budget problems. But, unlike Putin, who has retained much of his popularity, Brownback can ill afford it politically: He is the least popular governor in the U.S. today. He believes that's because of the public perception that the tax cuts are killing the Kansas school system, ranked 10th in the nation by high school student achievement. "Kansans treasure their schools, and I do, too," the governor says.
Schools are responsible for more than half of the state's spending. Brownback insists school allocations have gone up to $3.7 billion from $3.4 billion in fiscal year 2013, not counting the state's contributions to the public employees' retirement system. But at the school level all people see are painful cuts.
KayLynn Smith, who has worked in the Kansas public education system for 35 years and is now a school counselor in Andover, a Wichita suburb, says her school has had to lose eight teachers from a staff of 55 since the tax cuts, eliminating classes in electives such as Spanish or art. She is the only counselor in a school with 600 kids, even though the state's education commissioner says the goal should be a ratio of 200 to 250 students per counselor. Classroom assistants -- people not qualified to be teachers but still working directly with students, especially those who lag behind -- have been moved to a 29-hour week, stripping them of benefits and making them hard to hire at $7.50 an hour. While six years ago, there were 22 students in the average class, there are 27 to 28 now. The privatization of school transport has resulted in more crowded buses and longer routes.
"It's disconcerting to see decades of progress slipping away," Smith says. Indeed, Kansas students are slipping in National Assessment of Educational Progress tests: since the tax cuts, their results have converged to the national average after years of beating it.
Republican politicians and the governor's office don't see it that way. They contend that the cuts should make the public school system more efficient, not weaker. "Every time the schools need more funds," O'Neal, the former speaker, says, "They say, oh, we're going to lose this chemistry teacher. But why not a janitor or a third vice-principal?" According to O'Neal, schools only spend 55 percent out of each dollar they receive on instruction.
Sullivan, for his part, says the state's 286 school districts should work to consolidate, find savings through joint purchasing and insurance policies that would cover groups of districts rather than each separate one. Instead of savings, however, Sullivan may have to deal with a big increase in school funding in the next fiscal year: Several school districts have challenged Brownback's funding formula in the state supreme court, and if they got all they're asking it would cost the state $800 million a year. It doesn't have the money.
"We're broke," Goossen says. "There's no money in the bank." Sullivan believes property taxes may have to go up if the supreme court decision is unfavorable to the state government.
Russia, struggling to cut the budget deficit since commodity prices fell, has been looking for the same efficiencies as Kansas, consolidating schools and looking to cut administrative costs -- a reform that has met with some angry opposition in the educational community. Yet teachers and Russian school officials don't have the same power there as their counterparts in the U.S. -- it would certainly be useless to challenge funding formulas in the courts.
Goossen believes the next legislature, which will be elected on No. 8, might roll back some of the cuts, in particular closing the pass-through loophole. But that may be harder than it appears. "They'll get elected saying they're anti-Brownback," O'Neal says. "OK. So does that mean you favor raising taxes? That's not what voters asked them to do."
Tax cuts are like a train that cannot back up. Even Teflon Putin rebuffed his technocratic advisers this year when they suggested going back to a progressive income tax: The consequences of reversing the 2001 reform would be unpredictable.
The danger of Trump's Brownbackian proposals is not inherent in tax-cutting as such. It's that Trump and congressional Republicans might cut taxes for the wrong reasons, with the wrong expectations and in the wrong way. In Kansas, Brownback initially proposed a much milder version of the cuts, which would have limited revenue losses to $90 million a year, but legislators thwarted his Putin-like attempt to expand the tax base, eliminating certain exemptions. He still signed the bill.
"It was either that or do nothing," he explained to me. With tax cuts, though, it's better to do nothing unless there is absolute certainty that they'll work as intended.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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