Running the Numbers on the Kansas Experiment
Ah, the Kansas experiment. It doesn't seem to be going so well! Republican Governor Sam Brownback, who pushed through big tax cuts in 2012 at the urging of supply-side guru Arthur Laffer, now has an approval rating of 27 percent -- besting only New Jersey's Chris Christie. The Republican-majority Legislature voted earlier this month to override Brownback's veto of a $1.2 billion tax hike meant to bring the state's red-ink-ridden budget back to somewhere near balance.
In political terms, then, the experiment was clearly a failure. But was it really an economic failure -- and if so, how big a failure? And why didn't it work?
One way to judge is to look at the statistics being offered to defend the Kansas experiment. Writing in the Washington Examiner in March in response to a column from my Bloomberg View colleague Barry Ritholtz, Jonathan Williams of the Center for State Fiscal Reform at the American Legislative Exchange Council (a conservative group that advised Brownback on the tax cuts) pushed these data points:
- Kansas "enjoyed record-high private sector employment in 2016."
- In the 14 years prior to 2012, private-sector employment grew 6.3 percent in Kansas, ranking 41st among the states. In the three years since the tax cuts, Kansas's 4.8 percent private-sector job growth has ranked it 31st.
- Business startups "set another record in 2016 with 18,147 new domestic business filings."
- "Employment at pass-through companies grew by just 2.4 percent in the two years prior to tax relief but then jumped by 8.4 percent in the two years following."
Let's run through those. First, private-sector employment rises in most states most years, meaning that new all-time records are the norm. Even Illinois, which is losing population and enduring a seemingly never-ending fiscal crisis, enjoyed record-high private-sector employment in 2016. The statistics showing Kansas rising a little in the state ranks for employment growth are more meaningful, although 14 years is an odd time period to pick for comparison, and makes me suspicious that it was cherry-picked. Both statistics are an indication that the state's economy isn't falling apart, but they certainly aren't what you'd call dazzling.
Then there are those numbers on startups and pass-throughs. There was in fact a marked jump in new domestic business filings in Kansas in 2012. It was driven by the same thing that drove that big increase in employment in pass-through companies: a provision in the 2012 tax-cut legislation that eliminated all income taxes on pass-through entities 1 such as limited liability companies, S corporations, partnerships, farms and sole proprietorships.
This created some interesting incentives for high-earning Kansans. Here's how, according to public-radio station KCUR, University of Kansas basketball coach Bill Self responded:
Under his 2012 contract with KU, Self pulls down a salary of $230,000 a year. But that’s just a small part of his compensation.
He also gets at least $2.75 million annually for “professional services rendered,” including “educational, public relations, and promotional duties as assigned by the athletics director.
That $2.75 million is paid to BCLT II (the name comes from the first initials of Self and his family) by Kansas Athletics Inc., the entity that operates intercollegiate sports for KU. Which means that Self, who owes his employment to the state of Kansas and is the state’s highest paid employee, owes no Kansas income taxes on the bulk of his pay.
Not many people in Kansas have that big an incentive to get paid through a pass-through entity, and the evidence on how many people have shifted income to LLCs, S corporations and the like is muddled. A widely cited state estimate that the number of Kansans filing with the Internal Revenue Service as pass-through entities had doubled appears to have been a miscount (see the update at the bottom of this column for more details), but other signs still point to significant income shifting. Reports the Tax Foundation, a generally business-friendly Washington-based think tank that has been critical of the pass-through exemption:
Federal tax return data shows Kansas filers who report income on Schedules C, E, and F grew just 1.9 percent between 2012 and 2014 (the most recent federal data available), not the sharp increase that we (and everyone) have reported occurred. However, the total pass-through income reported by those filers did spike, by 11 percent in that time frame. Similarly, Kansas data continues to report significant entity-level growth: the Kansas Secretary of State reports new business filings grew 11 percent between 2012 and 2014, and a further 10 percent through 2016, so new pass-throughs were being set up at a brisk rate under the pass-through carveout policy. It is reasonable to conclude, based on this data and anecdotal evidence, that while few people went from zero income on Schedules C, E, and F to some, Kansans who already reported income on those forms increased how much they were reporting and created new Kansas business entities with the Secretary of State.
So while Williams' numbers on business startups and pass-through employment are correct, 2 it's hard to tell whether they mainly reflect job creation or tax avoidance. In any case, individual income tax revenue fell 23 percent from 2012 to 2016, according to the Kansas Department of Revenue.
If the pass-through exemption were bringing droves of new jobs and businesses to Kansas, maybe this initial direct tax loss would still be worth it. Rex Sinquefield, a Missouri quantitative investing zillionaire 3 (and former Laffer student at the University of Chicago) who has been one of the most vocal backers of the Kansas tax cuts, has assembled some possible evidence of affluent Kansas City-area residents moving from the Missouri side of the border to the Kansas side. Also, the Census Bureau's annual state-to-state migration estimates do show more people moving from Missouri to Kansas than vice versa every year since 2012. But the net migration doesn't add up to all that much and was generally positive before 2012 as well (this data is also subject to big margins of error):
According to some other Census Bureau estimates (less detailed but more accurate and timely than those in the above chart), Kansas experienced a net outflow of 34,632 residents to other states from April 1, 2010, through July 1, 2016. Missouri lost 6,804, while the rest of Kansas's immediate neighbors have experienced net inflows from other states. For Kansas, that's a similar pace to the period from 2000 to 2010, when it lost 64,864 people to other states.
In sum, some high earners may have moved from the Country Club District to Mission Hills to take advantage of the pass-through exemption, but on the whole Kansas is seeing neither an inflow of people from other states nor an increased outflow. And Kansas-experiment defender Williams's enthusiasm about the increase in business startups and pass-throughs seems misplaced.
Let us return, then, to private-sector job growth, which Brownback himself has cited as a metric he wants to be judged by. On the reelection-campaign trail in 2014, in fact, he promised that Kansas would add 100,000 private-sector jobs in his second term. So far it has added only 9,500, with about a year and a half to go to make up the missing 90,500. Things look a little better when you start with the passage of Brownback's tax cuts in May 2012, with private-sector employment up 51,100 since then. In percentage terms, though, that's a poorer job performance than in all but one of Kansas's neighbors (I left Colorado off the chart because it is basically off the charts, with more than 20 percent growth in private-sector employment).
Oklahoma has the most oil-and-gas-dependent state economy in the nation, and its poor jobs performance in 2015 and the first half of 2016 was the result mainly of low oil and gas prices. Kansas has some oil and gas, too, but they don't appear to drive its economy, which is more dependent on manufacturing (especially aircraft) and agriculture, among other things. Some things about that economy are pretty healthy -- the unemployment rate in Kansas is only 3.7 percent, compared with 4.3 percent for the U.S., and the labor-force participation rate is, at 67 percent, well above the national rate of 62.7 percent. Kansas just wasn't growing very fast before Brownback took over, and it hasn't grown very fast since.
So the Kansas experiment is an economic failure in the sense that it didn't have a discernible positive effect, although it hasn't exactly been a disaster -- except perhaps for Sam Brownback's future political aspirations. Why didn't it work? Three main reasons stand out to me:
- The total state and local tax burden in Kansas was 9.5 percent of state income in fiscal 2012, according to the Tax Foundation. That was slightly higher than in any of Kansas's neighbors but below the national average of 9.9 percent. When tax rates are very high, cutting them can have dramatic positive effects on labor supply and economic activity -- sometimes even dramatic enough to increase overall tax revenue (that's what the Laffer curve is about). But as my Bloomberg View colleague Megan McArdle wrote last month, tax rates in the 21st-century U.S. generally aren't that high. They certainly weren't that high in Kansas when Brownback started cutting them. Expecting a huge economic boost was unrealistic.
- Even in the absence of super-high taxes, there can be economic benefits to lowering tax rates. But it's generally better to lower rates across the board than to single out one tax, as Kansas did with the pass-through exemption. To quote Tax Foundation economist Scott Drenkard: "The pass-through exemption significantly narrows the tax base, and this has made for a less stable, productive, and competitive code." Worryingly, the Donald Trump administration's tax plan (if you can call it that) also calls for special treatment of pass-through entities.
- Finally, there doesn't seem to have been much of a constituency in Kansas for reducing the size of the state government. Unlike the federal government, states can't get away with running persistent budget deficits. So by cutting taxes without having political support for commensurate spending cuts, Brownback and Kansas lawmakers were putting the state in a position where, barring an economic miracle, taxes would soon have to be raised again -- with both a rate increase and an end to the pass-through exemption included in the legislation passed this month. This back-and-forth has surely been much more damaging to the state's economy than leaving taxes unchanged would have been.
Update: The original version of this column included this quote from January 2017 testimony to the Kansas House Committee on Taxation by Tax Foundation economist Scott Drenkard:
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, the latest tally (2015) on that number has grown to 393,814 claimants, over twice as many as anticipated. Estimates are that this deduction results in $200 million to $300 million in foregone revenue annually.
The Sentinel, a conservative Kansas online news service, pointed out in a response to my column that Dave Trabert of the Kansas Policy Institute, which has supported the tax cuts, had showed late last month that these numbers were incorrect. So the Tax Foundation on Friday appended a clarification to the online version of Drenkard's testimony, and that clarification is what I now quote from in the column above. Got it?
Trabert also argues that the annual Bureau of Economic Analysis tallies of state private-sector employment used in a Kansas Policy Institute study in January are more complete than the monthly Bureau of Labor Statistics numbers I use, and show Kansas in a better light because they capture more agricultural and small-business activity. He's right! But they (a) don't exactly transform Kansas into a barn-burner (its BEA job growth from 2012 through 2015 is better than Nebraska's, but about even with Missouri's) and (2) don't reflect the fall-off in payroll jobs in Kansas starting in October 2016 apparent in the chart above.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
A handy definition, from the Tax Foundation: "businesses that pay their taxes through the individual income tax code rather than through the corporate code."
The pass-through employment data is from this Kansas Policy Institute report.
He co-founded Dimensional Fund Advisors.
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