Democrat and moderate Republican lawmakers in Kansas have been grumbling lately about the unfairness of the state tax exemption for pass-through business income, according to an editorial board article in the Wichita Eagle. Gov. Sam Brownback signed off on this exemption in 2012, along with substantial tax rate reductions. In March 2014, the Center on Budget and Policy Priorities characterized the Sunflower State’s fiscal situation as a “cautionary tale, not a model…a serious threat to the state’s long-term economic vitality,” pointing out that “promises of immediate economic improvement have utterly failed to materialize.”
House Bill 2444 could have closed the loophole by repealing the pass-through exemption. One supporter of the repeal, State Sen. Jim Denning, declared that the loophole came about by way of a 31-word accident in the 2012 income tax reform legislation, suggesting that lawmakers thought they were making it possible for working capital in a business to pass-through tax free so the money could be reinvested back into the business. Instead, the words, "[e]liminating individual income tax on Non-Wage business income as reported by LLC's, S-Corps, and Sole Proprietorships on lines 12, 17, and 18 of the federal form 1040 individual income tax return" created the loophole. Sen. Denning also criticized the exemption as a $250 million budget destabilizer.
Despite the grumbling, the House rejected HB 2444 in a 45-74 vote on April 29, 2016. This means that Kansas is on track for a $348 million decrease in the 2016 and 2017 fiscal year tax revenue estimate, according to a State General Fund Revenue Estimate by the Kansas Legislative Research Department and Kansas Division of the Budget.
The Wichita Eagle’s editorial board contends that the pass-through exemption has damaged the state’s fiscal situation without providing a significant enough boost to the economy. Although those opposed to the repeal cited the fact that it wouldn’t fix the budget problems in their entirety, the board recognized that it would have helped by adding $61 million of new revenue next fiscal year, more than $200 million in revenue in 2018, and would have prevented painful cuts to services.
A Tax Foundation economist who has been critical of the exemption since the beginning testified before the Kansas House Committee on Taxation in favor of HB 2444, opining that “the pass-through exemption encourages tax avoidance without generating desired growth.” What is more, although projections estimated that 191,000 people would take advantage of the loophole, 70 percent more than that, or 330,000 taxpayers, did so. Ultimately, he insisted, “[i]t’s hard to impress how much damage has been done by Kansas’ failed attempt at tax reform in 2012. It has forced the state to raise taxes elsewhere, draw down its cash reserves, and compromise its bond rating.”