The centerpiece business tax cut in Gov. Sam Brownback’s plan to reform income taxes would enrich dozens of other states at Kansas’ expense, The Eagle has learned.
For out-of-state taxpayers who earn certain types of business income in Kansas, the state tax cut would shift revenue that Kansas now receives to the government coffers of the taxpayers’ home states.
The out-of-state taxpayers wouldn’t pay less, but the tax revenue would go to fund schools, roads and social services in their home states instead of in Kansas.
The reason the money would go to other state governments and not back to the out-of-state taxpayers is that income is taxed first in the state where it is generated.
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To avoid double taxation, almost all states that levy an income tax give their taxpayers a credit for income taxes paid in another state.
If the taxpayer doesn’t have to pay anything in the state where the income is made, there is no credit to claim and all the money goes to the taxpayer’s home state.
That reality has added a new wrinkle to the already convoluted issues before a House-Senate conference committee working to redesign the state’s income tax structure.
“It’s not been a specific item of discussion,” said Rep. Richard Carlson, R-St. Marys, chairman of the House tax committee and a member of the conference committee. “We’ll have to check on that. We’ll probably need to visit with the Department of Revenue.”
Asked about the shift, Brownback said he has discussed the issue with his staff and wants to evaluate it more before commenting. But he strongly backs the business tax cut, which he says will help create jobs. “It’s like shooting adrenaline into the heart, taking tax off small business,” he said.
Richard Cram, director of research and policy at the Kansas Department of Revenue, confirmed that the proposed change would shift tax money from Kansas to other state governments, but he said it is not known how much income Kansas would lose or other states would gain.
About 275,000 out-of-state taxpayers pay $340 million a year in Kansas taxes, Cram said.
He said most of that is believed to be from taxpayers in the Kansas City area who live in Missouri but work in Kansas.
He said the department was not immediately able to determine how much of the $340 million comes from nonresidents paying taxes on business income that would become exempt under the Brownback plan.
Cram said he thinks the tax savings for Kansas businesses would more than offset the revenue lost to other states and could encourage some of the out-of-state taxpayers to move to Kansas.
Some taxes targeted
The Brownback plan would eliminate state income taxes on farms and businesses organized as limited liability companies, subchapter S corporations and sole proprietorships.
Those types of businesses are called “pass-though” entities because while the business pays no income tax, taxes on the profits are collected through the owners’ personal income tax returns.
Most small businesses and many large ones are organized that way.
The plan to cut taxes on pass-though companies is an effort to put more money in the pockets of Kansas businesspeople, in hopes that they will invest their tax savings in expanding their companies and creating jobs.
How much tax revenue currently paid to Kansas would flow to other states would depend on how much money their residents make in Kansas and on their home-state tax rates.
The only states that wouldn’t benefit would be the nine states that don’t levy a personal income tax.
In states where the tax rate is lower than in Kansas, the benefit would be split between the taxpayer and his or her state of residence.
In states with equal or higher tax rates, the entire benefit of the Kansas tax cut would go to the other state’s government and the taxpayer would get nothing.
For example, a New York resident who makes $100,000 net income from a business investment in Kansas now pays $5,977 to Kansas and $476 to New York.
The $476 is the difference between the resident’s New York tax liability of $6,453, minus the credit for taxes paid to Kansas.
If the Brownback plan becomes law, Kansas would give up its $5,977, and New York would collect the entire $6,453.
Both the House and Senate have passed bills based on Brownback’s plan. The Senate version would implement the business tax cuts all at once in 2013, while the House version would phase in the cuts through 2018.
A six-member House-Senate conference committee is working on reconciling the differences between the bills. Cutting business taxes is their strongest accord so far.
‘An interesting point’
Although Brownback proposed the tax breaks in his State of the State speech in early January and both houses of the Legislature have worked on it for months, lawmakers said the wrinkle in revenue from out-of-state taxpayers had not been brought to their attention.
“It’s an interesting point,” said Rep. Nile Dillmore, D-Wichita, a member of the conference committee. “I’m not sure how you’d go about trying to fix that.”
Dillmore has strongly opposed the plan on several grounds and released an analysis last week calculating that the state would have to create 423,000 new jobs to offset the $829 million in tax cuts in one of the plans being considered.
Both Dillmore and his Democratic colleague on the conference committee, Sen. Tom Holland of Baldwin City, opposed the tax cuts for pass-through businesses before learning of the shift of tax revenue to other states.
Holland said that could be just the start.
“I think there’s an increased opportunity for unforeseen consequences coming out of this,” Holland said. “My fear is they have significantly underestimated the cost of exempting the small businesses.”
An analysis by legislative researchers estimates that phasing in business tax cuts would cost $51 million in its first full year, growing steadily to $168 million by the time the tax is eliminated. Cutting the tax outright would cost nearly $157 million in its first full year.
Dillmore said one major problem with the Brownback tax relief plan is that “it doesn’t matter how you earn your money, it’s how you’re organized in terms of assets.”
Both he and Holland said they think it will touch off a rush by traditional corporations to reorganize their structure to take advantage of the tax break.
Lots of work remains
Senate tax committee chairman Les Donovan, R-Wichita, who also serves on the conference committee, said he thinks people should look at the positives in the business tax cuts rather than the negatives. He also said the conference committee has significant work remaining to craft a final bill.
On the tax shift to other states, he said “I don’t know where we’re going to end up in the conference committee on that issue.”
The tax cut for pass-through businesses is part of a larger effort by Brownback to remake the state’s entire tax code.
Brownback also proposed cutting the number of tax brackets from three to two and eliminating a number of tax credits, including the earned-income credit that benefits low-income working parents.
Brownback wants to shift the money from the credit to fund medical and other social programs to benefit the poor.
Based on the theories of Reagan administration economic adviser Arthur Laffer, the idea behind overhauling the tax code is to cut taxes and free up money for businesses to expand. That, Laffer says, will increase commerce and, with it, state tax revenue.
Lawmakers had hoped to pass an overall tax bill before the end of the Legislature’s regular session, which concluded Friday.
But strong pushback on the elimination of popular tax credits and deductions, the plan’s effect on the poor and skepticism about Laffer’s theories have complicated the debate.
Now, lawmakers will be waiting until the Legislature returns for its wrap-up session on April 25.
The tax conference committee appeared to have reached consensus on the House plan for phasing in the business tax breaks.
Both houses abandoned Brownback’s original proposal to eliminate the earned income credit amid criticism that the plan would overtax the poor and undertax the rich, who are more likely to have the kind of unearned income that would be exempted.
At present, the House is advocating to cut the credit in half and the Senate wants to leave it alone.
The committee has also been unable to reach accord on base tax rates, with the House position favoring a 6.28 percent top rate and the Senate, 4.9 percent.
Dan Murray, state director of the National Federation of Independent Business, has watched the negotiations closely and said he expects lawmakers to find a compromise – possibly phasing in business tax cuts and replacing the lost state revenue by continuing some portion of the emergency 1 percent sales tax lawmakers approved in 2010. Part of that increase is supposed to expire next year.
“We’d like to have the whole kit and caboodle this year,” he said. “But, understandably, the governor proposed some pretty dramatic tax reform and sometimes it takes an initial step.”