President Donald Trump has made sweeping proposals to change the federal tax system, including some provisions that would dramatically change the way small businesses get taxed. However, there's a great deal of disagreement in Washington, even among Congressional Republicans, about whether the backbone of Trump's small-business tax policy is sound. Throwing more fuel on the fire is the decision from the Republican-controlled legislature in Kansas to roll back similar measures in that state and effectively raise taxes, despite its having to override a veto from Gov. Sam Brownback in order to do so. Many fear that the experience in Kansas could lead some to conclude that similar aspects of the Trump tax plan simply aren't worth the risk.
What happened in Kansas
The Kansas tax changes date back to 2012, when Brownback advocated for tax changes that have several aspects in common with the Trump federal tax proposal. Among the provisions were tax simplification moves like raising the standard deduction, along with business incentives like lowering the corporate tax. In particular, owner-operated businesses received a complete tax holiday, essentially removing income taxes on money received through pass-through entities like sole proprietorships, partnerships, and many limited liability companies.
Advocates for the proposal argued that the move would essentially provide economic stimulus for businesses. The anticipated result was that those businesses would have more money to invest in growth opportunities, leading to an economic revival for Kansas that would help it keep up with neighboring states like Colorado, Missouri, and Oklahoma. The positive cycle would create more jobs, spurring more business growth and helping to reinvigorate the business environment in the Sunflower State.
Instead, the move gave Kansas businesses an incentive to take advantage of the new tax rules. Tens of thousands of new pass-through business entities were created, but many of them were from former employees who simply shifted to an independent contractor relationship with their former employers. By doing so, they were able to convert what would have been taxable wage income into tax-free pass-through business income.
In response, lawmakers suddenly found themselves with insufficient tax revenue to fund their budget. Earlier this month, after multiple attempts to reverse the tax cuts, Republican lawmakers overrode a gubernatorial veto and by doing so undid many of the previous changes.
Will the Trump tax plan suffer the same fate?
Currently, the president's latest tax proposals look similar in many respects to what Kansas did. Lower standard deductions, simplified tax brackets, and favorable provisions for corporations and small businesses all seem to hinge on the idea that economic growth will more than make up for any immediate reduction in tax revenue.
Yet the same question remains whether individuals will just make cosmetic changes in order to reap tax benefits without actually doing any of the business investment that the plan counts on to work in the long run. Reducing the federal tax rate on pass-through income to 15% would give high-income employees a huge incentive to leave their jobs and create their own business entities. With current tax rates stretching as high as 39.6%, the savings would be almost 25 percentage points. Even under the Trump tax plan, the differential between 15% on pass-through businesses and 33% on top-bracket regular income tax would provide a lot of reason for taxpayers to explore alternatives to traditional employment -- with absolutely no intention to make business-growing moves afterward.
Meanwhile, the Trump plan wouldn't actually tie any of the tax savings to reinvesting money into businesses. Indeed, by reducing the tax rate, small-business owners would actually get less of an incentive from spending money in ways that create immediate tax deductions, because the tax savings would be reduced. What many people increasingly believe is that those who benefit would simply pocket the extra cash, and there's nothing to prevent that from happening.
So far, Republicans in Congress have shown only small amounts of the internal party divisiveness that led to what happened in Kansas. However, with so much more at stake, even the experience of a relatively small state could be enough to give lawmakers on both sides of the aisle pause before passing tax cuts with fundamentally flawed policy positions.