It is hard to think of a more obvious recent public-policy failure than the tax cuts that Kansas Gov. Sam Brownback championed in 2012. The state has been mired in a perpetual budget crisis ever since the package passed, forcing its residents to swallow painful spending cuts in essential areas like education. Kansas' credit rating has been downgraded, as well. The financial wreckage has been so severe that Brownback's fellow Republicans are now staging a rebellion; in February, the GOP–run legislature voted to undo the cuts, and came close to overruling the governor's veto.
Somehow, the sharpest minds in the Trump administration have gazed upon the smoldering ashes of this misbegotten experiment and decided that they should imitate it. On Wednesday, Treasury Secretary Steve Mnuchin and National Economic Council Director Gary Cohn unveiled the skimpy outline of the White House's current tax plan. While the one-page document lacked much in the way of detail, it confirmed that the president wanted to cut the tax rate on so-called “pass-through” businesses to 15 percent—which would amount to a bigger, potentially more disastrous version of Brownback's ill-fated cuts.
“This would be Kansas on steroids,” Eric Toder, co-director of the Tax Policy Center, told me.
Pass-through entities are by far the most common type of business in the U.S., encompassing about 94 percent of firms as of 2011. Instead of paying corporate taxes, they simply distribute profits among their owners, who then have those profits taxed as normal income. Obviously, many small businesses are organized this way, but so are major law firms, hedge funds, real estate developers, and plenty of other extremely profitable enterprises. The Trump Organization? It's a pass-through.
This raises the obvious concern that the White House is simply planning a massive, backdoor tax cut for the rich. The current top individual income tax rate is 39.6 percent. Trump would bump it down to 35 percent. Letting law-firm and private-equity partners pay a 15 percent rate on their profits, which often make up the vast majority of their pay, would significantly lower their IRS bills. Trump's team insists that this won't happen; today, Mnuchin said Wednesday that the new 15 percent rate will be limited to small and medium-sized businesses. It’s not clear, however, what would count as “medium,” or how Washington would enforce the rule.
The bigger potential problem with slashing taxes on pass-throughs is that many highly paid Americans will probably try to cut their tax bills by pretending to be small business owners. Instead of working as a salaried employee, you could set yourself up with an S corporation that “sells” your freelance services. As Bloomberg's Matt Levine joked:
This thing isn't going to become law so I'm never going to actually tweet this joke. pic.twitter.com/8y0NLgtoEc— Matt Levine (@matt_levine) April 26, 2017
Theoretically, the IRS could try to stop these sorts of shenanigans. But as Uber has taught us oh so well, discerning a contractor from an employee is tricky business. The relatively nonpartisan Tax Policy Center, for its part, assumes that under Trump's plan, half of high-wage workers would turn themselves into pass-through entities.
Actual business owners could get in on the action too. Because of payroll tax issues, people who run their own S-corps—which are an increasingly popular type of pass-through—are required to pay themselves a “reasonable” salary or wage, in addition to whatever profits they earn. The meaning of “reasonable” is, of course, up for interpretation. If Trump slashed the tax on pass-through income to 15 percent, however, it would encourage a lot of business owners to report more profit and less salary.
This is essentially what seems to have happened in Kansas. There, Brownback exempted pass-through profits from the state's income tax entirely. If you had a successful car dealership or farm, Topeka wouldn’t lay a finger on your profits come year's end.* The rationale was that this would energize the state’s economy with a wave of new businesses and hiring.
The wave didn’t materialize. Instead, far more residents filed for the break than expected, and few new jobs seemed to follow. Kansas trailed is next-door neighbors in employment growth in the years immediately after the tax cut; in 2016, it was fifth worst in the nation. A recent economics paper by researchers at the University of South Carolina, Indiana University, and the U.S. Treasury found little to no sign that the cuts had spurred any new economic activity. Instead, their results suggested “that the primary effect of the policy was to induce taxpayers to recharacterize income as pass-through business income, which was tax-preferred after the reform.” In other words, it just encouraged people to play the system.
Trump's proposed tax cut would create far, far greater incentive to game things than Brownback's ever did. Kansans who turned themselves into businesses were spared from a 5 percent top personal income tax rate in the state. In Trump's proposal, a well-paid professional or company owner could potentially shave 20 percentage points from their taxes by claiming their salary as a business profit. The Tax Policy Center thinks such shifting could cost Washington about $650 billion over a decade; in total, by their account, the special pass-through rate would cost $1.5 trillion.
Brownback cooked up Kansas' tax cuts with the help of anti-tax hacks like Club for Growth founder Stephen Moore and Art Laffer, who still insist against all available evidence that they will be a success. But even some supply-side–friendly conservatives have criticized the policy. The Tax Foundation, for instance, warned Kansas legislators against the tax cuts and later said that the fallout from them was “doing damage to the state tax reform conversation nationally.”
For fun, I called up Alan Cole, one of the Tax Foundation’s staff economists, to see what he thought about the new Trump proposal. He was not especially upbeat.
“Pass-through taxes are decently well-structured as they are, and it’s probably best to leave them alone,” Cole said. He told me that, according to the foundation's model, it would add about 0.12 percent to the country’s annual growth rate, but again, at a cost of about $1.5 trillion. “As far as tax reform trades go, really? Is this the one that you want?”
Apparently so, if you're Donald Trump.
*Correction, April 27: This post originally referred to Wichita as the capital of Kansas. The capital is Topeka.