The Kansas Tax Experiment: The Matter of Legal Form of Organization

Conservative politicians have advocated tax cuts for business as a way to foster faster growth. In 2012, the State of Kansas sought to boost economic growth by enhancing investment spending and thus employment with a sweeping business tax-cut program. This program lowered the (state) tax rate on pass-through business income to zero. The Kansas Tax Experiment is widely viewed as a dismal failure, and a cautionary tale for all future tax cuts. In this paper, we carefully analyze this policy in terms of a dynamic stochastic occupational choice model with heterogeneous firms. The model explicitly allows firms to enter and exit as well as to allow firms to make a decision on their legal form of organization (LFO). This is important as the tax cut in Kansas targeted pass-through firms rather that C-corporate firms. Because firms of different legal forms face different tax obligations, the lowering of the tax rate for pass-through firms means lowering the personal income tax for this type of firm. C-corporate firms may switch their LFO to take advantage of this favorable tax treatment. The Kansas tax policy distort firms LFO impacting the allocation of capital among firms. The model calibrated to the Kansas economic environment using data obtained from the State of Kansas Department of Revenue. When the Kansas tax policy is studied, we find that the economy experiences sluggish growth in both output and employment, while government deficits sharply increase. This is the same result that Kansas experienced, and is explained by pass-through firms facing tighter capital constraints and a decline in capital formation. In contrast, a lower corporate income tax rate leads to an expansion in the C corporate sector resulting an increase in output, consumption, and capital formation. Moderate job growth follows.