Abstract

The state of Kansas made dramatic changes to the structure of its personal income tax by eliminating taxation of business income and lowering marginal tax rates on other personal income sources. Proponents of the legislation maintain that the tax reductions will stimulate employment growth. Using a difference-in-differences approach, we estimate the impact of the tax changes on private-sector employment in the state of Kansas, relative to its border states, using data on the number of establishment employees and proprietors. We apply multistate county fixed effect model and countyborder matching approaches to identify tax effects. Our findings indicate that two years post enactment, the tax law changes have not yielded a net increase in private-sector employment.

Unincorporated business profits, also known as pass-through income, are the net earnings of an unincorporated business after all expenses including salary and wages are paid.1 In US states with a personal income tax, unincorporated business profits are taxed as personal income (Fisher 2007). In tax year 2013, Kansas became the only state in the United States to exempt unincorporated business profit from personal income taxation while still taxing other forms of personal income. Wage and salary income earned from an unincorporated business is not exempt from taxation in Kansas, only pass-through income is exempt. For example, if a law firm pays a firm partner a salary based on billable hours, he or she pays income tax on his or her income. If instead he or she receives income as the residual claimant on the earnings of the firm, then his or her income is untaxed. The business income exemption is part of a larger set of income tax cuts and tax base changes enacted in Kansas beginning in 2013 that taken as a whole constitute the largest tax cut in the state’s history and have drawn national attention as a test case for supply-side economics (e.g., see King and Peters 2013). Job creation is the rationale put forward for passage of the Kansas income tax cuts (Kansas Department of Commerce 2012).2 Proponents of the legislation predict large, positive indirect effects of the policy change through the expansion of existing firms, creation of new firms, and migration of firms from higher tax locales. Opponents maintain that the tax changes will not achieve the intended growth effects (e.g., Johnson and Mazerov 2012). The national discussion of the Kansas tax cuts makes investigation of the state’s policy change an important empirical task. There are reasons to expect that the exemption may not yield an increase in private-sector employment. First, the Kansas tax policy change creates a new opportunity for tax avoidance behavior through income shifting. For example, a Kansas business owner may reduce her taxable salary income from her business and offset the reduction with an increase in her untaxed business income. The change in policy therefore could simply be associated with the way in which an owner is compensated, resulting in a loss in income tax revenue and no growth in employment. Similarly, a wage employee may change her employment status to a contract employee, operate as a sole proprietor, and avoid paying income tax in Kansas. In this instance, the policy results in the loss of an establishment employee, a gain in a sole proprietor, and a loss in tax revenue, but zero net change in total private-sector employment.