Kansas Faces Additional Revenue Shortfalls After Tax Cuts

Kansas has missed its tax revenue targets again, and the state is in for new fiscal pain as a result.

You may recall that Kansas gained national attention back in June because it had cut income taxes and lost a lot more revenue than lawmakers had anticipated. For fiscal year 2014, which ended on June 30, the state collected $330 million less in taxes than it had forecast, and $700 million less than it had collected in the prior year.

Those are big numbers in a state that spends about $6 billion annually from its general fund, and the revenue weakness led both Moody’s and Standard & Poor’s to cut Kansas’ credit rating this year. The revenue shortfall has become the central issue in the tight race between Governor Sam Brownback, a Republican, and his Democratic challenger, Paul Davis.

In June, state lawmakers debated whether the revenue shortfall was temporary. Steve Stotts, the director of taxation at the state’s department of revenue, attributed the shortfall mostly to a one-time event unrelated to Kansas’ tax cuts: federal tax changes that encouraged people to shift capital-gains income from 2013 into 2012. The state has responded to the unexpected revenue loss in large part by spending down reserve funds, which makes sense as a way to cover a temporary shortfall, but would be an unsustainable way to finance a permanent tax cut.

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Revenue numbers for July through September, the first three months of fiscal year 2015, suggest Kansas’ revenue gap is permanent, not temporary. The state anticipated $578 million in personal income tax collections over the summer, but it took in just $524 million, an overestimate of more than 10 percent. That was nationally atypical; according to the Rockefeller Institute of Government, 14 states have published projected and actual monthly personal income tax receipts through September, and the other 13 all came within 5 percent of expectations.

Kansas’ wide miss was probably a result of wading into uncharted territory with its tax reforms. In addition to cutting income tax rates, Kansas made itself the only state with a general personal-income tax that exempts “pass-through income” from tax.

Business entities like S-corporations and limited liability companies are not taxed at the corporate level; instead, their income is passed through to their owners, who then pay personal income tax on the profits in most states — but not Kansas.

One problem with this policy is that pass-through income and wage income are often fungible. A small-business owner might choose to take less of his income as (taxable) salary and more as (tax-free) profits, reducing Kansas income tax revenues. Estimating how many small-business owners would make such changes was the key to figuring out the cost of the tax cuts.

“I think there is major reshuffling of how people are paying their taxes,” says Duane Goossen, who served as budget director under the three governors who preceded Mr. Brownback, including the Republican Bill Graves and the Democrat Kathleen Sebelius. “You have every incentive to push your salary down and take all of your income as profit.”

Mr. Stotts, the taxation director, expressed hope that revenues would be stronger in the spring; he noted that taxpayers who make quarterly estimated tax payments are setting those payments based on last year’s tax bills, which (given last year’s revenue shortfall) were low. If incomes are strong this year, the resulting boost in revenues may show up in final payments made with tax returns filed in the spring, rather than estimated payments made this summer and fall.

On the other hand, another income tax rate cut is scheduled to go into effect in January, which will weigh on tax collections in 2015. All told, Mr. Stotts said he suspected the state’s revenue-estimating group would cut the state’s revenue projections shortly after the election, at its next scheduled meeting. “I can’t tell you how much,” he said.

I can make an educated guess, though: If personal income tax revenues continue to fall short by 10 percent, that will add $250 million to the state’s budget gap. Bear in mind, even before the summer revenue miss, the state’s legislative research department expected the budget to be out of balance by $350 million, a gap that would be covered by drawing down all but $29 million of the state’s remaining reserve funds. Since the reserves are already scheduled to be nearly depleted, the Kansas legislature will have to respond to any cut in the revenue estimates by raising taxes or cutting spending in the current year.

There could be even bigger problems to come, because Kansas’ income tax estimates for the next nine months are actually more optimistic than this summer’s were. In fiscal year 2014, Kansas collected 26 percent of its personal income taxes in the summer quarter. But in forecasting this fiscal year’s revenues, Kansas attributed only 23 percent of expected annual personal income tax revenue to the summer — and then missed its projection anyway. If summer revenues make up 26 percent of total revenues, as they did last year, the state will be short by closer to $500 million than $250 million. And in addition to needing to close this year’s gap, the state will start deeper in the hole for fiscal year 2016, for which it already has a projected budget shortfall of $240 million.

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On the bright side, Kansas collected $28 million more in corporate income tax than expected in the summer, offsetting about half the shortfall in the personal income tax. But corporate income tax is highly volatile and unpredictable; it can be swung by the performance of a handful of large companies. (Near the end of fiscal year 2008, Delaware received a single surprise $63 million corporate income tax payment, bolstering its state budget by 1.5 percent.) Kansas will be able to soften the budget blow with extra corporate tax revenue from this quarter, but it can’t count on a continuing corporate tax surge to offset the continuing loss in personal income tax receipts.

In 2012, Gov. Brownback called his state’s tax cuts a “real live experiment” in how tax-cutting affects the budget and the economy. So far, the main result of the experiment seems to be that cutting taxes causes the government to lose revenue.