Nearly five years ago the state of Kansas underwent what was dubbed a real live "experiment" in tax reform when Republican Gov. Sam Brownback enacted a tax package that brought down personal income-tax rates and also eliminated income tax for pass-through entities. These included LLCs, S-corps, partnerships, farms and sole proprietorships. The idea was to stimulate the local economy with spending, hiring and small-business growth.
The majority of small businesses in America are structured as pass-throughs, passing through their business income to owners who are then taxed at the individual level. Entrepreneurs like Kelly McCracken, owner of Amazing Smiles of Kansas City, saw savings of thousands of dollars a year under Brownback's cuts, allowing her to invest in her business. For her company the experiment worked as planned.
"We hired other small businesses to help with our website and SEO, we hired another employee and most recently made a durable equipment purchase," she said.
But in June of 2017, the Kansas State Legislature reversed the experiment, reinstating taxes for pass-throughs. The reason: The tax cuts caused the state to have a budget shortfall in the billions in less than five years, according to the Tax Foundation, a Washington, D.C.- based advocacy group. The Tax Foundation also claimed that the cumulative budget deficits in fiscal 2018 and 2019 alone were $850 million.
The experiment also drained funding for the school system, state pensions and road maintenance. Under the reversal, individual rates range from 2.9 percent to 5.2 percent and will increase again in 2018. Businesses like McCracken's also have to pay retroactive taxes for 2017. For protection, she's taken out a line of credit while she plans what's next for her company.
"Just a few thousand dollars alters your usable income for the year. It greatly impacts these decisions we made just months ago, without the plan or knowledge this was going to be coming in the future," she said.
Critics of Brownback's plan say it reflects why similar cuts proposed by the Trump administration — bringing the business tax rate to 15 percent from a top rate of 39.6 percent and including pass-through businesses in that bracket — may not stimulate the economy.
In May, prior to the tax cuts being reversed, Brownback told CNBC the state had seen "record small-business creation in the last five years" and claimed that the conversion rate of C-corps to LLCs in order to benefit from the tax breaks was no higher than usual.
"So I think, as a strategy it's the right strategy, and that's how you grow the country, and that's how you grow the state," Brownback said. Trump's target of 15 percent "might really be the right point to be able to stimulate growth." The governor's office did not respond to repeated requests for comment.
The Tax Foundation reported that new business filings grew 11 percent between 2012 and 2014 and another 10 percent through 2016, adding that new pass-through businesses were being set up at a fast rate under the new policy.
State Democratic Party Chair John Gibson, who was against the experiment, said that while the cuts were supposed to "turbocharge" the state's economy, the opposite has happened and it's instead lagging behind neighboring states, like Nebraska and Missouri.
"We have not seen those benefits, and what we have seen, unfortunately, are our schools getting shortchanged, our highway fund being raided," he said. "Really, the investment in the future of Kansas has been put off and kicked down the road so that a few extremely wealthy individuals have been able to save money on their Kansas taxes."
Gibson also has a legal business, FreeState Patent Services, which is structured as an LLC. In the past few years, he did not pay income taxes on his earnings in the practice. He said the experiment allowed for wealthy individuals to structure their income as pass-through, allowing them to avoid paying income tax at the state level.
"It's a few thousand dollars over a few years. It's not a large impact on my bottom line," he said. "What is proposed as a small-business tax break is actually not about small businesses. It's about effectively eliminating taxes on a handful of extraordinarily wealthy individuals to the detriment of the rest of us."
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Other small businesses, like Karl Miller's Lark Label in Wichita, echoed Gibson's point in not seeing enough savings to benefit from the experiment. His company has been around for 20 years and has three employees, including Miller. Being structured as an LLC saved him some $1,400 a year max under the experiment, he said, nowhere near enough to hire a new employee.
"As a small-business guy, I'm always in favor of additional money in my pocket, less taxation," he said. "I don't think you'll find a person who will argue against less taxation. At the same time, I do believe in it. I enjoy driving down a good road; I enjoy the fact that I've got clean water and sewage and police protection. Those are all good things worth paying taxes for."
Beyond Kansas, Miller said he favors federal tax reform but said the Trump administration needs to learn from the lessons the Kansas experiment has provided. The issue is key for small businesses nationwide, ranking a top-three concern, according to the conservative lobbying group the National Federation of Independent Business, which advocates for parity between corporations and small businesses when it comes to tax reform.
"We have a very good example here where it didn't really work out," he said. "Not to say the entire concept is bad, but it needs to be changed up slightly to make sure that not so much money goes out that it causes economic problems for the government."