By Scott Drenkard , Forbes Contributor Ohio tax policy needs a lot of work, and Governor John Kasich talks about it a lot. The state ranks 44th in the Tax Foundation’s State Business Tax Climate Index, the municipal income tax system is the worst in the country, and the state’s corporate tax (called the Commercial Activities Tax, or CAT) is rare in that it is a gross receipts tax, which public finance experts have roundly criticized since Adam Smith in 1776.
Unfortunately, the plan which is set to be announced next Monday by Governor Kasich isn’t going to address any of these problems and will probably make them worse.
According to Cleveland.com, the plan will include an increase in personal exemptions for low and middle-income Ohioans, which is fine and good, but will also include a 100 percent deduction for pass-through businesses like LLCs, S-corps, and sole proprietors for their first $2 million in revenue—meaning many will pay no income taxes at all. This is a tax gimmick du jour made famous (not in a good way) by the ill-fated tax experiment in Kansas.
The idea for excluding small businesses from tax liability is to promote job creation and growth in the state, but the unintended consequence of this policy is that it allows wage earners to change their structure to avoid paying any income taxes.
For example, if they enacted this policy where I live in Washington, D.C., I would just go to my employer, the Tax Foundation, and ask them to start paying me as a contractor, then file my individual income taxes as a sole proprietor business and get a huge tax cut. I wouldn’t be contributing any more to economic growth—I’m still doing the same job—but state revenues would take a big hit.
In Kansas, which started excluding 100 percent of pass-through business income in 2013, this carve-out has resulted in year-over-year revenue shortfalls, as more people shift their form to achieve tax-free status.
The fact that this carve-out costs so much in revenue should be especially concerning to Ohioans, because Governor Kasich has a track record of proposing handfuls of hikes to other damaging taxes to make the budget numbers add up.
Last year, the governor’s Mid-Biennium Review plan had income tax cuts, but also proposed a hike in the rate of the Commercial Activities Tax, a hike to the cigarette excise tax, a new tax on electronic cigarettes, an increase in the state’s severance tax rate, and an $8 million levy on new well drills.
It comes down to this: good tax reform is composed of broadening the base, and lowering the rate. The Kasich plan would be a significant narrowing of the tax base, and that makes revenues less stable and less fair. If the Governor wants to give Ohioans an income tax cut, why not just do it across the board?