Lessons from Kansas: Taxes and Corporate Organization

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The Tax Cuts and Jobs Act of 2017 has some wondering if the decline in both personal and corporate income tax rates will increase employment, income and wages. A recent Economic Synopses essay examined how the legal forms of firms play into this question.

Don Schlagenhauf, an economist at the St. Louis Fed, and Shi Qi, assistant professor of economics at the College of William and Mary, explained that starting a firm typically means organizing as either a C corporation or a pass-through firm:

• C corporations are subject to a business income tax, and their after-tax distributions to owners are also subject to personal income tax.
• Pass-through firms are subject only to personal income taxes. However, these firms face legal limitations on what financing they can use beyond their owners’ individual funds.

The authors noted that the double taxation that C corporations face is an unattractive feature of that legal form. They explained that most firms don’t pay the corporate income tax, as they are classified as pass-through firms. In 2012, 95 percent of firms filing tax forms were pass-through entities.

However, C corporations tend to be larger, as evidenced by generating 41 percent of net income in 2012, despite only making up 5 percent of filers.

One area Schlagenhauf and Qi examined was how changes in personal income taxes may affect C corporations. They looked at Kansas, which exempted nonwage income of pass-through firms from taxation and reduced its personal income tax rates in 2012, as seen in the table below. (There was no change made to the corporate income tax.)

Schlagenhauf and Qi noted that Kansas’ economy had not grown any faster by 2016 than the economies of neighboring states. In addition, they pointed out:

• Many firms switched from C corporations to pass-through firms.
• The state’s bond ratings fell.
• Primary central services such as education had to be decreased.

The authors explained that when they simulated a similar policy change, they saw results similar to what happened in Kansas. The reform incentivized some C corporations to switch to pass-through firm status.

“As a result, highly productive firms that switched from the C-corporate legal form reduced their ability to access outside financial capital and thus employment and output did not increase,” they wrote.

“An obvious question is whether the Tax Cuts and Jobs Act will increase employment and output,” Schlagenhauf and Qi noted.

They wrote that tax reductions work in favor of both directions:

• The statutory corporate tax rate was substantially reduced, potentially making C corporation status more attractive to pass-through firms.
• Personal income tax rates have been lowered and many pass-through firms can deduct 20 percent of their income, combining to reduce personal income tax liability of pass-through firms.

“It is not obvious that pass-through firms have the incentive to reorganize as a C corporation with possible improved access to capital that eventually results in employment and output growth,” Schlagenhauf and Qi wrote.

• Economic Synopses: On Corporate Income Taxes, Employment, and Wages
• On the Economy: What Is the Outlook for the Federal Budget?
• On the Economy: Do Red and Blue States Differ on Government Finances?