The impact of state taxes on pass-through businesses: Evidence from the 2012 Kansas income tax reform

In 2012, Kansas undertook a large-scale tax reform that excluded pass-through business income from individual taxation. In theory, these changes enhance the incentives to undertake more real economic activity, such as new business formation or expansion of existing businesses. The reform also increased the incentive to avoid taxation by recharacterizing income sources. This paper provides evidence of these effects using federal administrative income tax data spanning 2010–2014. Several findings suggest that, on both the extensive and intensive margins, the pass-through exclusion led to increased tax avoidance in the form of income recharacterization and shifting of effort from activities compensated through wages to those compensated with business income. We do not find much evidence, however, that the Kansas reform led to increases in real economic activity.