The Ohio Senate has swapped out the high-end income tax cut in favor of the 50% tax deduction for small business investors. This plan lets $2.8 billion flee the state without being taxed.

Here’s how it works: for the first $750,000 in income for the owners of a Pass-Through Entity, half of that income can be deducted from the amount subject to state income tax.

Who are the owners of Pass-Through Entities? Small businesses, sole proprietorships, law firm partners, medical practices, and venture capitalists.

Venture capitalists are key, because they have ownership stakes in lots of PTEs. Whereas small business owners will get tax deductions on smaller incomes, every venture capitalist will be able max out the $750,000. If the deduction is tied to PTE (rather than the filer) then there will be no cap on venture capitalists; they just get a 50% tax cut.

Now, as I said originally, this won’t have any expansionary employment impact. A boutique that makes $75,000 in profit for its owner isn’t going to hire another worker because the owner gets an extra $1500 in after-tax income. That’s Horseshit Economics, and it’ll have no impact at all in the behavior of the firm.

What I didn’t get into in that original post is why Kasich would come up with this scheme. His Jobs Budget publication lets it slip:

… the tax reform proposal caps the amount of owner/investor income eligible for the deduction at $750,000 annually…. So, capping the eligible income for deduction at $750,000 per owner/investor is a proxy for capping the deduction…

“Investor” is the key word here. And how did the Governor score the fiscal impact of the plan?

Untaxed Income

Tax Cut

Ohio residents $11.2B $561M
Out-of-state investors $2.8B $140M

In this plan, one of every five dollars will leave the state of Ohio, never to return.  What good does it do Ohio to let $2.8 billion flee the state tax-free?

The example used in the Kasich budget is even more telling:

The hypothetical business in this case is an Ohio LLC with 3 owners (members), each of whom have one-third ownership of the company. The company produces rubberized cases for tablet computers like the Apple iPad, which it sells to retailers around the country. Let us assume that this is a profitable business, with net income for taxable year 2015 of $1.5 million.

The $1.5 million in business net income is divided three ways, with each of the owners receiving $500,000….

Collectively, the three LLC owners receive a tax cut of slightly over [$39,000]* per year, with that money being freed up for hiring or capital investment in the business.

Again, none of this makes the firm more profitable. It would be inefficient to expand the firm because of this cut.

If this company makes $1.5 million in profits, it will have been bought by venture capitalists. So we’re giving $13,000 a year to out-of-state investors, who aren’t going to hire or invest in this firm in Ohio. They’ll invest in some other firm somewhere else.

And that investment decision will be made based on the profitability of the company they’re buying! To say that a 2% tax cut plays any kind of a role in the decisions of venture capital firms is yet more Horseshit Economics**.

If it is owned by Ohioans, this plan is even worse! It makes a leveraged buyout of the firm more likely, which is great for the original owners… until the company (now free of any personal connection to Ohio) holds the state ransom for more tax incentives before ultimately fleeing to a jurisdiction that will bribe them.

Now, this scheme may not be all bad. If we can show that profitable Ohio firms are having trouble attracting out-of-state investors, then we should do things to incentivize that investment. After all, that’s money flowing into the state.

However, Kasich presents zero evidence that this policy will actually increase investment. Instead he pulls our leg by saying that firms will expand production even though they’re no more profitable than they were before. And it stands to reason that investors would be a lot more interested in the kind of business climate (educated workforce, capitalized client base) that this policy does nothing whatsoever to create.

If I were an out-of-state venture capitalist, I’d be insulted that John Kasich intimated that I don’t know how to run a business.

But I’d probably take his $2.8 billion in tax-free money as a fitting apology.