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Iowa Enacts Sweeping Tax Reform

6 min readBy: Jared Walczak

When Iowa Gov. Kim Reynolds (R) delivered the Republican response to the State of the Union Address on March 1, she touted a state taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform package on which the ink was barely dry: “Today, I signed legislation that eliminates Iowa’s tax on retirement income and sets our tax rate at 3.9 percent. That’s less than half of what it was just four years ago.”

The ongoing transformation of Iowa’s tax code is certainly remarkable. In 2018, Iowa had a nine-bracket individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. with a top marginal rate of 8.98 percent and a graduated-rate corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. with a top rate of 12 percent, both with alternative minimum taxes; an inheritance taxAn inheritance tax is levied upon an individual’s estate at death or upon the assets transferred from the decedent’s estate to their heirs. Unlike estate taxes, inheritance tax exemptions apply to the size of the gift rather than the size of the estate. ; and a well-intentioned but distortive policy of federal deductibility. Once current reforms have phased in, Iowa will be able to boast a 3.9 percent single-rate individual income tax, a 5.5 percent flat corporate income tax, and no inheritance tax or alternative minimum taxes. Improvements have been made to the state sales tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. and several tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s have been reformed. Additionally—a more mixed bag economically—the state will exempt retirement income and certain farm rental income from taxation.

The most recent legislation, H.F. 2317, builds on reforms adopted in 2018 and 2021, and is broadly consistent with recommendations made by the Tax Foundation in our 2016 guide to Iowa tax reform. Before the reforms of 2018 took effect, Iowa ranked 46th overall on our State Business Tax Climate Index, a measure of state tax structure. With the full phase-in of the newly enacted reforms, Iowa would rank 15th overall, an improvement of 31 places. This would tie North Carolina for the largest improvement in the Index’s history. In the wake of historic reforms beginning in 2013, North Carolina improved from 41st to 10th overall in seven years (currently 11th).

Iowa Could Improve 31 Places on the State Business Tax Climate Index
Index Rank Pre-2018 Reforms Current System (2022) Fully Implemented
Overall 46 38 15
Corporate Taxes 48 38 16
Individual Income Tax 42 38 10
Sales and Excise Taxes 19 15 15
U.I. Taxes 33 39 39
Property Taxes 37 39 34

Source: Tax Foundation, State Business Tax Climate Index, with new projections.

These tax reductions come with a significant price tag—most notably, the individual income tax cuts involve forgoing $1.65 billion a year in revenue by FY 2027, when reforms have fully phased in—but based on current revenue forecasts, state lawmakers believe that this can be accomplished out of future revenue growth without even dipping into a taxpayer relief fund with a balance surging toward $2 billion.

According to the governor’s office, 98 percent of Iowans with $10,000 or more of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. will see lower tax liability under the 3.9 percent flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. . Initially, marginal rates below about $16,000 in income are slightly higher, and this will be true for income below $7,000 once the tax plan is fully phased in, but at nearly all income levels, Iowa taxpayers will experience tax relief. The median household in Iowa ($60,523 in income) would see its income tax burden decline by 26 percent, from about $2,765 to $2,052. The following table shows current tax rates and brackets, along with the consolidation—ultimately to a flat 3.9 percent rate—beginning next year.

Iowa is Transitioning to a Low, Flat-Rate Income Tax
Above 2022 2023 2024 2025 2026
$0 0.33% 4.40% 4.40% 4.40% 3.90%
$1,743 0.67%
$3,486 2.25%
$6,000 4.82% 4.82% 4.82%
$6,972 4.14%
$15,687 5.63%
$26,145 5.96%
$30,000 5.70% 5.70%
$34,860 6.25%
$52,290 7.44%
$75,000 6.00%
$78,435 8.53%

Source: H.F. 2317 (2022).

Economic decision-making happens at the margin. Decisions about work and investment are based on the treatment of the next dollar, not prior ones. Consequently, it is taxpayers’ marginal rates which matter, which is why a low top marginal rate is the relevant factor for economic growth. By going to a single-rate system, like neighboring Indiana (at 3.23 percent, with plans for a 2.9 percent rate), Iowa would not only have a low marginal (and only) rate, but also adopt a system which tends to create greater certainty around low rates—which is also important for investment and location decision-making.

When the same rate applies to almost all income (except for that excluded due to the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and certain other adjustments), it is much more politically difficult to raise rates in the future than it is under a graduated rate system. This appears to be one reason why Illinois voters resoundingly rejected a graduated rate income taxA graduated rate income tax system consists of tax brackets where tax rates increase as income increases. Typically, this results in a taxpayer’s effective income tax rate, or the percentage of their income paid in taxes, increasing as their income increases. recently: voters understood that, whether or not they were subject to higher rates initially, the flat-rate system is the only thing keeping their own income tax rates competitive.

The full exclusion of retirement income, while undoubtedly appreciated by retirees, does little to benefit the state’s overall economic competitiveness. It may induce more retirees to stay in state, potentially a welcome policy goal in its own right, but that is separate from any goal of promoting economic growth. Most economists believe that retirement income should be taxed, but only once: whether that income is taxed on the way in (think a Roth IRA) or on the way out (a traditional IRA) is largely immaterial. Iowa, however, will leave retirement income untaxed both in and out.

The tax reform legislation also phases down the corporate income tax rate, with a target rate of 5.5 percent. The bill accomplishes this aim over time using tax triggers which set base collections of $700 million per year. Each year, rates will be adjusted to those that would have been necessary to collect no more than $700 million in the preceding year. Given that FY 2022 net collections are projected at $780 million, Iowa starts with the capacity to make a cut of approximately 1 percentage point across the board on its current three-bracket corporate income tax. Based on current forecasts, further reductions will be slow, and a 5.5 percent rate may not be achieved for quite some time, but Iowa is now committed to a path of rate relief, very similar to Indiana’s successful reforms of the 2010s.

The bill also modifies several tax credits, provides a lease exemption for retired farmers (who must choose between this and the capital gains exemption on the sale of farmland), and some other smaller provisions. Finally, it provides for the use of money in the Taxpayer Trust Fund—projected for almost $2 billion by the end of FY 2023, and designed to facilitate tax relief—should those funds be necessary to implement the planned rate reductions, though under current projections, state revenue growth could be enough without even dipping into these tax relief reserves.

Iowa was the fourth state to adopt rate-cutting legislation in 2022, following individual and corporate income tax cuts in Idaho and Utah, sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. rate cuts in New Mexico, and inheritance tax rate cuts in Nebraska. Many states are likely to follow, in what is shaping up to be a year of significant bipartisan focus on tax relief in an environment characterized by soaring tax revenues, increased mobility, and a renewed emphasis on state tax competitiveness. Many white-collar workers can increasingly work from anywhere with an internet connection, and companies no longer need to have their entire workforce located near their facilities.

But even if 2022 sees many tax reforms, the scope of Iowa’s tax relief measures is likely to stand out. With H.F. 2317, Iowa lawmakers have made a significant investment in a more competitive tax climate for an increasingly competitive era.