Iowa’s existing 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. code is outdated and needlessly complex. Too often, it puts a thumb on the scale, favoring some industries and activities over others. It has high “sticker” rates and a curious distribution of tax burdens in part because of an atypical deduction for federal taxes paid. It leans heavily on corporate tax credits, many of them refundable. It selectively decouples from important pro-growth provisions of the federal tax code. It is beset by nuisance provisions like alternative minimum taxes which raise a negligible amount of revenue but create additional compliance costs. For all these reasons and more, the state was long overdue for tax reform.
Now, after several years of stalled efforts, Gov. Kim Reynolds (R) is on the verge of signing tax reform legislation which reduces rates and simplifies certain aspects of the tax code.
In the waning days of the legislative session, there were growing risks that legislators could adopt a cuts-only package that missed out on any opportunity for tax reform, sacrificing the plan’s economic potential and limiting its reach. While the final bill language doesn’t include some of the changes that reformers had sought (we wrote a book on the matter back in 2016), and many of the more significant reforms are backloaded, it includes meaningful reforms that will improve the state’s overall tax structure.
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.
The individual income tax, currently a nine-bracket tax with a top marginal rate of 8.98 percent, will be converted, in two steps, to a four-bracket tax with a top rate of 6.5 percent. A modest across-the-board rate reduction will be implemented in 2019, reducing the top marginal rate from 8.98 to 8.53 percent. This year, the Section 179 small business expensing limit will be increased from $25,000 to $70,000, upped to $100,000 in 2019, at which time the state will adopt the federal law’s new pass-through deduction at a reduced amount, phasing it up from 25 percent of the federal value in 2019 to 75 percent in 2022.
Iowa will also decouple from the new federal $10,000 SALT deduction limit (which would have also capped the amount of local property taxes deducted on state returns) and temporarily decouple from the federal repeal of like-kind exchanges. (This is not strictly an individual income tax issue, but it is included here due to its significance for Iowa farmers in particular.) In 2020, the state will fully couple with the federal Section 179 limits in exchange for following the federal government in repealing like-kind exchanges, and the state will implement rolling conformity with the federal Internal Revenue Code.
In 2023, subject to revenue triggers:
- Brackets will be consolidated and larger rate reductions implemented, bringing the top rate to 6.5 percent;
- Federal deductibility, under which federal tax liability can be deducted from Iowa 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 be repealed;
- The income tax starting point will shift to federal taxable income, fully incorporating federal itemized and 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. amounts;
- The alternative minimum tax, which increases compliance costs while raising very little revenue, will be eliminated; and
- The pass-through deduction will be increased to the full value of the federal deduction.
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.
At 12 percent, Iowa’s top corporate income tax rate is currently the highest in the nation. In 2021, federal deductibility will be repealed and the top rate reduced to 9.8 percent, paired with the repeal of the corporate alternative minimum tax. Several business tax credits (available against both individual and corporate income taxes) are to be modified, including:
- The Research Activities 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. , which will see tighter eligibility restrictions narrowing its scope to a smaller range of industries;
- The Geothermal Heat Pump Tax Credit and Geothermal Tax Credit, which is to be repealed effective July 2019; and
- The Innovation Fund, which is to be renewed for another five years.
A tax credit review will also be established in the summer of 2019, and as of tax year 2020, Iowa will have rolling conformity with the federal code, except that the state will continue to decouple from the new federal policy of full first-year expensing of machinery and equipment, just as it previously decoupled from “bonus depreciationBonus depreciation allows firms to deduct a larger portion of certain “short-lived” investments in new or improved technology, equipment, or buildings in the first year. Allowing businesses to write off more investments partially alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. .”
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.
With the Supreme Court deliberating in South Dakota v. WayfairSouth Dakota v. Wayfair was a 2018 U.S. Supreme Court decision eliminating the requirement that a seller have physical presence in the taxing state to be able to collect and remit sales taxes to that state. It expanded states’ abilities to collect sales taxes from e-commerce and other remote transactions. , regarding states’ authority to collect taxes on remote sales, the pending Iowa legislation seeks to take advantage of whatever opportunities there may be to capture this additional revenue, while also broadening the 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. to include other transactions currently exempt from taxation.
Beginning in tax year 2019, Iowa’s sales tax base would be expanded to include digital goods, ride sharing, and subscription services, and imposed upon the full amount charged to a customer for hotel rooms or car rentals—including booking fees. The state would also expand its definition of sales tax nexus to include economic nexus, click-through nexus, marketplace collection, and more, meaning that—subject to the Supreme Court’s decision—the state would be able to collect taxes on a wide range of remote sales.
Iowa’s approach embraces multiple theories of nexus. Economic nexus, sometimes called “factor presence,” is based upon the idea that a certain amount of economic activity creates enough of a presence for a company to be required to collect state sales taxes, even if the company has no physical presence in the state. Click-through nexus focuses on the location of the computer where the purchaser is located, regardless of where the company may be. And marketplace collection requires any company which is within the sales tax base through other means to collect and remit sales taxes on transactions on its platform by third-party sellers (think eBay or Amazon Marketplace).
Iowa Tax Changes in Context
Some of these changes are straightforward reforms: simplification, consolidation, and elimination of nuisance provisions which raise negligible revenue. Other changes, like adopting the new federal pass-through deduction, lose a substantial amount of tax revenue for very little economic gain. (We’ve argued against both state and federal pass-through deductions on multiple occasions.) And while states ought to have the authority to tax remote sales (we submitted an amicus brief to this effect in the Wayfair case), the pending Iowa bill’s multipronged approach embraces an expansive definition of nexus which gives rise to concerns—though depending on the outcome of Wayfair, they may be rendered moot.
On net, the Iowa legislation represents a substantial tax cut, though one that is largely revenue-contingent, only implemented if the state experiences enough revenue growth to make up the difference. The triggers will be difficult to achieve in 2023, as it requires consistent growth in the ballpark of 4 percent per year. If the final round of reforms are triggered, though, in 2023 or thereafter, Iowans can look forward to meaningful improvements to the state’s tax structure.
Erratum: This post originally stated that the bill eliminated the solar tax credit. Although it was repealed in prior versions of the bill, that provision was dropped in the enrolled bill, saving the credit.
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