Iowa Governor Proposes Second Round of Tax Reform

Building on 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. reforms adopted in 2018, Iowa Gov. Kim Reynolds (R) is proposing additional reforms which expand and guarantee the promises of the 2018 legislation while modestly rebalancing tax collections between income and consumption. Were these proposed reforms in effect today, Iowa would rank 37th overall on our State Business Tax Climate Index, an improvement from its current rank of 42nd, with particularly stark improvement in the 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. component of the Index.

The 2018 legislation is gradually transforming Iowa’s nine-bracket individual income tax, with an initial top rate of 8.98 percent (now 8.53 percent) into a four-bracket tax with a top rate of 6.5 percent; the top rate of the 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. is slated to decline from 12 to 9.8 percent. In both cases, an unusual policy of “federal deductibility,” under which federal tax liability could 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. , would be repealed. Other changes include the repeal of the individual and corporate alternative minimum taxes, modifications of several business credits, and an enhanced deduction for pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. income.

Governor Reynolds’ proposal would:

• Increase the state 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. by one percentage point, from 6 to 7 percent;
• Cut the individual tax by about 10 percent in 2021 with further cuts in 2023 that drop the top rate to 5.5 percent and reduce the number of brackets from nine to four;
• Repeal the water excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. ;
• Exempt diapers and feminine hygiene products from the sales tax;
• Reduce the statewide mental health property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. levy and instead have more mental health spending funded by the state directly; and
• Expand access to the Early Child Development and Child and Dependent Care tax credits by doubling the eligibility limit from $45,000 to $90,000.

Beyond the tax realm, the proposal also dedicates increased funding to water quality and quality of life efforts and invests additional state resources in the mental health system. Furthermore, whereas some of the currently scheduled individual income tax reductions are subject to revenue triggers, the new proposal would lock reductions in place, taking the top income tax rate to 5.5 percent in 2023.

Were these additional reforms in place, Iowa would rank 20th on the individual income tax component of our State Business Tax Climate Index, which measures the competitiveness of states’ tax structures, improving from 42nd. It would rank 26th on sales taxes, a decline from 15th, reflective of the rate increase, which yields a higher-than-average state and local combined rate. And, as noted, it has the overall effect of improving the state’s total rank from 42nd to 37th.

If adopted, these reforms would increase tax certainty and improve the state’s overall tax structure. The slightly greater emphasis on sales over income tax collections is also beneficial, as sales taxes tend to be more economically neutral, meaning that they have less of an impact on economic growth or decision-making than do income taxes.

In 2016, the Tax Foundation published a guide to reforming Iowa’s tax code. Although there is still more work to be done, particularly in the structure of the state’s corporate income tax, the 2018 reforms, combined with the governor’s proposals, would represent a substantial step in the direction of the simpler, more neutral, more pro-growth tax code we envisioned.

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