Iowa Considers Alternative Maximum Tax

March 19, 2015

Right now, Iowa’s income tax has nine different brackets, with rates ranging from 0.36 percent (in the first $1,539 of taxable income) to 8.98 percent (on all income above $69,255), and that’s not going away—but if some legislators get their way, taxpayers might have an alternative.

House Study Bill 215 revives a concept considered in 2013 and 2014: an alternative maximum tax, or, as it’s termed in the bill language, an “alternative base cumulative income tax.” The basic idea is that each year, taxpayers get to choose between (1) paying under the current graduated income tax structure, claiming any credits, deductions, or exemptions for which they are eligible; or (2) paying a flat 5 percent rate on all taxable income while foregoing most income subtractions.

Those making the election for a flat rate would still be able to subtract the standard deduction ($6,235 for an individual), plus interest and dividends from federal securities, and federal pension income, but would forego other subtractions. In exchange, they could pay a flat 5 percent rate. Since they would be paying a lower rate, those making this election would also pay 122 percent of the school district-levied surtax rate for their district.

This alternative tax structure functions as an alternative maximum tax: informed taxpayers would select the option yielding the lower tax burden, which, for many taxpayers, would be the alternative base cumulative income tax. The state’s tax credits greatly advantage farmers, low-income families with children, and those harnessing alternative energy sources, but for other taxpayers, foregoing most income tax credits and deductions would not be a substantial loss.

The one wrinkle is federal tax deductibility. Iowa is one of a small number of states that allow a deduction for federal income taxes paid, which can certainly be significant. However, I crunched the numbers on a variety of scenarios, and conservatively estimate that taxpayers with more than $40,000 in taxable income would almost always be better off paying the alternative tax—unless, again, they fall into tax-advantaged categories as farmers, low-income families with children, and the like.

It is not, however, a sure thing. Some high income taxpayers might fare better under the traditional rate structure if they combine that federal deductibility with, say, sizable deductions for charitable contributions. And some low middle-income families might qualify for enough assistance through the tax code to make the standard approach worth their while. This adds complexity to the system, as taxpayers would want to calculate their tax burden both ways.

Iowa’s top tax rate of 8.98 percent is anomalously high, and its rate structure is steeply progressive, with seven different rates falling on the first $31,000 of income (nine rates in all). Among neighboring states, only Minnesota has a higher top tax rate; Illinois, Missouri, Nebraska, South Dakota (which foregoes an income tax entirely), and Wisconsin all offer lower top rates. A lower flat rate on a broader base would be good tax policy and make Iowa more competitive. As an alternative rather than a replacement, though, it does add a degree of complexity.

The 5 percent flat rate proposal is intended as a tax cut, not as a revenue neutral alternative. A similar proposal in 2013, which would have adopted a flat rate of 4.5 percent, would have resulted in an estimated reduction of $396.5 million in income tax liability in tax year 2013, and $469.9 million by 2017. At a 5 percent rate, the reduction in revenue by tax year 2017 might be expected to be in the neighborhood of $410 million, about twice the amount of the increased revenue associated with a recent gas tax hike.

Alternative maximum taxes are rare but not unknown. Rhode Island adopted an alternative flat income tax structure from 2006 – 2011 which culminated in lower overall rates and the elimination of the state’s top brackets. That bill included phased-in reductions in the flat rate, whereas the legislation pending in Iowa sets the rate at 5.0 percent in perpetuity, but like the Rhode Island bill, this Iowa proposal draws upon elements of good tax policy. Ideally, though, Iowa would look at ways to reduce its high income tax burden without making taxpayers calculate their tax burden twice.

More about Iowa here. Our writeup of the 2013 proposal can be found here.

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