Federal 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 may have been the spark needed for Iowa to proceed with its own program of reform. Overhauling the state’s tax code has been a goal of state policymakers for years—we wrote a book outlining options for the state in 2016—but competing priorities and budget shortfalls postponed efforts. This year, however, Gov. Kim Reynolds (R) has made tax reform a centerpiece of her agenda, and, boosted by anticipated revenue gains due to federal tax reform, she has now announced the broad details of her proposal.
Iowa anticipates an additional $138 million a year in revenue from federal tax reform, due to (1) broader tax bases, where the state conforms to elements of the federal code that changed this year, and (2) the reduced cost of the state’s deduction for federal taxes paid, given that Iowans’ aggregate federal tax liability is projected to fall by $1.5 billion under the new law. Iowa is one of only six states to allow a deduction for individual income taxes paid to the federal government, and one of only three not to cap that deduction. The state also provides a 50 percent 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. deduction.
Repealing federal deductibility is a worthy goal in its own right, as this anachronistic policy ties Iowa’s tax code to federal policy in unexpected and often undesirable ways. When federal taxes go down, Iowa taxes go up. When the federal government provides preferential treatment of something—from the child 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. to research incentives—Iowa penalizes it. High earners, because they have higher federal effective rates, see their Iowa tax liability reduced, while low-income filers, because they have little or no federal tax liability, get scant benefit from the deduction. This undermines the state’s progressive rate structure, but the result isn’t a flatter tax, just a more distorted one.
Conforming to the federal tax code is often good policy, as it simplifies filing. Federal deductibility, however, is more like a funhouse mirror, inverting and distorting the federal code in ways that fail to achieve the state’s policy goals.
The governor’s tax plan begins by phasing out federal deductibility for 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. , with full repeal by 2021, which is the right place to start. Unfortunately, outlines of the plan released thus far do not appear to extend this logic to the corporate income tax, where federal deductibility produces equally undesirable outcomes.
The governor also proposes cutting rates across the board, with the top marginal rate declining from a very high 8.98 percent to a more reasonable (though still above-average) 6.9 percent by 2023, subject to revenue availability. These cuts are enabled by (1) the repeal of federal deductibility, (2) a broader 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. due to federal reform, and, potentially, (3) increased revenue from taxes on remote sales and (4) economic growth. An outline of the plan specifies the use of contingent revenue triggers to phase in the rate cuts.
The use of triggers is an increasingly popular way to phase in changes to state tax codes, the intent being to ensure revenue stability at each step along the way. The details released thus far do not indicate what sort of trigger design is contemplated, but the best-designed triggers set a permanent baseline against which growth is to be measured, so that rate reductions are implemented on the basis of real growth, and not just year-to-year fluctuations. (For instance, if an economic downturn reduced revenue in one year, simply having the economy grow back to where it was previously should not be enough to trigger a cut.)
The state’s 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. would also increase, rising from $2,070 to $4,000 for single filers ($5,090 to $8,000 for married filers) in 2019. While this increase benefits a wide range of taxpayers, the greatest benefit is for lower- and middle-income filers. Iowa also has an alternative minimum tax, which raises a negligible amount of revenue but forces many taxpayers to calculate their taxes twice. Governor Reynolds proposes its repeal.
The governor proposes two changes to help pass-through businesses (S corporations, LLCs, partnerships, and sole proprietorships), which are subject to the individual income tax rather than the corporate income tax. The first is an increase in the size of the Section 179 deduction, which allows some small business investments to be fully expensed (deducted) in the first year. Iowa’s deduction is uncommonly stingy, and this proposed increase, while modest, is a step in the right deduction.
Unfortunately, the other proposal is a departure from sound tax policy. The new federal law allows a 20 percent deduction for certain 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. While this sounds good, there’s no compelling reason why a small business owner should pay less on her earnings than her employees do on their wages, and it incentivizes efforts to game the tax code by recharacterizing income to take advantage of the deduction. The governor’s plan would allow Iowa businesses to take a deduction worth one-quarter of the new federal pass-through deduction. This is a costly provision which makes the tax code less neutral and does little to drive economic growth.
Finally, the plan alludes to attempts to tax more remote sales (particularly online sales). It is unclear what steps the state might take to accomplish this aim, as requiring out-of-state retailers to collect 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. is proscribed by federal case law unless the retailer has a physical presence in the taxing state. Some states have attempted workarounds, most of dubious legality. However, a legal challenge on this issue, spearheaded by South Dakota, is currently pending. The governor may be laying the groundwork for Iowa to expand its collections if South Dakota prevails in court.
Overall, Governor Reynolds’ plan is an important step in the right direction. A more ambitious proposal would have also swapped the repeal of corporate federal deductibility and the elimination of some targeted tax incentives for lower corporates rates, and the proposal could—and still should—be improved by dropping the pass-through deduction. Still, Iowa’s tax code has been out of line with its competitors for a long time, with high rates and a convoluted tax structure. A full analysis will have to await legislative language, but tax reform is long overdue in Iowa, and this year, policymakers have a real opportunity to make their tax code more competitive.
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