Iowa Governor Outlines Plan to Cut Rates and Repeal Federal Deductibility

February 14, 2018

Federal tax 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 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 credit 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 tax, 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 base 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 deduction 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 business 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 tax 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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