Iowa Tax Reform Options: Building a Tax System for the 21st Century

Introduction & Executive Summary

Iowa is strongly positioned for success. An Iowa businessman with whom we spoke put it best: while South Dakota’s competitive advantage is its overall tax climate, and Nebraska’s advantage is its generous credits, Iowa’s competitive advantage is its people. 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. structures can be tweaked; building up human capital is far harder. The state boasts a dedicated and talented workforce. What remains is to implement a tax structure that can unleash the energy, creativity, and ambition of hard-working Iowans into a force to be reckoned with, in the region and across the country.

That is the theme of this book.

In the following pages, we examine Iowa’s economy, detail the state’s existing tax structure, and offer recommendations for reforming the tax code. We seek to identify what Iowa does well and to point out opportunities for improvement. Underlying our analysis is the goal of enhancing Iowa’s competitive standing and a commitment to the principles of sound tax policy—that, to the greatest extent possible, taxes should be simple, transparent, neutral, and stable, and that the best tax structures are those with broad bases and low rates.

In the course of our research, we poured over Iowa’s tax code, dusted off old tax studies, reviewed the economic literature, and examined successful reforms implemented by other states. First and foremost, however, we talked to Iowans—state and local government officials, business leaders, and everyday taxpayers alike. The insights and perspectives of those who actually interact with Iowa’s tax system inform every page of this book.

In the following pages, we provide background on Iowa’s economy and overall fiscal system (Chapter 1). We then review each major tax, outline concerns, and propose options for reform (Chapters 2, 3, 4, and 5). Chapter 6 examines additional tax considerations that fall outside of the four major tax types.

The Future of Iowa Foundation commissioned the Tax Foundation to prepare this review of the Iowa tax system and recommend possible solutions, and this book is the result. While they supported our study, they did not direct this or any of our recommendations. We offer our thanks to the many Iowans of all walks of life who met with us as we worked on this book.

A Menu of Tax Reform Solutions

Individual Income Tax

Our 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. solutions improve the tax code by broadening the tax base and reducing tax rates, making the state more competitive with its neighbors and rendering the system more neutral and fair. Iowa’s present system of high, progressive taxation, partially countered by federal deductibility, is inefficient and inequitable, and the misleadingly high resultant rates hinder the state’s ability to attract new residents. Each of our proposals address these concerns.

Enhancing tax neutrality. Iowa’s individual income tax consistently fails to treat taxpayers evenhandedly. Our solutions for improving neutrality would:

• Double bracket widths for married filers, replacing the existing option for married couples to file separately on the same return.
• Repeal the alternative minimum tax, which imposes high compliance costs but only generated $9.9 million in tax year 2013.
• Adopt permanent conformity to federal Section 179 expensing levels to offer greater certainty for farmers and small business owners.

Rolling back business incentives. Pass-through businesses, which remit individual rather than corporate income taxes, claimed nearly $117 million in individual income tax credits in 2013, many of them pure preferences or business incentives. These credits erode the 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. while providing little economic benefit. Accordingly, our solutions would:

• Eliminate most or all business tax credits other than the S CorporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). ApportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. Credit.
• Use the revenue associated with credit elimination to reduce individual income tax rates.

Lowering rates and repealing federal deductibility. Iowa’s rates are anomalously high, creating “sticker shock.” Federal deductibility introduces a range of unintended consequences which undermine the state’s competitiveness. Consequently, we offer a menu of options for broad-based reform, all of which include, at minimum, the repeal of federal deductibility and the elimination of the alternative minimum tax:

• Repeal federal deductibility, offset on a revenue neutral basis by an across-the-board rate cut of 20 percent, yielding a new top marginal rate of 7.2 percent.
• Repeal federal deductibility and adopt a 5.8 percent flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. coupled with a $10,000 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. on a revenue neutral basis.
• Repeal federal deductibility and adopt a 5.3 percent flat tax on a revenue neutral basis.
• Repeal federal deductibility, eliminate all business credits, and adopt a 5.15 percent flat tax on a revenue neutral basis.
• Repeal federal deductibility, eliminate all business credits, and adopt a 4.0 percent flat tax, with an attendant reduction in revenue of about $200 million.
• Repeal federal deductibility, eliminate all business credits, adopt a 4.0 percent flat tax, and implement a $25,000 standard deduction, for a tax cut of $1.9 billion.
• Repeal federal deductibility, eliminate all business credits, modestly raise the standard deduction and personal exemption, and consolidate the existing nine-bracket system into two rates of 4.3 percent and 6.5 percent on a revenue neutral basis.

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.

Iowa’s 12 percent top marginal rate gives the state—at least on paper—the highest corporate income tax rate in the country. Our corporate income tax solutions would make Iowa more competitive by moving to a lower and flat rate. Our solutions also include base-broadening elements and help mitigate tax uncertainty for businesses.

Repealing federal deductibility. The 50 percent federal deduction eases the burden of Iowa’s high, progressive corporate income tax rates, but increases complexity and introduces unintended distributional effects. We offer several options for the repeal of federal deductibility coupled with rate reductions:

• Repeal federal deductibility and adopt a 9.0 percent flat tax on a revenue neutral basis.
• Repeal federal deductibility and adopt a 6.5 percent flat tax at a tax cost of $100 million.
• Repeal federal deductibility and adopt a 4.0 percent flat tax for a $200 million tax cut.

Rolling back tax credits. In 2013, tax credits reduced corporate tax liability by $102.5 million. Evidence suggests that these tax credits provide minimal return to the state, and that a policy of picking winners and losers is ultimately counterproductive as well as inequitable. We propose that Iowa:

• Bring all existing tax credits under a unified cap and resist increasing the capped amount, or even impose a declining cap.
• Establish a standing tax expenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit (EITC), child tax credit (CTC), deduction for employer health-care contributions, and tax-advantaged savings plans. committee charged with making and introducing legislative recommendations for the reform or repeal of ineffective tax credits.
• Substantially reduce or eliminate corporate income tax credits.

We also offer several options for pairing 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. reductions with rate reform:

• Repeal federal deductibility, eliminate 50 percent of tax credits, and adopt a 7.7 percent flat rate on a revenue neutral basis.
• Repeal federal deductibility, eliminate 50 percent of tax credits, and adopt a 5.2 percent flat rate at a tax cost of $100 million.
• Repeal federal deductibility, eliminate all tax credits, and adopt a 6.5 percent flat rate on a revenue neutral basis.
• Repeal federal deductibility, eliminate all tax credits, and adopt a 3.9 percent flat rate at a tax cost of $100 million.

Improving tax structure. Iowa’s corporate income tax code diverges from best practices in a number of ways which yield relatively little revenue while substantially increasing compliance costs and taxpayer uncertainty. Therefore, our solutions would:

• Eliminate the corporate alternative minimum tax, which only 1 percent of businesses pay but must be calculated by all businesses, and raises less than $6 million per year.
• Restore the three-year net operating loss carrybackA Net Operating Loss (NOL) Carryback allows businesses suffering losses in one year to deduct them from previous years’ profits. Businesses thus are taxed on their average profitability, making the tax code more neutral. In the U.S., a Net Operating Loss cannot be carried back (only carried forward). provision.

Sales Taxes

Iowa’s 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 a critical source of both state and local revenue. Currently, however, many goods and services are unnecessarily exempted, while some business inputs are subject to tax, which can lead to multiple layers of taxation being imposed on the same final product at different points along the production process. Similarly, tax structure and administration is complex and introduces needless compliance costs. Our solutions strive to simplify the sales tax and include a range of base broadening options.

Modifying the sales tax base. A well-structured sales tax applies to all final consumer transactions, both goods and services, while exempting business to business transactions. While Iowa’s tax base is broader than average, it still exempts many services. Similarly, while some strides have been made in excluding business inputs from the sales tax base, many remain. Accordingly, we offer a range of options for both service expansion and the exemption of business inputs. Any base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. provides an opportunity to pay down reductions in the sales tax rate.

Our base broadening options are as follows:

• Modest expansion to personal services and entertainment products, like museum admissions, veterinary services, and amusements.
• Intermediate base broadening to also include final consumer purchases of professional services, including legal, accounting, and financial services.
• Broad base expansion to also include rental housing, health care services, and higher education expenses.

We also suggest the following options for excluding business inputs:

• Individual exemptions for goods and services likely to be business inputs, including business supplies and 25 enumerated services.
• Provision for all purchases made by businesses to be exempt from the sales tax, in much the same manner as nonprofits are often permitted to make tax exempt purchases.

Improving tax structure. Iowa’s sales tax is rendered unnecessarily complex by a patchwork of local option sales tax rates and a series of dedications and diversions. Our solutions would:

• Eliminate the minuscule diversion into the 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. Equity and Relief Fund, which has seen revenues dip as low as $6.3 million.
• Modify the school infrastructure dedication to make it more responsive to future tax base changes.
• Provide for clearer regulations and published guidance on sales tax administration.

Property and Related Taxes

Property taxes account for the overwhelming majority of local revenue in Iowa. Base-narrowing exemptions, formula-driven adjustments, and divergent assessment ratios on different classes of property combine to produce a property tax structure that few understand, while an inheritance tax and real estate transfer tax impose substantial tax burdens on the transfer of property. Accordingly, our solutions would:

• Repeal the inheritance taxAn inheritance tax is levied upon an individual’s estate at death or upon the assets transferred from the decedent’s estate to their heirs. Unlike estate taxes, inheritance tax exemptions apply to the size of the gift rather than the size of the estate. , which disadvantages some heirs more than others and leads to inefficient tax avoidance strategies.
• Limit further imbalances in Iowa’s rollback structure by extending the 3 percent allowable growth factor to commercial and industrial property.
• Eliminate the “Ag Tie,” an artificial restriction on the rate of assessment growth for residential property.
• Standardize filing and payment deadlines for local property taxes to reduce compliance costs for individuals and businesses with property in multiple localities.

Other Tax Considerations

We also consider several tax provisions which do not fit into the four major tax categories above, but which warrant their own separate consideration. Here, we offer a few options for consideration:

• Eliminate future authority for tax increment financing (TIF) for economic development purposes or, failing that, require a demonstration of how a proposed TIF will encourage development that would not have been realized otherwise.
• Index the motor fuel tax for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. to avoid an erosion of revenue in real terms over time.

Comprehensive Reform

Were all of our major reforms adopted, in each case selecting the most significant revenue neutral option for rate reductions of major taxes, Iowa could move from 40th to 10th place on the State Business Tax Climate Index. Other reform packages, drawing from the options provided in this book, would also result in significant improvement on the Index. Several possible comprehensive reform options are reviewed below, each with a corresponding Index score. Throughout the book, Index scores are provided for each reform proposal individually as well.

In all of the options below, rate reduction options are revenue neutral, but other reforms, like the repeal of the inheritance tax, alternative minimum taxes, and the marriage penalty are not.

Option A

This approach, which incorporates the most significant revenue neutral rate reduction options for each tax category, is aggressive, but is provided to demonstrate the degree to which the reforms offered in this book, taken together, can enhance Iowa’s tax code, and improve the state’s competitiveness. Option A includes:

• A 5.15 percent flat individual income tax made possible by the repeal of federal deductibility and business tax credits, which also has the effect of eliminating the marriage penaltyA marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples. ;
• The retention of the current standard deduction of $1,970 and the $40 personal exemption credit;
• The repeal of both individual and corporate alternative minimum taxes;
• A 6.5 percent flat corporate income tax with the repeal of federal deductibility and all business tax credits;
• The restoration of a three-year net operating loss carryback;
• The exclusion of business inputs from the sales tax base; and
• The repeal of the inheritance tax.

Option B

This option pairs a somewhat higher flat tax with a generous $10,000 standard deduction, providing a tax cut for taxpayers with taxable incomes below $40,000. This component and the flat-rate corporate income tax are designed to be revenue neutral, though other elements would involve modest revenue reductions. This option includes:

• A 5.8 percent flat individual income tax with a generous $10,000 standard deduction, made possible by the repeal of federal deductibility, while retaining all existing credits;
• The repeal of both individual and corporate alternative minimum taxes;
• A 6.5 percent flat corporate income tax with the repeal of federal deductibility and all business tax credits;
• The restoration of a three-year net operating loss carryback;
• The exclusion of business inputs from the sales tax base; and
• The repeal of the inheritance tax.

Option C

This option features a simplified two-rate individual income tax and retains existing business tax credits but otherwise follows Option A. This option includes:

• A two-bracket individual income tax with a top rate of 6.5 percent coupled with the repeal of federal deductibility;
• An increase in the standard deduction to $3,000, while raising the personal exemption credit to $60;
• Doubling of bracket widths for joint filers to eliminate the marriage penalty;
• A 6.5 percent flat corporate income tax with the repeal of federal deductibility and all business tax credits;
• The restoration of a three-year net operating loss carryback;
• The exclusion of business inputs from the sales tax base; and
• The repeal of the inheritance tax.

Option D

This option adopts a two-bracket individual income tax and single-rate corporate income tax while reducing corporate credits by 50 percent. It makes no changes to the sales tax base. This option includes:

• A two-bracket individual income tax with a top rate of 6.5 percent coupled with the repeal of federal deductibility;
• An increase in the standard deduction to $3,000, while raising the personal exemption credit to $60;
• Doubling of bracket widths for joint filers to eliminate the marriage penalty;
• A 7.7 percent flat corporate income tax with the repeal of federal deductibility and a 50 percent reduction in corporate tax credits;
• The restoration of a three-year net operating loss carryback; and
• The repeal of the inheritance tax.

The above options would result in the following changes to Iowa’s rankings in the State Business Tax Climate Index, compared to its current system.

	Overall	Corporate	Individual	Sales	Unemployment Insurance Tax	Property
Current System (2016)	40th	49th	32nd	24th	34th	40th
Option A	10th	3rd	14th	7th	34th	35th
Option B	10th	3rd	17th	7th	34th	35th
Option C	14th	3rd	20th	7th	34th	35th
Option D	24th	18th	20th	24th	34th	35th

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