Illustration by Nathan Klaus and Freepik
Illustration by Nathan Klaus and Freepik

The national Tax Foundation wants the Iowa legislature to perform a little magic.

The state should scrap its complicated tax structure and replace it with something simpler. The result, it promises, would jump-start economic growth in the state.

And it would do that without significantly reducing government revenues. That’s the magic.

More magic: If the plan works, tax burdens on individuals and businesses could actually drop as the state shifts to a more vibrant and dynamic economy. That, of course, would require a special type of conjuring – lawmakers cutting tax rates rather than giddily distributing their newfound riches.

It sounds great, but how would it work?

Sticker Shock

To understand the mechanics of this sleight of hand, you need to start with “sticker shock” – how Iowa’s tax system looks to people doing a comparison of states.

Only California, Minnesota, and Oregon have a higher top personal-income tax rate than Iowa’s 8.98 percent.

Only California and Missouri have more personal-income-tax brackets than Iowa’s nine.

And with corporate income taxes, no state’s highest rate tops Iowa’s 12-percent ceiling. In fact, no other state taxes corporate income at a rate of 10 percent or above.

Those comparisons are damaging when businesses and people are deciding where to locate, said Jared Walczak, a policy analyst with the Tax Foundation’s state team: “Iowa may not make the cut. In many cases, it would simply be written off on the first pass because it doesn’t look that attractive.”

Jeff Smith, president and CEO of the Iowa Taxpayers Association, said businesses often narrow down their location options to a handful of states: “If you look at the top corporate rate in Iowa at 12 percent, that pretty much eliminates us.”

Yet Iowa’s actual tax burden compared to other states – and particularly nearby states – is actually relatively low. According to the Tax Foundation, Iowa’s state and local tax burden as a percent of state income ranked 31st in the country in Fiscal Year 2012. That’s far better than neighbors Minnesota (eighth), Wisconsin (fourth), and Illinois (fifth) – and slightly better than Nebraska (30th) and Missouri (29th).

Furthermore, that Iowa tax burden – 9.2 percent in 2012 – has over the past two decades been lower than it was from the mid-1970s to the mid-1990s, when it topped 10 percent.

The difference between the appearance of Iowa’s tax system and its reality comes from a structural quirk: high tax rates offset by adjustments such as credits and federal deductibility – the latter a part of the tax systems of just a few states.

The high rates, Smith said, might not even register with the state’s taxpayers, but they certainly grab the attention of outsiders. “I think everybody in the state understands what federal deductibility is, but do they understand the ramifications of how that affects the tax rates?” he said. “Our rates are artificially high.”

That dissonance is at the heart of Iowa Tax Reform Options: Building a Tax System for the 21st Century – a new book produced by the Tax Foundation and commissioned by the Future of Iowa Foundation (a sister organization to the Iowa Taxpayers Association).

The book offers four options for comprehensive tax reform in Iowa, and enacting any of those would boost the state’s ranking in the foundation’s State Business Tax Climate Index – from its current 40th to between 10th and 24th. In other words, the state could shift from the 10th-worst state in the nation on tax policy to 10th-best in the eyes of the Tax Foundation if it enacts the two most-aggressive options.

And it could do that without substantially reducing state revenues – before accelerated economic growth even enters the picture.

“What ... surprised me was the various options that are available that really don’t have a negative fiscal impact on the state ... ,” said Smith, who’s also a board member of the Future of Iowa Foundation. “We can actually make some improvements to our state code that make it appealing to all businesses, not just cherry-picking one industry here or there, ... and really not impact the state’s budget.”

He added that these reforms wouldn’t merely be shifting the tax burden around: “Structure really matters when it comes to the tax code.”

“A good tax structure involves simplicity, neutrality, transparency,” Walczak said. “You want taxes that are easy to comply with, [are] easy to understand and to predict, and – to the greatest degree possible – don’t pick winners and losers. They allow [business] decision-making to take place without regard to tax structure. That’s what we’re looking for, and few states meet these. ...

“Right now Iowa has one of the worst structures in the nation. It’s confusing, it’s difficult to comply with, it’s hard to predict, and, if you’re an outsider thinking about bringing your business to Iowa or coming to live in Iowa ... , it can be very intimidating.”

Recipes for Reform

Iowa Tax Reform Options gives multiple strategies for each aspect of the state’s tax system, but its comprehensive recommendations share some basic features:

• a flat or two-bracket individual income tax (from a 5.15-percent flat tax to a top rate of 6.5 percent, depending on the option);

• a flat corporate-income-tax rate (from 6.5 percent to 7.7 percent, depending on the option);

• a repeal of federal deductibility – the deduction from gross income for federal taxes paid;

• the elimination or reduction of business tax credits; and

• a repeal of the inheritance tax.

The first four of those in each option are revenue-neutral for the state, meaning that collections would remain the same assuming a static economy and the current mix of taxpayers. Repealing the inheritance tax, Walczak said, would cost the state between $80 million and $100 million a year, while repealing individual and corporate alternative-minimum taxes (a component in two of the four comprehensive options) would cost $16 million a year.

The four comprehensive options do not include any reform of the state property-tax system – although the book does include suggestions there, too. Similar to the income-tax system, it notes, Iowa imposes “above-average property-tax burdens on Iowans overall, even as an arcane and needlessly complex structure seeks to abate costs for select taxpayers.”

The comprehensive packages in Iowa Tax Reform Options, Walczak said, would “make the state more attractive ... . Even without changing their [businesses’ and individuals’] actual tax liability, it just gets Iowa into the conversation with location consultants and others who are looking at the state.”

There are other benefits to simplifying the tax system, he said: “If you’re reducing compliance costs, you make it cheaper to live and work even if your actual tax payments are the same.”

And “you stop picking winners and losers.”

The current tax system rewards certain industries (with tax credits targeting specific types of activities) and certain geographic areas (with Tax Increment Financing districts reducing property taxes).

“You ossify the tax code around an existing industry mix,” Walczak said. “It’s a great deal to be in banking or insurance or farming or some types of manufacturing in Iowa. But if you don’t participate in one of those industries, it can be extremely difficult to break into the market because you’re not getting the advantage of all the incentives that exist in the state, and instead you’re being subjected to really high corporate taxes. ...

“That makes it difficult for your economy to grow as economies shift. We live in a dynamic world where the industries that exist now may not be the industries 20 years from now. If you have a tax structure that holds back the new entrants, you are preventing growth even though you could promote growth with a tax structure that raises a similar amount of revenue.”

And he argued that reducing or eliminating business tax credits would not drive companies out of the state. “There is room for a discussion about reform that might reduce some of the incentives that wouldn’t send businesses packing, because there are a lot of reasons they came to Iowa,” he said. “In many cases, these transfers are free money for some businesses that isn’t really making a difference as to whether they employ people in the state. It’s a bad deal for the state if you overdo that.”

The state’s Research Activities tax credits, for example, often go to major companies. In 2015, the biggest beneficiaries for those credits were Rockwell Collins, DuPont, Deere, Monsanto, and HNI. In 2014, according to the Des Moines Register, just 16 companies claimed 80 percent of the credits.

“The state is handing out a significant amount of money for jobs that would already be created, for businesses that would probably be here anyway ... ,” Walczak said. “In many cases, these are rewards for businesses that end up doing the same thing that they would have done otherwise.”

Supporters of the research credits, however, claim they generate economic activity. A Rockwell Collins representative told the Des Moines Register in 2015: “These credits help us determine where our research takes place, while also spurring innovation and supporting many high-tech jobs at our company.”

But Walczak said that a more-neutral tax system would spread benefits across the entire tax base: “That sort of money – or even a fraction of it – can be all the difference in the world for a company just starting up.” And making that money available – through lower base tax rates – would spur greater economic growth, he said.

The North Carolina Example

While the Tax Foundation looks at the unique characteristics of each state it studies – “We don’t want a cookie-cutter approach,” Walczak said – the basic principles of sound tax policy apply across the board. So it’s instructive to look at what happened when a state implemented one of the organization’s comprehensive reform plans.

North Carolina was the subject of the first Tax Foundation state book, back in 2013. That same year, the legislature passed one of the comprehensive options. Those changes moved the state from 44th in the 2013 State Business Tax Climate Index to 16th in 2015.

It’s a mistake to assume that North Carolina’s 2013 tax reform is solely or mostly responsible for the state’s recent economic growth, but there’s no denying that the state is performing well.

In analyzing a claim by North Carolina Governor Pat McCrory about his state’s Gross Domestic Product (GDP), in April concluded: “Between the first quarter of 2013 and the third quarter of 2015 (the most recent data we have), no state’s economic output grew as fast as North Carolina’s 13.4-percent rate.”

According to numbers from the U.S. Department of Commerce’s Bureau of Economic Analysis, North Carolina outpaced the rate of GDP growth for both the United States and the southeast region in six of seven quarters from the beginning of 2014 through the third quarter of 2015.

“Education Is the Key”

The Iowa Taxpayers Association hopes to follow the example of North Carolina.

The goal, Smith said, is to pass one of the Tax Foundation’s comprehensive-reform options next year, with revenue-neutral components being implemented immediately and other elements – such as repealing the inheritance tax – triggered by hitting economic-growth benchmarks. “If we’re looking at changes that will ... have any reductions to revenue in the state, then I think it’s realistic to look at those as being phased in so it can take some of the shock off ... ,” he said.

That effort will start this summer. Smith said his group is setting up meetings with the chairs and ranking minority-party members of both legislative chambers’ Ways & Means committees, and it’s planning a seven-city tour to present options to the public and legislators. (A Davenport session is planned for July 14. Details will be available at when they’re finalized.)

He said he hopes those meetings will help people understand the importance of truly comprehensive reform – and set the stage for the legislature to enact something without molesting a plan by protecting favored industries, businesses, or credits.

“Politics is inevitable ... ,” Smith said. “Education is the key. ...

“What we try to get away from is trying to improve the tax code with just a tweak here and tweak there. What we end up with is what we have right now – a very arduous and bloated tax code that’s ... hard to understand for folks. ...

“There are individual pieces of this that will make some people in the state happy, and they’ll make some people sad. ... There are going to be people that benefit and some that don’t. But I’d argue that right now our current tax code has people that benefit and some that don’t.”

Walczak sounded a similar note: “Our hope is that some of these comprehensive options or perhaps plans similar to them do offer the sort of economic growth and stability that would allow many people to come to the table and say, ‘You know what? I don’t like everything in it ... , but on the whole it’s good for Iowa.’”

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