It was devised to keep Iowans’ tax burdens in check, but now a peculiar provision of the state’s tax code threatens to drive an unintended tax increase if legislators fail to act.
Since the enactment of federal tax reform legislation in late December, much ink has been spilled over the state and local tax deduction, which is now capped at $10,000. Iowa is one of a small handful of states to provide a counterpoint to that deduction, allowing Iowans to deduct the amount they pay in federal taxes when calculating their state tax liability.
That provision has long meant that Iowans pay less than might be expected under the state’s high individual and corporate income tax rates. But it also means that, when Iowans receive a federal tax cut, their state liability goes up. In her Condition of the State address, Gov. Kim Reynolds called for legislative action to repeal federal deductibility, as it is called, and prevent a stealth tax increase on Iowa families.
Only six states offer federal deductibility, and three of them cap the benefit. Iowa’s deduction has long been the target of reformers, Democrats and Republicans alike. It has also enjoyed its defenders, who often feared that it would be repealed without lowering rates, resulting in a net tax increase.
As a side effect of the new federal tax law, most states are set to see their own revenues increase, because provisions which broaden the tax base often flow down to state tax codes, whereas the offsetting federal rate reductions do not lower state tax rates. In Iowa, however, federal deductibility makes that revenue growth much more substantial than it will be in most other states.
Federal deductibility is confusing, and creates distributional effects that would be difficult to defend if created intentionally. It essentially incorporates the whole of the federal tax code into Iowa’s tax code: every deduction, exemption, preference, or penalty. It also contributes to “sticker shock,” with the state’s 12 percent corporate rate and 8.98 percent top individual income tax rate potentially scaring some would-be residents away before they ever calculate what their actual tax liability would be.
Large businesses get it, of course, as do businesses already located in Iowa. But when smaller businesses weigh their options or retain a location consultant, they often narrow down their list based on headline rates and other broad indicators of what they are looking for in a location, and only dig into the details for a small number of pre-selected states. With its artificially high rates due to federal deductibility, some businesses may never even put Iowa on their list.
The newly implemented federal tax law provides a golden opportunity to repeal an archaic deduction which unnecessarily complicates the state’s tax code. Inaction would result in an unexpected, and unintended, tax hike. Governor Reynolds’ alternative: repealing federal deductibility, combined with individual income tax rate reductions.
In 2016, the Tax Foundation outlined several options for making Iowa’s tax code more competitive. All our proposals began with repealing federal deductibility, bringing the state more in line with its peers. The enactment of federal tax reform makes what had been a desirable change into a near imperative.
If Iowa policymakers fail to act, the state will continue to operate under a needlessly convoluted tax code—and residents will face a tax hike, without their elected officials ever voting for one. Such decisions should be made in Des Moines, where Iowans have a voice, not in distant Washington.
Repealing federal deductibility is an idea whose time has more than come. It restores taxing authority to Des Moines and creates a simpler, fairer tax code. Now that federal tax reform has provided the impetus for getting rid of this antiquated provision once and for all, Iowa policymakers should seize the chance.