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Baby steps towards fixing Iowa's business tax climate

Everyone talks about Iowa's bad business tax climate, but nobody ever does anything about it. What should a would-be climate-changer do?

Iabiz20140225As we discussed here last month, Iowa consistently has a poor rating for its business tax climate because of its tax complexity and high rates. High rates and complexity are twins. When rates get high, the well-connected lobby for tax breaks, each of which make things more complicated. When there are lots of tax breaks, the rates have to go higher to raise more revenue. The standard approach to tax reform is to do the opposite --  lower the rates, and pay for it by eliminating tax breaks.

Tax reform is hard, but you don't have to do it all at once. A few baby steps, and the grown-up steps can come later.

Some first steps that would make life easier for Iowans without affecting tax policy or state revenues:

Eliminate the alternative minimum tax for individuals and corporations. One of the reasons reason the Tax Foundation's annual Business Tax Climate Index gives Iowa low marks is because every taxpayer is required to compute both a "regular" tax and the AMT, paying the one that produces the higher tax. But Iowa's AMT applies to very few taxpayers. It is rare to see it in tax practice unless you have clients who are public-company executives with incentive stock options. The Iowa Department of Revenue doesn't even track AMT receipts -- which fuels my suspicion that AMT revenues in Iowa amount to a rounding error in the state budget. Eliminating the AMT would simplify a lot while costing the state little.

Make Iowa's tax system automatically adopt federal changes, unless the legislature votes a specific exception. Iowa every year passes a "code conformity" law to mirror federal changes in the computation of taxable income. Because large parts of the federal tax law are enacted only a year at a time, often in December, tax season is well under way before Iowans have an official tax law. It would be much easier if federal changes were automatically adopted. If Iowa wanted to exclude an area of the law from automatic changes -- like it does with depreciation -- that would be easy enough to do as part of a "floating conformity" approach. Much simplification, little or no revenue loss.

Tie all return due dates to federal due dates. While Iowa returns are generally due at the end of the month federal returns are due, there are exceptions. For example, non-resident alien individual federal returns are due on June 15, but Iowa wants them on April 30, and imposes penalties if they are filed on the federal deadline. That's unfair and un-neighborly.

Then there are reforms that would be harder to enact, but that have policy arguments that are so strong, they might win out. These would include:

Encourage or require "composite" returns or withholding for pass-through non-resident taxpayers. Almost all other states do a version of this. This would make it much easier for Iowa to collect taxes on Iowa-source income from non-resident owners partnerships and S corporations, and would almost surely generate revenue that could be used to lower rates.

Repeal the deductibility of federal taxes in exchange for lower rates. Just incorporating the tax benefit of the federal deductibilty into Iowa's rate structure would bring the top rate down from 8.98% to somewhere between 5.5% and 6.9%.

Repeal "refundable" or "transferable" incentive tax credits and roll the savings into lower rates. When "refundable" credits exceed your Iowa tax, the state mails you a check for the difference. "Transferable" credits can be sold -- in effect, allowing third parties to buy Iowa tax reduction at a discount. These amount to unappropriated subsidies; if the legislature wouldn't vote a corporate subsidy as an appropriation, it shouldn't be paid  through a tax return. 

Iowa's research activities credit alone gave checks to corporations of $37 million in 2014 -- $11.7 million to a single corporation. Just ending the refundability of this credit would save the state enough revenue to shave a full percentage point off of Iowa's highest-in-the-nation 12% corporation tax rate.

That's the easy stuff. Enacting just these ideas would improve Iowa's tax system, but that would leave much undone. What would an Iowa income tax look like if we wanted to start it over and make it as friendly as possible for taxpayers and growing Iowa businesses? We'll talk about that next time.

 

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