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Does Iowa's deduction for federal taxes prevent tax increases?

-Joe Kristan is a founding member of Roth & Company P.C.

Iowa could lower its high income tax rates significantly with no revenue loss if it traded lower rates for elimination of Iowa's unusual deduction for federal taxes paid. Such a trade-off plays a big part in the recently released Iowa Tax Reform Options prepared by the Tax Foundation for the Iowa Taxpayers Association.


While policy geeks generally favor this trade-off, many taxpayers have doubts. 
A common argument against the trade-off goes something like this: "If we give up the deduction in exchange for lower rates, they'll turn around and raise the rates on us." They see the deduction as a sort of brake against higher rates.

The history of Iowa's income tax tells a different story. In fact, the deduction for federal taxes has allowed Iowa to raise its real tax rates.

The deduction for federal taxes paid obscures the real top tax rate. The deduction for federal taxes lowers the effective Iowa rate, and vice versa. Tax practitioners call the resulting actual rates the "crossed" rates. The current effective crossed Iowa tax rate on each additional dollar earned by a top-bracket taxpayer is about 5.184 percent.

Let's go back to 1975, when Gov. Robert Ray signed an increase in Iowa's top tax rate from 7 percent to 13 percent. At that time the top federal tax rate was 70 percent. When you make the circular crossing computation, taking deductions into account, the top Iowa rate for top federal bracket taxpayers before this increase was 2.208 percent. Afterward, the effective rate went up to 4.29 percent. That's a 94 percent increase in the top tax rate. If the deduction for federal taxes can't brake a near-doubling of the top effective tax rate, it's not a very good brake.

 

Crossed iowa rates 1971-2016

Chart by the author.

The first round of Reagan tax cuts took the top federal rate down to 50 percent. This made the Iowa deduction for federal taxes worth that much less, so the top effective Iowa rate soared to 6.952 percent. The state government cheerfully pocketed the windfall.

The 1986 federal tax reforms lowered the top federal rate to 28%. At that point, Iowa decided to give its taxpayers some of the windfall back, lowering the top stated rate to 9.98 percent. The real Iowa top marginal rate, though, actually went up to 7.39 percent when the 1986 federal tax reforms took full effect in 1988.

In 1990, the feds started backsliding on the Reagan tax reforms, and the subsequent federal rate increases, combined with the cut in the Iowa top rate to 8.98 percent, has brought the top crossed Iowa rate down to 5.184 percent. While better than its peak 7.39 percent rate, that's still a 284 percent increase over the 1974 effective rate, and a 20 percent increase over the 1975 top rate.

The deduction for federal taxes hasn't prevented increases in the top Iowa effective rate. It just has camouflaged them.

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