Economists, tax groups weigh in on income tax proposal
MICHAEL CRUMB Jan 18, 2022 | 3:17 pm
7 min read time1,601 wordsAll Latest News, Economic Development, Law & Government
Leading up to the start of the 2022 Legislature, some state lawmakers and leaders of Iowa’s largest business organizations made cutting the state’s individual income tax rate a top priority for the session.
They said that Iowa’s current rate isn’t competitive and that lowering it could attract more people to the state and help address the ongoing workforce shortage.
In her Condition of the State address last week, Gov. Kim Reynolds proposed a 4% flat income tax rate to be phased in over four years. If approved, it would build on the 2018 tax reform package that would lower the tax rate to 6.5% by 2023, down from about 9% five years ago.
Reynolds said the 4% flat tax would put more money in Iowans’ pockets to spend on Main Street rather than have it spent by bureaucrats at the Statehouse.
Critics suggest that cutting taxes too deeply could lead to increases in other revenue streams, such as the sales tax, and disproportionately affect lower-income taxpayers.
Proponents argue that data shows that people are leaving higher-taxing states and moving to states that have low or no income taxes, and that a lower, flat tax would not only reduce taxes for most Iowans, but also for those companies that pay individual income taxes, creating an environment of stability that could lead to greater investment and job creation.
“The economic literature shows that lower top-margin income tax rates are associated with higher levels of in-migration, higher levels of economic growth and … more business formations,” said Jared Walczak, vice president of state projects for the nonpartisan Washington, D.C.-based Tax Foundation.
Walczak said 95% of businesses are subject to the individual tax rate and not the corporate tax rate because they are structured as S corporations, partnerships, limited liability companies, or those that have income flow through to the tax return of owners, known as pass-throughs, rather than a C corporation, where owners or shareholders are taxed separately from the entity.
“We know that business location decisions are often made, at least in part, on after-tax income of management and employees,” he said. “Businesses like to locate where taxes are lower generally … so we’ve seen robust growth in lower-tax states.”
During the coronavirus pandemic, low- and no-income tax states have significantly increased their populations, while those with higher taxes have seen significant outflow of their populations, he said.
Examples of low-tax states that have seen increases in population include Texas, Florida, North Carolina, Nevada and Utah, Walczak said.
And no-tax states, of which there are eight, are all in the top 10 for growth and in-migration every year, he said.
According to Walczak, graduated, or progressive rates, which Iowa has had for decades, have a stronger adverse effect on business decision-making, innovation and labor inputs.
Flat rates tend to be politically stable, he said.
“Graduated-rate taxes get raised or lowered frequently based on political winds, and single-rate taxes tend to be fairly hard to raise,” Walczak said. “Therefore, they provide significant certainty, and businesses love certainty.”
He said flat taxes have not only been a mainstay in red states, but also in some blue states, such as Massachusetts and Illinois, where the flat tax is 4.95%.
If Iowa goes to a flat 4% rate, based on what is being enacted elsewhere around the country, it would be below the median top rate in the country, which would be 5% by the time the flat tax would be fully enacted — and fifth-lowest in the country, Walczak said.
People will also choose to move because of amenities, climate, family proximity, cost of living and higher quality of life, Walczak said.
“But taxes will be an overall part of that calculation for many people, so Iowa’s high rates stand out, to its detriment,” he said.
Walczak said the fact that Iowa has a $1 billion budget surplus and $1.2 billion in its taxpayer trust fund plays to its favor.
“There’s a real opportunity to address this right now because it doesn’t have to be offset elsewhere,” he said.
The nonpartisan, nonprofit public policy research and advocacy organization Common Good disagrees.
In a statement after Reynolds’ speech, the group said there is no evidence pointing to more people moving to Iowa if the governor’s flat-tax plan is adopted. It would only put the state’s financial health at risk, the group said.
“Despite talk of surpluses, official estimates project only 1.7 percent growth in revenues for the new budget year,” the statement read. “That’s not enough with rising costs to fund services at existing levels. If lawmakers cut revenues further, the current budget surpluses — created largely by federal stimulus programs of the past two years — will be short-lived. They cannot be used to fund perpetual tax cuts.”
Tom Sands, a former Iowa state representative who now serves as president and CEO of the Iowa Taxpayers Association, said as long as the state continues to budget responsibly, he wouldn’t foresee a need to tap other revenue streams or reduce services if the economy slows.
“There’s always tough decisions to be made in the valleys of an economic time when revenues flatten out or don’t grow as much,” he said. “I don’t see how this puts the state in a worse position. I would argue it puts the state in a stronger position. You’re lowering the tax rate, but you’re empowering taxpayers to keep more money and buy more goods that would increase sales tax revenue. And if you’re a business owner, you’re growing your business, and that grows tax revenue through greater incomes and more employees that pay more Iowa tax.”
Sands said a flat tax is easier to explain than the state’s current graduated, multibracket system, making it a more attractive sell to businesses looking to move to Iowa.
“No. 1, it clearly identifies what your tax rate is,” he said. “This way everyone knows their established rate is 4%.”
And that can help improve the state’s chances of landing a prospective new company, said Sands, who served in the Iowa House from 2003 to 2016, the last six as chair of the Ways and Means Committee.
“Most of them you never got a chance to speak with because when they saw that top rate we were automatically put in a pile that wasn’t even given a chance,” he said. “This will give us a chance.”
Sands said the move to 4% builds off of what began in 2018, making the move more palatable.
“If we tried to do this 10 years ago, we’d be going from our top rate then of 9.8% and … that would be a greater leap,” he said. “This is more of a stepping stone.”
Dave Swenson, an economist at Iowa State University, said he would argue that Iowa’s taxes aren’t too high, and have had little effect on the rate of growth in the state.
“There just doesn’t seem to be evidence that our taxes are too high, and that they in and of themselves have had any meaningful effect on the rate or pace of growth in the state’s economy,” he said.
Swenson said Iowa has an image problem because its advertised tax rate is among the highest in the country. Once federal deductibility is figured in, Swenson said, Iowa’s individual tax rates “are pretty darn moderate.”
Meanwhile, Swenson said, if you consider all income levels, including the highest-income earners who he said can capitalize on a wide variety of exclusions that allow them to lower their tax burden, the weighted average tax rate in Iowa was 3.7%.
If you eliminate the highest-income earners, who Swenson said have an average tax rate of 1.4%, the weighted average increases to about 4.3%. That would mean Reynolds’ proposal would lower taxes for a significant number of middle- to upper-income earners in Iowa, he said.
“What it does to those lower-paying taxpayers remains to be seen,” Swenson said.
According to Swenson, people who earn between $20,000 and $40,000 pay taxes at rates of 2% to 3.4%.
“So what we don’t know is, is [the income tax rate proposal], as designed, going to raise taxes on those at the bottom who have benefited by our progressive income tax system, and is it going to benefit the most those people making over $75,000 a year?” Swenson said. “It depends on where you sit as to how you’re going to look at this in terms of desirability.”
He said it’s probably too early to accurately analyze the effect of Reynolds’ proposal because all the details aren’t yet known.
Something to watch is whether any relief is provided to low-income individuals, Swenson said.
“What is the threshold that’s going to be determined that says you now have to pay state taxes?” he said. “At what point does the 4% kick in and some level below you don’t pay taxes? We tend to want to have some circuit breakers that treat low-income or special classes like the elderly more beneficially, so we’ll just have to wait to see what they devise.”
Walczak said anyone making more than $6,700 a year would pay less taxes under the governor’s plan.
“In the current progressive system, virtually all income is subject to rates in excess of what the new flat rate would be,” he said. “People often see fairness as equal treatment, and a tax cut that benefits all taxpayers with a low flat rate will not only benefit many taxpayers, but will probably meet with approval of many taxpayers across all income levels and across the political spectrum, and Iowa has the ability to afford it right now.”