The Trump tax cuts have created a problem for Iowa.
Under the state's current tax code, the federal tax cuts would result in an automatic tax increase for Iowans at the state level, partially offsetting the federal tax relief for some taxpayers.
That’s because of an unusual feature of Iowa’s tax system: A 100 percent deduction for federal income taxes paid.
The deduction is the reverse of the state and local tax, or SALT, deduction at the federal level, the one that Republicans put a new $10,000 limit on, a major and hard-won change to federal-state relations.
Only three states — Alabama and Louisiana are the others — have a full deduction for federal taxes. Normally, it gives state taxpayers some relief for paying federal taxes. But when the federal government passes a tax cut, as it did last month, it creates the perverse effect that it will result in tax increases for Iowans, because they will have fewer federal taxes to deduct.
In her “condition of the state” address this month, Iowa Gov. Kim Reynolds, a Republican, called for responding to the Trump tax cuts by eliminating the deduction as part of a state-level income tax reform, to allow Iowa’s taxpayers to receive the full value of the federal tax cuts.
“It’s the time to do it,” said an official in the governor’s office, who requested anonymity to freely discuss the implications of the complex proposal.
The timing is auspicious because, for years, some conservatives in the state have resisted the idea of eliminating the deduction out of a fear that doing so would be a tax increase. But such worries don't apply now, because the federal tax cuts are lowering the deduction’s value to the tune of $130 million to $160 million a year, according to the Institute on Taxation and Economic Policy, a left-of-center think tank.
The reason for eliminating the deduction is that the state must impose higher tax rates to make up the revenue it will lose. Iowa’s top individual tax rate is 8.98 percent, among the top five for states, and its top corporate rate is also high.
The high rates create “sticker shock” for businesses — many of which are partnerships or sole proprietorships that are taxed at individual rates — considering a move to Iowa, said Tax Foundation senior policy analyst Jared Walczak. That discourages companies from moving to the state by overestimating how much they would pay in taxes.
The deduction is “very anachronistic,” Walczak said. “It’s also confusing, because it’s almost circular.”
Another issue with the deduction is that it runs counter to the intent of changes made to the federal tax code. For instance, the federal GOP tax cuts were meant to benefit small businesses by including special breaks for them. Instead, the federal deduction would mean that those small businesses would have less to deduct at the state level, mitigating the benefit of the new law to them and increasing it for bigger businesses.
The new federal tax plan is a “unique opportunity to show the inequities” of the federal deduction, the Reynolds administration official said.
For that reason, the idea of eliminating the tax has support among some liberals as well.
“Simply eliminating deductibility would make our state income tax more progressive,” said Peter Fisher, research director for the Iowa Policy Project, which has long advocated ending the deduction.
Yet, the deduction wouldn't simply be eliminated. Instead, it will be part of a larger tax reform package. And that is where liberals have reason not to fully endorse the idea. Meg Wiehe, deputy director for the Institute on Taxation and Economic Policy, said she favored ending the deduction. But she fears that the Iowa GOP will end up “blowing this opportunity and enacting some sort of change that results in Iowa losing revenue.”
Reynolds does aim to enact tax cuts on top of restoring the value of the deduction, the official in her office said, a move that should appeal to Republicans in the legislature and conservatives around the state.
The plan is to announce a legislative package within weeks and then have it sent to Reynolds’ desk by the end of the legislative session in April. The governor aims to win over skeptics in the upcoming weeks.
“Congress didn’t cut taxes for state government to generate additional tax revenue, so we will be looking for opportunities to leave that money in taxpayers' pockets,” said Iowa House Speaker Linda Upmeyer. She added that she “would guess” that federal deductibility would be part of the package.
Tom Sands, president of the Iowa Taxpayers Association, said his organization would support a tax reform package that eliminated the deduction, as long as it proved not to be a “revenue grab.” While the governor’s office has not set out a target top rate, Sands advocated one of 6 percent or lower.
“We support and applaud [Reynolds] trying to take care of the taxpayers of Iowa, so Iowans would not see an increase to their state taxes just because of a federal tax decrease,” Sands said.