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Yes, Jason, Iowa does have a poor business tax climate.

October 28, 2010

Des Moines Register reporter Jason Clayworth is moved by Iowa's poor ranking in the current Tax Foundation State Business Tax Climate Index to ask: Does Iowa really have a poor business tax climate? He cites a 2005 report by the leftish think tank Economic Policy Institute that criticizes the Tax Foundation's approach.

The Tax Foundation is perfectly capable of defending their own methodology; I'll just point out what I see in doing business returns for Iowa and elsewhere for clients operating in most states.

Compared to most other states, Iowa truly does have high tax rates. Our corporate rate is the highest in the entire country -- the second highest when the partial deduction for federal taxes is taken into account -- and our individual tax rate, even after federal deductibility, is higher than that of all our neighbors except for Minnesota.

Iowa's taxes are very complex. You have to compute both regular tax and alternative minimum tax for Iowa, and a third computation can apply for low income individuals. There are many differences between Iowa and IRS tax rules. Iowans have to cope with dozens of narrowly-crafted deductions and loopholes, and some weird addbacks, to compute their tax.

Iowa's taxes are grossly inefficient. Mr. Clayworth reports:

Iowa has a top corporate income tax rate of 12 percent, the highest in the nation. However, the tax applies only to in-state sales and, along with numerous tax breaks, few companies pay the top rate, said Mike Lipsman of the state revenue department. In the fiscal year that ended June 30, the state collected less than $190 million from the tax, less than 4 percent of the state’s $5.3 billion general fund budget.

An extremely-high rate that collects little revenue is a sure symptom of a dysfunctional tax system. It clobbers the unwary and the unadvised while lining the pockets of those with good lobbyists and good advisors. Even taxpayers that end up with a low Iowa liabilty still have the deadweight cost of paying people like me to navigate to that meager bottom line. And trust me, they don't all end up paying low tax -- especially taxpayers who do most of their business in-state.

If good tax policy aims at simplicity and a broad base and, attempting to achieve lower rates for all, doesn't try to play favorites among industries, Iowa's tax law fails.

If you look at an important secondary measure of business climate -- how the state grows and fosters new business -- Iowa also does poorly. Indexes of entrepreneurship consistently place Iowa in the bottom tier, and sometimes dead last.

None of this takes away the many things Iowa has to offer. We have a relatively good regulatory and labor law climate, assuming that the efforts to repeal or scale back Iowa's Right to Work laws continue to fail. We have good schools, affordable houses, and short commutes. That doesn't change the reality that Iowa's current system of high tax rates, high complexity, and subsidies for well-connected businesses does nothing for the little guy struggling to grow a new business. Real growth occurs from the ground up, not from bribing the occasional plant to locate here.

Iowa could have a much better system to collect the same amount of revenue. Too bad the legislature and the candidates for governor aren't bold enough to embrace the Tax Update Quick and Dirty Tax Reform Plan, reproduced below.

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The meltdown of the Film Tax Credit program illustrates the inherent problems of economic development tax credits. Iowa's subpar economic performance over the years in spite of its array of tax credits illustrates their futility.

It's time for Iowa to take a new approach to become attractive to all businesses, not just those with good lobbyists. Not only will it eliminate the opportunities for corruption built into tax-credit programs, but it will save Iowans millions of dollars and hours in tax planning and prep fees.

The Pieces:

1. Eliminate the Corporation income tax. The Iowa corporation income tax has the highest stated rate in the country, and one of the highest effective rates. The only reason it doesn't destroy Iowa's economy altogether is that it is so riddled with loopholes that collections are very low - well under 5% of the state budget. Yet it is a very expensive tax to administer and to comply with. Eliminating the tax would send a powerful message to companies looking for a place to invest for the long term.

2. Reduce the Iowa individual income tax to 4% or less. 3.99% would be much more attractive to entrepreneurs and executives considering Iowa locations. It would bring our rate decisively below all of the border states except for Illinois and South Dakota. Only a low rate will enable Iowans to give up the large number of special breaks that make compliance and tax administration expensive.

3. Strip down the Iowa tax law. To get the rate down to this level, Iowa will need to strip its tax law of a host of politically-motivated tax breaks. These include, among others,

- All economic development tax credits - ethanol, films, R&D, "targeted" jobs and the like, they all should go. Low rates are more important than any of these, all of which serve primarily to fund the well-connected.

- The deduction for Federal income taxes. If the rates are low enough, the deduction doesn't matter nearly as much. If its built into the rates, you protect poorly advised taxpayers who have a big once-in-a-lifetime income item - say, from selling a business - and losing the value of the deduction by paying the tax when it is due, rather than prepaying in the year of sale.

- The exclusion for ten-year capital gains.

- The credits for tuition funds, community foundations, and the like.

- The special pension and tuition breaks for old folks. Any breaks for poor folks should be in the form of a generous low-income exemption. Old folks with low income aren't necessarily more worthy than younger folks. In fact they often are much more wealthy than their younger counterparts.

Just because a break isn't mentioned here doesn't mean I want to keep it.

4. Make federal taxable income the starting point for Iowa taxable income. If you use federal AGI as the starting point, you can achieve even greater simplification and lower the rates further. (Unmodified AGI as a tax base can create grossly unfair results, but it if you allow a deduction for gambling losses and Schedule A investment interest, you get a decent base). Federal changes in income computation would automatically be incorporated in Iowa's tax code, absent a vote of the legislature otherwise. It also makes Iowa's tax forms potentially postcard-sized.

5. Make Iowa's tax forms into a reconciliation format, starting with Federal taxable income. Have lines to back out federal Treasury income, which the state can’t tax. If Iowa chooses to tax muni bond income, have a line for that. Have one last line for all (any) other addbacks and subtractions, which would feed from separate detail schedules.

6. The most difficult issue is taxation of S corporations. I would allow S corporations to elect to be Iowa C corporations and make Iowans taxable on distributions from the corporation as if they were C corporations. Electing corporations would have to report distributions to Iowa shareholders to the state, and the shareholders would be taxed as if the distributions were taxable dividends; otherwise electing corporations would pay no tax on Iowa-source income. Iowans owning Non-electing S corporations would be taxed in Iowa on all their S corporation income. This would achieve near-parity between Iowa C and S corporations.

These proposals do not have revenue projections. The idea is to not reduce Iowa’s tax receipts. This is an attempt to provide a target, an ideal for improving the system. I would love to see what the revenue projections would be. Unfortunately, unlike IRS, Iowa doesn't release any statistical information that would enable us to make those kinds of estimates.

Whatever the projections would be, I have no doubt that "no corporate taxes and low individual rates" would be better for Iowa's economy than "high taxes with lots of loopholes for those with connections and lobbyists."

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