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Yes, state taxes do matter

February 10, 2011

The Iowa Fiscal Partnership, the big-government think tank joint venture of David Osterberg's Iowa Policy Project and the Child and Family Policy Family Center, has a new Peter Fisher report saying Iowa's business taxes are just hunky-dory.

It concludes:

Business tax breaks are an expensive and inefficient way to attempt to stimulate a state economy. Because of the small effect of tax breaks on business costs, and the much larger importance of other production costs and location considerations, tax breaks will have little if any positive effect on private sector employment.

I would agree with that conclusion if "business tax breaks" meant special interest "incentives" like the Iowa Film Credit program or the "green jobs" tax rebates proposed yesterday by Democrats in the Iowa legislature. Where the Fisher report goes off the rails is the way it treats reductions in Iowa's highest-in-the-nation corporation tax rate as just another "tax break."

Details matter, and marginal rates matter more than most. Marginal rates are the ones that affect the start-up, the new business that is getting off the ground and can't afford expensive tax help or fancy lobbyists to qualify it for tax credit pork. It's not coincidental that Iowa has a poor record at creating and sustaining start-ups. Growing economies grow from the ground, not by stealing businesses from neighboring states. With a 12% rate kicking in at only $250,000 of taxable income -- and 8% at only $25,000 -- Iowa is not a good place for a struggling corporation.

If rates don't matter, why doesn't Peter Fisher just propose a 100% rate? They obviously do matter, and the only question is how much. If they matter at all, it's not good to have the highest one.

Yes, get rid of "tax breaks" directed at politically-favored industries and companies. But use the savings to lower the tax rates for everyone. Let the little guy benefit from a simple and inexpensive to comply with tax system. Stop taxing businesses that are already here to lure and subsidize their competitors. Impossible? I say not. Keep reading to see how we can have both low rates and a simple system that doesn't favor the powerful and well-connected.

Other coverage: Think tank report says Iowa businesses taxed lightly

The Tax Update Quick and Dirty Iowa Tax Reform Plan

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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