June 2007

The Case for Keeping the
Federal Income Tax Reduction on
Iowa Income Tax Returns

I. NO TAX ON A TAX

Federal deductibility is simple fairness. Iowans should not be forced to pay a state income tax on money used to pay their federal income tax. This is money the average taxpayer never touches, sees, or has any discretion over how it is spent.

The federal deduction is not the only example of this kind of fairness in the Iowa tax code. Those who itemize their deductions also have the right to deduct property taxes on their Iowa income tax returns.

Simple fairness says governments should not tax income that is used to pay another tax. Federal deductibility is one of the best examples of this philosophy and must remain a part of the Iowa income tax code.

II. THE HISTORY OF TAX “REFORM”

There have been many proposals to combine the elimination of federal deductibility with a reduction in personal income tax rates. Some have attempted to be revenue neutral, although they would change the distribution of the tax burden.

On paper, such a proposal can look inviting. However, in practice, such a trade would soon lead to higher income taxes.

The federal “Tax Reform Act of 1986” is a painful example of what happens when you trade lower tax rates for elimination of various deductions.

In the name of “simplification”, many tax deductions were removed, the definition of income was broadened, and tax rates were lowered in return.

This tax “reform” was short lived. In 1990 and again in 1993 the income tax rates were raised.

Thus, taxpayers are now forced to pay higher tax rates on an expanded income base that was originally justified by a promise of lower rates. This is a mistake Iowans for Tax Relief will work to avoid in Iowa.

This trade would not be tax reform—it would be double taxation and would inevitably result in higher income taxes.

Iowans for Tax Relief favors lowering actual taxes on all Iowa families and businesses.

III. IOWA INDIVIDUAL INCOME TAXES ARE ALREADY STEEPLY “PROGRESSIVE”

Some persons attack federal deductibility as an obstacle to a “progressive” individual income tax structure. They argue we must eliminate federal deductibility in order to make our income tax more “progressive”.

In reality, Iowa’s individual income tax system is already steeply “progressive”—even with the existence of the federal income tax deduction. See Table 1 and Graph 1.

As Table 1 and Graph 1 clearly show, when income rises, so rises the percentage of income that is paid in Iowa personal income taxes. Iowans with an adjusted gross income (AGI) of less than $10,000 pay about one percent of their taxable income in Iowa personal income taxes, while those above $75,000 pay nearly 8% of their taxable income in Iowa personal income taxes.

The deduction for federal income taxes clearly does not prevent Iowa from having a “progressive” income tax structure. Anyone who desires an income tax system that “soaks the rich” ought to be extremely satisfied with Iowa’s current income tax law.

Opponents of federal deductibility claim the deduction allows “wealthy” Iowans to avoid paying their “fair share” of Iowa personal income taxes. This is simply false.

The data clearly show the top income earners in this state are paying a huge share of the total Iowa personal income tax burden. In fact, the top 10% of Iowa taxpayers pay over 45% of all Iowa personal income taxes.

The next 20% of taxpayers pay about 29% of the burden, the next 20% pay about 17%, and the bottom 50% of all Iowa income taxpayers pay less than 10% of total Iowa personal income taxes.

We must also be careful how we use the words “rich” and “wealthy” when discussing Iowa taxes. It takes only an AGI of $50,000 to qualify as part of Iowa’s top 10% of income tax filers. Thus, eliminating the federal deduction in an attempt to make Iowa’s tax system “progressive” seems redundant. In fact, attempts to “soak the rich” may indeed make them so “wet” that they will move to states with a “drier” tax climate.

IV. FEDERAL DEDUCTIBILITY AND ECONOMIC GROWTH

It has been argued that the elimination of federal deductibility and a lowering of Iowa income tax rates would make Iowa more attractive to persons looking to relocate themselves or their businesses. While this opinion is superficially plausible, upon examination it comes up short.

With tax preparation software readily available, it is inconceivable that an individual or business seeking to relocate would limit research to a simple list of top tax rates. In reality, an individual or business looking to relocate is very likely to use available tax preparation software to determine the total tax burdens in the states under consideration.

Also, federal deductibility and marginal tax rates are not the only two components of the effective tax rate. From state to state there are tremendous variations not only in marginal tax rates, but also in income tax brackets, personal exemptions, standard deductions, treatment of married couples, and other factors—all of which have a definite impact on effective tax rates.

It is not simply a matter of do you or don’t you have federal deductibility and how that affects your effective tax rate. Such a narrow discussion would exclude many other important factors that significantly influence a potential investor’s decisions.

Thus, trading federal deductibility for lower rates would do little to enhance economic growth. It would probably have the opposite effect. Any repeal or weakening of federal deductibility would be seen as a defeat for Iowa taxpayers and a foot in the door for higher income taxes. Potential investors would correctly see it as a danger signal.

V. FEDERAL DEDUCTIBILITY IS NOT AN ISLAND

As previously stated, it is a mistake to treat federal deductibility as an island — to focus on this one deduction and ignore Iowa’s total income tax system.

When examining Iowa’s tax code we must view federal deductibility as one of many determinants of actual tax incidence.

In Table 4, we measure the effect the entire Iowa personal income tax code has on taxable income as a percentage of adjusted gross income, for taxpayers at all income levels.

Does the tax code benefit some income groups more than others? Or, are taxpayers treated about the same?

The data show that when you examine the Iowa personal income tax code as a whole, taxpayers at all income levels receive roughly proportional benefits from all the various deductions, exemptions, and rates. The tax code, as a whole, treats Iowa taxpayers roughly the same.

VI. THE PEOPLE INSIST ON KEEPING FEDERAL DEDUCTIBILITY

Survey after survey has shown Iowans strongly support keeping this important component of tax fairness.

When asked whether they wanted to keep their right to deduct federal taxes on their Iowa returns, 94% of Iowans said yes (Dec. 1997, margin of error +/- 3.5%).

Even when given the opportunity to trade the federal deduction in return for lower income tax rates, 63% of Iowans wanted to keep federal deductibility while only 26% were willing to trade if for lower income tax rates (Nov. 1998, margin of error +/- 3.5%).

VII. CONCLUSION

Federal deductibility is right in principle. It is sound economics. It is fair. It is the will of the people. It must be kept.

Iowans for Tax Relief will continue to fight vigorously for every Iowan’s right to deduct all federal income taxes on Iowa returns.