ENGAGEIOWA.ORG

Income TaxRESEARCH POLICY PAPER

DERMOT HAYESPioneer Chair of Agribusiness

Professor of EconomicsProfessor of Finance

Iowa State UniversityPhone/ 515-294-6185

Cell/ 515-450-7646Email/ dhayes@iastate.edu

/ ENGAGEIOWA.ORG

Iowa has high marginal taxes rates on personal incomes.

Yet the average tax take in Iowa is below average. This

report provides evidence, based on recent work from

economists at ISU, that high marginal rates deter

businesses from investing in Iowa and that this has

reduced average income by about 2.65%. The report also

shows that the high marginal income tax rate has caused

a net outflow of high earners to states such as South

Dakota and Texas. This outflow has cost the state $3.89

billion or 3% of total income.

One solution to this problem is to eliminate deductions

and credits for all those earning above $10,000. This

would allow Iowa to reduce the marginal rate to 3.27%

while maintaining total income taxes collected. Iowa’s

income tax calculation form would read as follows.

“Multiply the Annual Gross Income (AGI) reported on

page one of your Federal tax return by 0.0327.” The tax

calculation for those with incomes below $10,000 would

remain as it is now so that they could continue to receive

the benefit of the earned income credit. The state could

go even further and use 5/8 of a sales tax increase to

reduce the marginal rate to 3%.

The balance of the one cent sales tax could be used as

constitutionally mandated, with up to $80 million per

year being available to dramatically speed up the

implementation of Iowa Nutrient Reduction Strategy.

The switch to a new tax structure would immediately

improve Iowa’s reputation as a business friendly state

and lead to a significant growth in the state’s economy.

It is not clear how long it would take for the state to

catch up with its potential. A likely scenario is an

additional 4% of economic growth over ten years. If

tax rates remained constant, then total taxes collected

would also grow by this amount. In short, a significant

change in Iowa’s tax statute could both increase

economic growth in Iowa and allow our state to more

rapidly improve the quality of our water in lakes, river

and streams.

EXECUTIVE SUMMARY

/ ENGAGEIOWA.ORG

Iowa’s marginal personal income tax rate of 8.98% is

fourth highest among US states. As a result, the Tax

Foundation ranks Iowa 40th out of 50 states for its

business tax climate.1

Iowa’s individual income tax rules allow for federal

deductibility. In 2013 (the latest year for which detailed

data is available), Iowa collected $2.76 billion in personal

income taxes on reported income of $74.5 billion. This is

an effective rate of only 3.7%234. If the ranking is adjusted

to reflect the income tax that is actually collected, the

state ranking improves to 30th. Take into account Iowa’s

below average tax revenue in other areas and the ranking

further improves to 21st out of 50. In other words, Iowa

is slightly below average in terms of taxes collected, but

close to the bottom based on its tax reputation.

Figure 1 shows the income tax rate in Iowa by income

group. Despite what appears to be a progressive tax

structure, the effective tax rate is relatively flat. In fact,

Iowa residents with an AGI of more than one million

dollars pay a lower effective rate than those with an

income between $40,000 and $50,000.

SOLVING IOWA’S TAX PROBLEM

1The appendix to this report shares some recent information showing how Iowa is ranked relative to other states.2http://www.iowabiz.com/2015/03/kristan-draft-for-20150225.html3http://www.iowabiz.com/2015/03/kristan-draft-for-20150318.html4http://www.iowabiz.com/2015/01/is-iowas-business-tax-climate-really-that-bad.html

/ ENGAGEIOWA.ORG

A recent study by three ISU economists provides specific

measures of the negative impact of high marginal rates.56

The study uses an econometric model of the value of

output per worker (labor productivity) across US states

and across time. The measure of labor productivity used

will track state income (GDP) in the absence of changes

in the size of the labor force.

Key results from this study of relevance to Iowa are as

follows.

• “High marginal tax rates have a double dose on

retarding the state’s labor productivity,” said Peter

Orazem, a University Professor of Economics at Iowa

State.

• “The optimal tax structure is most likely flat across

income levels; marginal tax rates should not rise and may

even decline at upper income levels and capital income

should be taxed at the margin.”

• This study shows that “studies of tax effects must use

marginal and not average tax rates.”

• Iowa ranks 44 out of 50 states in terms of the

distortionary impact of high marginal rates.

• A 10% reduction in the marginal income tax rate for

income and capital gains (holding total tax revenues

constant) would cause an increase in labor productivity

(income per worker) of 0.3%.

The results of the Orazem et al. study are of immense

importance because they suggest a way to increase

incomes in Iowa and the total amount of taxes that are

collected. All that has to be done is to flatten the income

tax structure so that the new marginal rate is as low as

possible while targeting a total income tax collection that

is at least as large as it is today.

Based on Orazem et al., a change in the Iowa marginal

income tax rate from 8.98% to 3.27% would lead to an

increase in output per worker of 2.65%. At the end of the

adjustment period, productivity per worker would be

$1,496 higher in 2008 dollars than if the changes were not

implemented.

ACADEMIC WORK

5See http://www.news.iastate.edu/news/2011/mar/ialabor andhttp://econ.iastate.edu/sites/default/files/publications/papers/p11552-2010-05-26.pdf6For a comprehensive discussion of the academic literature on marginal taxes see http://taxfoundation.org/article/what-evidence-taxes-and-growth

/ ENGAGEIOWA.ORG

Another way to explore the marginal tax issue is to look at the migration patterns of high income workers. The IRS publishes annual data on the annualized gross income of those who move from one state to another. This data is summarized below and refers to total AGI movement between 1992 and 2013. If an individual who reports $200,000 in annual income moves from Iowa to South Dakota and five people who make $20,000 move from South Dakota to Iowa, then the AGI measure will show a net outflow of $100,000 from Iowa. This measure is specially designed to pick up incentives (such as high marginal tax rates) that cause wealthy people to change addresses.

As can be seen, Iowa had a net outflow of almost $3.89 billion in annual gross income over the period and it has lost much of this to states with a better business tax reputation such as Florida, Arizona, South Dakota and Texas7. South Dakota has benefited by a total inflow of $831 million over the same period, almost half of which is from Iowa. Had Iowa retained this $3.8 billion in AGI, the state’s overall income would be 3% higher and its total personal income tax revenue would be more than $300 million greater. The $372 million that South Dakota gained from Iowa alone in 2013 is worth $436 to every person in South Dakota. The South Dakota comparison is of particular relevance because of climate and cultural similarities that make it unlikely that the net flow is driven by weather or quality of life.

The IRS data also shows that the nine states with the highest marginal tax rates lost $107.4 billion and that the nine states with the lowest marginal tax rates gained $142.2 billion8.

IRS DATA ON MIGRATION BETWEEN STATES

7To access this data visit http://www.howmoneywalks.com/8See Brown, Travis H. How Money Walks-How $2 Trillion Moved Between the States, and Why It Matters. How Money Walks, 2013.*AGI - adjusted gross income as defined by the IRS. For most people the AGI is starting point in calculating their table income.AGI stats above were gained (lost) between 1992 and 2013 - How Money Walks

/ ENGAGEIOWA.ORG

Table 1 below shows personal income and personal

income tax data for Iowa residents in 2013. The state

collected $2.766 billion in total income taxes from Iowa

residents with a combined AGI of $74.578 billion.9

Treatment of taxpayers with incomes less than $10,000

Note that tax payers with an income less than $9,999

actually paid negative taxes. This is true because of child

care and earned income credits. In the scenarios that

follow, it is assumed that the state continues to provide

these credits to low income people. The total of this

negative income tax payments equaled $9.68 million.

This brings the total tax collected from those with

incomes above $10,000 up to $2.775 billon.

FLAT TAX SCENARIOS

9Iowa also collected $84.9 million from nonresidents but this is offset by the $87.7 million in tax credits provided to Iowans who paid taxes in other states.

TABLE 1-BRESIDENT PAY AND NO-PAY RETURNS

/ ENGAGEIOWA.ORG

This report uses 2013 data to approximate economic

conditions in the year the tax simplification is

implemented. Therefore, it should be clear that the

proposed tax rates described below are subject to minor

error. Further analysis may require some recalibration of

the number.

Removal of tax credits for those with incomes above $10,000

Iowans collected $347 million in tax credits in 2013. In the

analysis that follows, these credits have been removed

for those earning more than $10,000. The Out of State

tax credit is maintained but revenues are replaced with

the income taxes that Iowa collects from other states.

The Taxpayers Trust Fund credit is also removed even

though this is a temporary credit. This credit resulted

from a surplus in the state budget that is reflected in

the state financial picture in 2013. A Subchapter S

apportionment credit of $40 million is retained. The net

impact of these credits is to reduce the target income

taxes collected by $333 million. As a result, the target

income tax is reduced from $2.775 billion to

$2.442 billion.

Possible use of a sales tax increase to reduce income taxes

Iowa collected $2.08 billion in sales tax in 2013. If this

amount were increased by multiplying it by 7/6 then

an additional $346 million would be collected. If 5/8 of

this additional revenue were devoted to income tax

reduction, then this would provide $216 million to

lower flat rates.

Dynamic scoring

The motivation for flattening the income tax rate is to

increase economic growth. The research cited earlier

suggests that this is likely to occur. However, the

research is not specific as to how long this will take or

to the magnitude of the growth. A reasonable scenario is

that at some point in the future the state GDP would be

4% higher than would otherwise have been the case. The

AGI of residents is increased by 4% to $77.56 billion in the

scenarios where this is considered.

FLAT TAX SCENARIOS (CONTINUED)

/ ENGAGEIOWA.ORG

The calculation for the tax rates reported below is as

follows: Divide the amount of taxes required to maintain

existing tax collections by the total income to be taxed,

multiply the result by 100 and use this as a tax rate on all

AGI for all those with incomes above $10,000. This

procedure will result in at least as much income tax

collection as the existing system.

BASE CASE: A FLAT TAX WITHOUT DYNAMIC SCORING

OR A SALES TAX

In the base case, the target revenue is $2.44 billion and

the AGI is $74.58 billion. The flat tax that is required to

maintain revenues is 3.27%.

SCENARIO 1. A FLAT TAX WITH DYNAMIC SCORING

In this scenario the AGI is $77.56 billion and the target tax

collection is $2.23 billion. The required flat tax rate is 3.1%.

SCENARIO 2. A FLAT TAX WITH DYNAMIC SCORING AND

A 5/8 CENT SALES TAX

With the additional $216 million in sales tax revenue used

to lower the income tax rate, the required flat tax rate

would be 2.86%.

SCENARIO 3. AN EQUAL AND LOWER EFFECTIVE TAX

RATE FOR ALL TAXPAYERS

In Scenario 2, with a flat tax, sales tax revenue, and

dynamic scoring, the 2.86% flat rate would be lower than

the current effective tax rate for all tax payers with

incomes above $40,000. Those with incomes between

$30,000 and $40,000 would pay a similar tax and those

with incomes below $30,000 would pay $143 million in

additional taxes. If instead, those with incomes below

$30,000 were effectively compensated for the change

then the required flat rate would be 3.05%.

SCENARIO 4. A FLAT TAX WITH FEDERAL DEDUCTIBILITY

Iowans paid $19.79 billion in Federal Taxes in 2013. If this

is deducted from the AGI then the flat tax required to

maintain revenues is 4.2% with dynamic scoring and 4.4%

without dynamic scoring. These rates would each fall by

approximately 0.3% if the sales tax increase is

implemented as well.

Each of these scenarios can be further refined and adjusted. But they do provide a basis for a rigorous policy discussion on modernizing Iowa tax structure to encourage economic growth.

FLAT TAX CALCULATIONS

/ ENGAGEIOWA.ORG

At least one of these tax modernization scenarios

includes raising the sales tax by 1% and plowing 5/8

of that revenue into reducing the income rate.

Iowans overwhelmingly decided with a constitutional

amendment referendum that the balance of any sales

tax increase, 3/8 of a cent, should go to protect and

enhance our natural resources.

Approximately $80 million annually of that portion of

the sales tax would be available to dedicate to more

rapidly implementing Iowa’s Nutrient Reduction

Strategy to clean up our waterways. That 8-fold increase

in the State’s funding commitment could be used in

targeted watersheds to make Iowa the model for the

nation in protecting its waters while not unnecessarily

burdening our highly productive ag sector.

However, this major commitment of public resources

should not be made without a concomitant match of

funds by the private sector.

A taxpayer’s only solution usually never works. The

private sector must be involved. Every town across Iowa

has a project they can point to that involves a successful

partnership. Public/private partnerships work. By adding

the corporate match piece to the sales tax, a powerful

partnership would be created for water quality. A 50%

match of the 80 million is a good starting point. Most

large corporations have social responsibility scorecards

as part of their annual reports. Iowa just needs to set

up the mechanism to be the beneficiary of corporate

resources dedicated to helping the environment. This

should not be limited to just Iowa companies. This should

be open to national and international commitments.

WATER QUALITY ALTERNATIVE

/ ENGAGEIOWA.ORG

APPENDIX

HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

/ ENGAGEIOWA.ORG

APPENDIX

HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

Figure 7 | State-Local Tax Burden by Rank Fiscal Year 2011

/ ENGAGEIOWA.ORG

APPENDIX

HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

/ ENGAGEIOWA.ORG

APPENDIX

HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

/ ENGAGEIOWA.ORG

APPENDIX

HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

Iowa’s 12 percent top corporate income tax rate is the highest in the

county. Iowa has ranked 40th in the State Business Tax Climate Index for

the last three years.