The Iowa flat tax proposal: a good deal for middle class and up, but not for lower incomes.

February 17th, 2013 by Joe Kristan
If Iowa's tax law were a car, it would look like this.

If Iowa’s tax law were a car, it would look like this.

Iowa House Republicans have proposed (HF3) an optional flat tax of 4.5% of adjusted gross income, with no tax credits and no deductions other than a standard deduction of $6,235, or $12,470 on joint returns.   Because taxpayers can be expected to compute the tax both ways and pay the lower amount, I call this an “alternative maximum tax.”

While a flat rate return with few deductions is much better policy than Iowa’s rusty loophole-ridden income tax, most people are more interested in their pocketbook than abstract tax policy.  What taxpayers would benefit from this plan?  If this plan were enacted as a substitute for the current income tax, rather than an option, who would be hurt?

I have dummied up some examples to see how it would affect taxpayers.  While generalizations are dangerous, my computations lead me to some tentative conclusions:

 

  • HF 3 would reduce taxes for most filers with over $45,000 in taxable income.  Even taxpayers  large charitable contributions and itemized deductions typically are better off under HF 3 at higher income levels.

 

  • It would rarely be worth filing under the current tax system just to take advantage of the deduction for federal taxes. 

 

  • Raising the standard exemption amount to around $15,000 for a single filer would probably make it break-even for income levels down to around $24,000, making up for the loss of the earned income credit.  Similar results could be achieved by adding large dependent exemptions.

I made up some hypothetical taxpayers to see what HF 3 would do:

Single parent, 3 kids, $24,000 of wage income, standard deduction.  This taxpayer would have Iowa income tax of $378 under the current system, but $799 using an HF 3 return.  Much of the difference is the $327 earned income tax credit that is unavailable under the flat tax.

Two-earner married couple, each with $40,000 W-2 income; also $100 interest income, $3,000 home mortgage interest, $1,000 property tax deduction, $500 charitable contribution.  This couple would save about $323 using my simplifying assumptions by filing an HF 3 return.  The couple has too much income to use the Iowa earned income credit, and benefit of the lower rate offsets the loss of personal exemption credits and the lower Iowa rate brackets.

Married couple, $500,000 in wage and S corporation income (100% Iowa), $2,000 interest income, $32,000 Iowa itemized deductions.  Even though this couple loses the benefit of $32,000 Iowa itemized deductions and $105,000 of federal income tax deductions, the HF 3 plan is still better for them by over $6,600.

Retired single taxpayer, $50,000 pension income, $100,000 gambling winnings, $110,000 gambling losses.  This is a profile of a retired person who devotes her day to feeding slot machines.  This example highlight the flaws of using AGI as a tax base.  While the gambling winnings are “above the line,” the losses are below-the-line itemized deductions.  This taxpayer is nearly $4,400 worse off filing under HF 3 — a big chunk when your “real” income nets to only $40,000.

I contacted the bill’s chief sponsor, Iowa House Ways and Means Chairman Tom Sands, to see what sort of projections they have received from the Department of Revenue.  To my surprise, the state projects different results.  From Rep. Sands (my emphasis):

The highest percentage of expected beneficiaries is found between the $100,001 up to $250,000.  The expected percentage of filers that would see a benefit is between 59.1% and 64.3%.  People earning $20,000 or less will not benefit much from this bill, it is projected only 3.6% of those filers might benefit.  People making $1,000,001 or more it is estimated that only 19.6% of those filers would benefit.  That surprises me, but I think it is where there income may come from or the amount of the deductions they may have.  We have asked for another run on a different rate and some info on percentage of savings in each bracket.

In playing around with $1 million-plus incomes on my software, I find it hard to get better results under the existing rules than the HF 3 rules absent either implausibly-large itemized deductions or significant tax credits.

The tax credits that would most likely reduce taxes under current law to below HF 3 levels include the non-resident credit against Iowa taxes, the Iowa resident credit for taxes paid in other states, and the Iowa “Form 134 credit” for owners of S corporations with substantial non-Iowa sales.  High-income Iowans would be most likely to benefit significantly from these credits as a result of pass-through income from businesses.   I hope that these details come out as the tax reform discussion progresses.

Recommendations.  While HF 3 is a welcome step towards improving Iowa’s income tax,  it needs work.  My thoughts:

The “alternative” bit should be abandoned.  Adding it as an option to the current tax just adds another computation to an already bad system.  They might be doing so to avoid a fight over the deduction for federal taxes paid, but that has to be faced someday.  They should tweak the proposal to make it acceptable as a replacement to the current income tax.

Adjusted gross income is a bad tax base without modifications.  By allowing investment interest expense, gambling losses and deductible hobby losses to go against the base, it would match up income and expense items that should go together.

Increase the standard deduction amount to make it work for lower-income taxpayers.  The higher exemption could replace the Iowa Earned Income Tax Credit, which is rife with fraud and a poverty trap for the working poor.

You can’t tax federal interest.  They should modify the tax base to reflect that.  Maybe they feel they can get away with the alternative computation because it’s only an option, but I’m not so sure.

They should provide a credit for taxes paid by non-residents and for Iowans taxed in other state.  I believe the non-resident credit would be required by federal law if it were the only income tax, and it might be required under equal protection law anyway.

With that, it would begin to look a lot like The Quick and Dirty Iowa Tax Reform plan.  And that’s a good thing.

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