Iowa Enacts Sweeping Tax Reform

When Iowa Gov. Kim Reynolds (R) delivered the Republican response to the State of the Union Address on March 1, she touted a state tax reform package on which the ink was barely dry: “Today, I signed legislation that eliminates Iowa’s tax on retirement income and sets our tax rate at 3.9 percent. That’s less than half of what it was just four years ago.”

The ongoing transformation of Iowa’s tax code is certainly remarkable. In 2018, Iowa had a nine-bracket individual income tax with a top marginal rate of 8.98 percent and a graduated-rate corporate income tax with a top rate of 12 percent, both with alternative minimum taxes; an inheritance tax; and a well-intentioned but distortive policy of federal deductibility. Once current reforms have phased in, Iowa will be able to boast a 3.9 percent single-rate individual income tax, a 5.5 percent flat corporate income tax, and no inheritance tax or alternative minimum taxes. Improvements have been made to the state sales tax base and several tax credits have been reformed. Additionally—a more mixed bag economically—the state will exempt retirement income and certain farm rental income from taxation.

The most recent legislation, H.F. 2317, builds on reforms adopted in 2018 and 2021, and is broadly consistent with recommendations made by the Tax Foundation in our 2016 guide to Iowa tax reform. Before the reforms of 2018 took effect, Iowa ranked 46th overall on our State Business Tax Climate Index, a measure of state tax structure. With the full phase-in of the newly enacted reforms, Iowa would rank 15th overall, an improvement of 31 places. This would tie North Carolina for the largest improvement in the Index’s history. In the wake of historic reforms beginning in 2013, North Carolina improved from 41st to 10th overall in seven years (currently 11th).

These tax reductions come with a significant price tag—most notably, the individual income tax cuts involve forgoing $1.65 billion a year in revenue by FY 2027, when reforms have fully phased in—but based on current revenue forecasts, state lawmakers believe that this can be accomplished out of future revenue growth without even dipping into a taxpayer relief fund with a balance surging toward $2 billion.

According to the governor’s office, 98 percent of Iowans with $10,000 or more of taxable income will see lower tax liability under the 3.9 percent flat tax. Initially, marginal rates below about $16,000 in income are slightly higher, and this will be true for income below $7,000 once the tax plan is fully phased in, but at nearly all income levels, Iowa taxpayers will experience tax relief. The median household in Iowa ($60,523 in income) would see its income tax burden decline by 26 percent, from about $2,765 to $2,052. The following table shows current tax rates and brackets, along with the consolidation—ultimately to a flat 3.9 percent rate—beginning next year.

Economic decision-making happens at the margin. Decisions about work and investment are based on the treatment of the next dollar, not prior ones. Consequently, it is taxpayers’ marginal rates which matter, which is why a low top marginal rate is the relevant factor for economic growth. By going to a single-rate system, like neighboring Indiana (at 3.23 percent, with plans for a 2.9 percent rate), Iowa would not only have a low marginal (and only) rate, but also adopt a system which tends to create greater certainty around low rates—which is also important for investment and location decision-making.

When the same rate applies to almost all income (except for that excluded due to the standard deduction and certain other adjustments), it is much more politically difficult to raise rates in the future than it is under a graduated rate system. This appears to be one reason why Illinois voters resoundingly rejected a graduated rate income tax recently: voters understood that, whether or not they were subject to higher rates initially, the flat-rate system is the only thing keeping their own income tax rates competitive.

The full exclusion of retirement income, while undoubtedly appreciated by retirees, does little to benefit the state’s overall economic competitiveness. It may induce more retirees to stay in state, potentially a welcome policy goal in its own right, but that is separate from any goal of promoting economic growth. Most economists believe that retirement income should be taxed, but only once: whether that income is taxed on the way in (think a Roth IRA) or on the way out (a traditional IRA) is largely immaterial. Iowa, however, will leave retirement income untaxed both in and out.

The tax reform legislation also phases down the corporate income tax rate, with a target rate of 5.5 percent. The bill accomplishes this aim over time using tax triggers which set base collections of $700 million per year. Each year, rates will be adjusted to those that would have been necessary to collect no more than $700 million in the preceding year. Given that FY 2022 net collections are projected at $780 million, Iowa starts with the capacity to make a cut of approximately 1 percentage point across the board on its current three-bracket corporate income tax. Based on current forecasts, further reductions will be slow, and a 5.5 percent rate may not be achieved for quite some time, but Iowa is now committed to a path of rate relief, very similar to Indiana’s successful reforms of the 2010s.

The bill also modifies several tax credits, provides a lease exemption for retired farmers (who must choose between this and the capital gains exemption on the sale of farmland), and some other smaller provisions. Finally, it provides for the use of money in the Taxpayer Trust Fund—projected for almost $2 billion by the end of FY 2023, and designed to facilitate tax relief—should those funds be necessary to implement the planned rate reductions, though under current projections, state revenue growth could be enough without even dipping into these tax relief reserves.

Iowa was the fourth state to adopt rate-cutting legislation in 2022, following individual and corporate income tax cuts in Idaho and Utah, sales tax rate cuts in New Mexico, and inheritance tax rate cuts in Nebraska. Many states are likely to follow, in what is shaping up to be a year of significant bipartisan focus on tax relief in an environment characterized by soaring tax revenues, increased mobility, and a renewed emphasis on state tax competitiveness. Many white-collar workers can increasingly work from anywhere with an internet connection, and companies no longer need to have their entire workforce located near their facilities.

But even if 2022 sees many tax reforms, the scope of Iowa’s tax relief measures is likely to stand out. With H.F. 2317, Iowa lawmakers have made a significant investment in a more competitive tax climate for an increasingly competitive era.