Experts Agree: Iowa’s Business Climate is Improving

Thanks to changes implemented by Gov. Kim Reynolds and the Republican-controlled Iowa Legislature, Iowa’s business climate is seeing major and long overdue improvements, according to Tax Foundation analyst Jared Walczak and two Iowa Association of Business and Industry leaders long involved with tax policy.

In a March 14 article posted on the Tax Foundation website, Mr. Walczak, vice president of state projects, described the “ongoing transformation of Iowa’s tax code” as “certainly remarkable.” As recently as 2018, the state had a nine-bracket individual income tax with a top marginal rate of 8.98% and a graduated corporate income tax with a top rate of 12%, both with alternative minimum taxes. The Iowa tax code at that time also included an inheritance tax and what Mr. Walczak describes as “a well-intentioned but distortive policy of federal deductibility.”

Once reforms enacted in H.F. 2317 take effect, building on others adopted in 2018 and 2021, Iowa’s individual income tax rate will drop to a single-bracket 3.9% and its corporate rate to a flat 5.5%, with no inheritance or alternative minimum taxes.

Getting taxes as low as possible is “good for Iowa business and good for Iowa,” says ABI President Mike Ralston. “I believe most tax experts would say the goal of any sound tax reform is to eliminate as many deductions and credits as possible to make the base as broad as possible. That makes it possible to squeeze rates down as low as possible. That seems to be what the Governor and General Assembly are doing. As long as Iowa can provide the services needed by its citizens (and benchmarking against other states is one way to determine if the funds exist to do that), that’s good.”

Joe Kristan, a CPA and member of the ABI tax policy committee, applauds the changes but would like to see more aggressive reforms targeted to help corporations. “Corporate rates are important for businesses. Iowa has traditionally had one of the worst corporate tax rates in the country. I think corporate rates needed fixing even more than the individual side,” said Mr. Kristan, who also blogs on tax policy at https://www.eidebailly.com/insights.

Mr. Kristan notes that his comments for this article reflect only his personal views and not those of the accounting and consulting firm, Eide Bailly, of which he is a partner.

Mr. Walczak said Iowa’s 2018, 2021 and 2022 reforms generally follow the blueprint created by the Tax Foundation in a 2016 study commissioned by the Future of Iowa Tax Foundation. Cumulatively, they will drastically improve Iowa’s ranking in the Tax Foundation’s State Business Tax Climate Index, a measure of state tax structure, he said. Before the reforms of 2018 took effect, Iowa ranked 46th, but would improve 31 places to 15th overall with the full phase-in of the newly enacted reforms — an improvement of 31 places, according to Mr. Walczak. This would tie North Carolina for the largest improvement in the Index’s history. 

Corporate, individual income tax cuts both affect business

House File 2317, the legislation signed by Gov. Reynolds on March 1, 2022, enacts contingent tax cuts in the state’s corporate income tax rate and phased reductions of the individual income tax rate, along with making changes to the state’s research activities tax credit and treatment of retirement income, according to a summary published by Ernst & Young.

“ABI has never debated elimination of income taxes. The general principle is that taxes should be as low as possible. I think the legislature has taken a pretty cautious approach,” said Mr. Ralston. “Our general thing is that government costs money. It needs to have resources. We get the need for taxes. We just don’t want to collect a penny more than necessary,” he said.

The cautious approach is reflected in the trigger mechanism built into HF 2317’s corporate tax cuts. The state’s 2021-2022 corporate income tax rate is 5.5% on the first $100,000 of taxable income, 9% on taxable income from $100,001 to $250,000 and 9.8% on taxable income greater than $250,000.

If both the Iowa Department of Revenue and the Iowa Department of Management determine by Nov. 1 in a given year that net corporate income tax receipts in the prior fiscal year exceeded $700 million, the 9% and 9.8% rate brackets will be dropped to generate $700 million in net corporate income tax receipts. Those rates will apply to tax years beginning on or after the next Jan. 1, but can’t fall below 5.5%, according to the Ernst & Young summary.

In fact, we’re already going to see reductions in the corporate rate for Tax Year 2023. Income up to $100,000 will be taxed at 5.5% while income past that will be taxed at 8.4%. Going from a top rate of 9.8% to 8.4% is a drop of 14.2%, which is very significant for corporate tax filers.

Also reflecting legislative caution, HF 2317 designates the Taxpayer Trust Fund, expected to hold $2 billion by the end of FY 2023, to facilitate tax relief if needed, although current projections show state revenue growth may be sufficient.

Mr. Kristan believes legislators “probably had more incentive to reduce individual rates than corporate rates” as there are a lot more voters who own smaller businesses and see their income taxed at individual rates. 

“The reduction in tax rates on individuals is good news for Iowa’s tax climate. Most businesses are pass-through entities, which means the owners pay the business taxes on their own returns,” he said. “Lower individual taxes mean lower business taxes, which, everything else being equal, makes Iowa more attractive for commerce.”

“In general, when it comes to pass-through, it’s important for folks to understand that simply means taxes are paid by individuals (the owners) on their income, rather than the business. It’s a choice to have one’s business designated in a certain way (such as an S corporation). Owners typically choose a pass-through designation if the goal is to put as much profit as possible back into the business to grow it as quickly as possible,” added Mr. Ralston. “Whatever the rate is, they want to put it back into the corporation. All things being equal, rates would be similar.”

Retirement income tax relief

Along with scaling back Iowa’s individual income tax rate to a flat 3.9% by 2026, HF 2317 excludes taxation the retirement income of persons who are disabled, at least 55 years old or are the surviving spouse of someone who would have qualified for the exclusion. Previously, Iowa only excluded Social Security or retirement income of $6,000 or less.

Retirement income is broadly defined as “the total amount received from all governmental or other pension or retirement plans, including defined benefit or contribution plans, annuities, individual retirement accounts, plans maintained or contributed to by an employer or by a self-employed person as an employer, and deferred compensation plans,” according to Ernst & Young. 

“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,” Mr. Walczak commented in his article.

He observed that most economists believe that retirement income should be taxed — on the way in as in Roth IRAs, or on the way out as in traditional IRAs. Iowa’s changes will leave retirement income untaxed, coming or going.

The 2022 law also establishes a three-year phase-in of a one-time irrevocable election to exclude net capital gain from the sale of a qualified corporation’s capital stock to qualified employee-owners. Retired farmers get a similar capital gain break and a lease income exclusion under the new law.

Tax credit reforms

HF 2317 implements major changes to Iowa’s refundable research activities tax credit, which previously stood at 6.5% of Iowa’s apportioned share of qualifying expenditures for increasing research activities. Iowa’s research activities credit is based on the federal research tax credit and is calculated using the ratio of Iowa research activities to total research expenditures.

The new law limits the amount of credit in excess of the tax liability that can be refunded, phasing the refundable portion of the credit down 10% per year for five years beginning in 2023. That means 90% of the excess credit can be refunded this year, but only 50% by 2027, according to Ernst & Young. There’s also no provision in HF 2317 allowing taxpayers to carry forward unused portions of refundable tax credits.

The changes also phase out the eligibility of payments for supplies over five years, limit the eligibility of wage expenses and require that the research credit be calculated using the same method on both state and federal returns.

In addition to the research activities credit, refundable tax credits for historic preservation, redevelopment, assistive devices and third-party development will phase down and be capped at 75% for tax years beginning on or after January 1, 2027.

Mr. Ralston said that “rather than trying to incentivize certain behaviors,” it’s best for the state and its businesses to just get tax rates as low as possible.

“Having said that,” he adds “economic developers will say (and they are correct) that it’s also important to have diverse tools in Iowa’s economic development toolbox, such as incentives now in place related to world-class research and development occurring in Iowa.” Iowa’s Research Activities Credit “is a model other states have envied,” he noted. 

Unemployment Insurance Tax changes

Recent legislation and action by Gov. Reynolds also affected the state’s unemployment insurance system by reducing the eligibility period for unemployment beneficiaries before they are required to accept lower paying jobs, using federal pandemic relief dollars to replenish the unemployment trust fund and reduce unemployment insurance tax rates paid by employers.

“ABI advocated hard for the changes to the trust fund and to the use of federal dollars to replenish the fund,” noted Mr. Ralston. “ABI is deeply grateful to Governor Reynolds for her leadership in doing so. Her action was one of the reasons Iowa has been able to recover more quickly from the COVID-19 pandemic than some other states and she deserves the credit for this swift action. Unemployment is low and the Iowa unemployment insurance trust fund is sound. That’s good for employer taxpayers, for unemployed Iowans, and for the state in general.”

Improving Iowa’s competitiveness

In a time of tax reform in states across the nation, the scope of Iowa’s tax relief measures is likely to stand out,” wrote Mr. Walczak. “With H.F. 2317, Iowa lawmakers have made a significant investment in a more competitive tax climate for an increasingly competitive era.”

Mr. Kristan, however, points out “Taxes aren’t the only thing that is important to business climate. Iowa needs to be able to convince businesses that we can attract highly-skilled and well-educated employees. Iowa also needs to keep its reputation for good governance. Whether the current legislative climate is suited to do so is an open question.”

Overall, he sees Iowa’s business climate improving. Taxes aren’t everything, said Mr. Kristan, “but they are definitely a thing, and a much better thing in Iowa than they were a few years ago.”

Looking at the broad picture of tax reforms and unemployment changes, Mr. Ralston concurs. “All of these things together, with the leadership of the Governor, the General Assembly, and Iowa Economic Development Authority Director Debi Durham, have made Iowa a great place to own a business and employ people.”