DES MOINES — Democrats in the state Legislature today rolled out a tax plan that alters Iowa’s tax code and ends federal deductibility, which allows state residents to write off their federal taxes on state returns.

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But while supporters and opponents of the plan dispute its merits, one of the state’s most respected economists says both sides’ arguments are lacking. The deduction should end, he says, because it serves very little purpose.

“I think it’s an archaic holdover from a long ago time that nobody really knows why it exists anymore,” said David Swenson, an economist at Iowa State University.

Under Iowa’s current tax code, when the state calculates a person’s adjusted gross income for taxable purposes, it subtracts from  that total the amount of taxes already paid to the federal government. The effect is that income subject to state taxes is much lower.

The problem is that in order to generate enough revenue, the state has to institute a higher tax rate.

“The deductibility really favors more wealthy taxpayers, because they are going to be subject to the much more progressive federal tax system,” Swenson said. “So, this system favors people with money and people who are able to itemize their deductions.”

The Democrats’ plan ends federal deductibility and reworks the tax code, lowering the overall tax rate for every citizen. But those making more than $125,000 a year would begin paying slightly more under the new system, up to $1,400 a year for Iowans making $250,000 or more a year.

Democrats say the changes amount to a middle-class tax cut.

“This plan helps Iowa’s middle-class families. It is a sharp contrast to the tax cuts approved by the Legislature in previous years which have largely benefited the wealthiest Iowans,” said Sen. Joe Bolkcom, D-Iowa City, chairman of the state Senate Ways and Means Committee. “We intend to reward work and provide needed tax cuts to middle-class Iowa workers who are bearing the brunt of the national recession.”

Charles Bruner, executive director of the Iowa Child & Family Policy Center, said the tax rate on Iowa’s wealthiest citizens could be lowered significantly to put it more in line with other states while still allowing for the wealthiest to pay slightly more and giving middle-class Iowans a tax cut.

“Our tax system has been skewed towards the wealthy for a long time,” Bruner said. “Reform that provides more tax fairness and tax reductions for working Iowa families making between $25,000 to $75,000 a year is really warranted. Iowa’s tax code is really out of line there.”

Arguments for the change
Groups like the Iowa Taxpayers Association and the Iowa Chamber Alliance support getting rid of deductibility. They argue that under the current system, Iowa’s tax rate appears artificially high, which can drive away businesses interested in locating in Iowa. Ending deductibility would allow for the tax rate to be lowered and make Iowa appear more business-friendly.

“This tax reform proposal would strengthen Iowa’s business climate,” said Rep. Paul Shomshor, D-Council Bluffs, chairman of the state House Ways and Means Committee. “For years, state and local economic development groups across Iowa have urged us to reduce Iowa’s income tax rate, which is often perceived to be the 4th highest in the nation. Under our proposal, Iowa’s top income tax rate will drop 2 points from 9 percent to under 7 percent.”

Swenson said this argument has no merit.

“Any sophisticated individual is smart enough to figure out in just a few minutes that the tax rates in Iowa are not as high as they appear,” he said. “My counter argument is that they would be awfully ignorant business people if they can’t figure out the state’s tax code in just a few minutes.”

Besides, Swenson said, taxes on upper income people are not an important factor in how and why businesses choose where to locate.

“They look at dozens of factors, and by several measures, local taxes are way, way down the list,” he said.

The main argument to end the tax, Swenson said, is to simplify the code and end “counter-cyclical consequences for Iowa. …

“If the federal government raises taxes, it raises the deductibility on Iowa taxes and lowers the amount of revenue Iowa can take in unless it raises its taxes,” he said. “If federal taxes are lowered, the state sees a windfall. Eliminate deductibility, make the tax code simpler, and the issue goes away.”

If deductibility is ended with no further changes to the tax rate, Iowa would generate about $590 million in revenue, Bruner said, with the majority of that coming from people making more than $250,000 a year.

“But we have the opportunity to really make Iowa’s tax code more progressive, and if we do, this will end up being revenue neutral but much more fair,” he said.

Arguments against the change
Opponents of ending federal deductibility, including Republican lawmakers and watchdog organizations like Iowans for Tax Relief, argue that the change would institute a tax on a tax.

For example, if a person makes $100,000 a year and pays $25,000 in taxes, the state would use $75,000 as his or her base income for state tax purposes. Without the deductibility, Iowans would pay state taxes on the $25,000 in income even though they never pocketed the money.

“This is money the average taxpayer never touches, sees, or has any discretion over how it is spent,” Iowans for Tax Relief said in a position paper on the issue. “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.”

Swenson also believes this argument has no merit.

“It’s kind of a bogus argument, because we pay taxes on taxes all over the place. You have your payroll, [Medicare] and Social Security deductions taken right off the top, which is close to 9 percent. You pay taxes on that tax,” Swenson said. “That isn’t deducted from your adjusted gross income. So the argument that it’s a tax on a tax is silly, because smart people can generate the appropriate rates that would make this mostly revenue neutral.”

It is possible to simply revise the tax code so everyone basically pays the same taxes as they did with the deductibility, and it would be a much simpler process, Swenson said.

But the Democratic plan shifts the tax burden upward, which opponents argue could hurt Iowa’s already struggling economy.

“While Democrats attempt to mask this as a tax reduction, this proposal would actually result in a tax increase for many Iowa families, employers, businesses, manufacturers and entrepreneurs,” Senate Minority Leader Paul McKinley, R-Chariton, said in a statement.

Product of a bygone era
Iowa has debated whether to end federal deductibility for decades. Former Gov. Terry Branstad, a Republican, first proposed ending the deduction in the 1980s, and the debate has crept up several times in the years since.

“One of the reasons I have always believed it has endured this long in Iowa has to do with the nature of agriculture income in Iowa,” Swenson said. “The reason for that is that farmers often had boom years, and when they had boom years, they were taxed much higher by the federal government. So this was an argument to buffer them on their state taxes.”

Later on, those who opposed the change developed the mantra that ending federal deductibility would result in double taxation, Swenson said, and that’s where the argument has stalled for more than a decade.

“We have things like that on our property tax code and some of our credits for taxes that are just decades old. It’s archaic and inefficient, and it’s a cobbled together kind of thing,” he said. Federal deductibility “is not the only efficiency problem with our tax system, but it is the one that stands out.”

Iowa, Alabama and Louisiana are the only states that allow federal deductibility.