Federal deductibility: the reality

The word of the month in Iowa tax discussions is “federal deductibility.” It means you can deduct your federal income tax from your state income at filing time. Only a handful of states let their residents do it.

Iowa is one of only three states that permit taxpayers to deduct the full amount of federal income taxes paid.

Make no mistake: Federal deductibility is a benefit targeted for Iowa’s highest-income families. Some others benefit, but mostly, it is those at higher incomes.

The last, best analysis of this we have shows that the wealthiest 20 percent of Iowa taxpayers receive 80 percent of the tax benefit from federal deductibility (2002 figures). For the other 80 percent of Iowans, the tax cut amounted less than half of 1 percent of their income. Using those 2002 numbers, by the way, the dollar amount of the average tax cut for the top 1 percent of taxpayers was about $13,900 — more than the income of people in the bottom 20 percent.

To understand why wealthier people get the greatest benefits under federal deductibility, consider this: You have to pay federal income tax to get the Iowa deduction. Many Iowans at moderate and low incomes simply do not make enough money to pay income tax to the federal government — but Iowa law still makes them pay income tax. some provisions in the tax-reform bill in the Iowa Legislature make that situation better for low-income families.

Remember these perspectives when someone defends “federal deductibility” as something to help low- or middle-income working families. For most of them, it’s just not so.

Common sense, stability in tax reform

Statement of Beth Pearson, Iowa Policy Project
Public Hearing on Income-Tax Reform • Iowa House Chamber • March 31, 2009

Beth Pearson
Beth Pearson

Thank you, and good evening. In my capacity as a researcher at the Iowa Policy Project, I evaluate potential budget and tax policies according to whether they make our overall fiscal system more sound and help support our shared public priorities.

In general, good changes to our tax system are ones that make it fairer, more competitive, more stable and secure, and easier to understand. We want a system that provides sufficient revenue to fund essential public services, but we want it to generate that revenue in a way that respects a taxpayer’s ability to pay a tax and doesn’t distort an individual’s private economic decisions.

The income tax reform proposal now before you goes a long way in moving Iowa’s overall tax system — comprised of income, sales, and property taxes — in the direction of these basic principles. Let me talk about just two of those principles: competitiveness and fairness.

First, competitiveness. When profits dip for a small business owner during a recession, their income tax bill goes down automatically. Even those small business owners lucky enough to have steady profits in these tough economic times will likely see a tax decrease as a result of this proposal. The Tax Policy Center, a project of the Urban Institute and the Brookings Institution, found that, nationwide, seventy percent of taxpayers with small business income earned less than $100,000 in 2009. Assuming the same distribution holds true for Iowa, that would mean that more than 70 percent of taxpayers with small business income in Iowa would see an average tax decrease under this proposal. I think that makes it a more competitive system.

Second, fairness. There’s no question that there are particular types of households who benefit the most under this package: low-income working families with children. In addition to seeing lower income tax rates, these families also stand to benefit from expansions in the Earned Income Tax Credit, which helps make work pay by targeting tax assistance to income earners with children, as well as expansions in the child and dependent care credit. So, yes, this package does offer a disproportionate share of its benefits to low-income families who are sending their kids to child care every day so that they can hold down a job in a tough economy. I think that makes it a fairer system.

Most tax changes made during the past 20 years in Iowa haven’t held up when scrutinized according to good budget and tax principles. But this proposal offers us an opportunity to take a step in the direction of common sense and fiscal stability, and I urge the Legislature to pass and the governor to sign this bill.

See the Iowa Fiscal Partnership analysis (3-page PDF) of the legislation, Iowa Income Tax Reform: An Emphasis Upon Sound Principles.