Income Tax RESEARCH POLICY PAPER

Transcription

1 Income Tax RESEARCH POLICY PAPER E N GAGE I OWA.O R G DERMOT HAYES Pioneer Chair of Agribusiness Professor of Economics Professor of Finance Iowa State University Phone/ Cell/ / dhayes@iastate.edu

2 EXECUTIVE SUMMARY Iowa has high marginal taxes rates on personal incomes. Yet the average tax take in Iowa is below average. This report provides evidence, based on recent work from economists at ISU, that high marginal rates deter businesses from investing in Iowa and that this has reduced average income by about 2.65%. The report also shows that the high marginal income tax rate has caused a net outflow of high earners to states such as South Dakota and Texas. This outflow has cost the state $3.89 billion or 3% of total income. One solution to this problem is to eliminate deductions and credits for all those earning above $10,000. This would allow Iowa to reduce the marginal rate to 3.27% while maintaining total income taxes collected. Iowa s income tax calculation form would read as follows. Multiply the Annual Gross Income (AGI) reported on page one of your Federal tax return by The tax calculation for those with incomes below $10,000 would remain as it is now so that they could continue to receive the benefit of the earned income credit. The state could go even further and use 5/8 of a sales tax increase to reduce the marginal rate to 3%. The balance of the one cent sales tax could be used as constitutionally mandated, with up to $80 million per year being available to dramatically speed up the implementation of Iowa Nutrient Reduction Strategy. The switch to a new tax structure would immediately improve Iowa s reputation as a business friendly state and lead to a significant growth in the state s economy. It is not clear how long it would take for the state to catch up with its potential. A likely scenario is an additional 4% of economic growth over ten years. If tax rates remained constant, then total taxes collected would also grow by this amount. In short, a significant change in Iowa s tax statute could both increase economic growth in Iowa and allow our state to more rapidly improve the quality of our water in lakes, river and streams.

3 SOLVING IOWA S TAX PROBLEM Iowa s marginal personal income tax rate of 8.98% is fourth highest among US states. As a result, the Tax Foundation ranks Iowa 40th out of 50 states for its business tax climate. 1 below average tax revenue in other areas and the ranking further improves to 21st out of 50. In other words, Iowa is slightly below average in terms of taxes collected, but close to the bottom based on its tax reputation. Iowa s individual income tax rules allow for federal deductibility. In 2013 (the latest year for which detailed data is available), Iowa collected $2.76 billion in personal income taxes on reported income of $74.5 billion. This is an effective rate of only 3.7% 234. If the ranking is adjusted to reflect the income tax that is actually collected, the state ranking improves to 30th. Take into account Iowa s Figure 1 shows the income tax rate in Iowa by income group. Despite what appears to be a progressive tax structure, the effective tax rate is relatively flat. In fact, Iowa residents with an AGI of more than one million dollars pay a lower effective rate than those with an income between $40,000 and $50, The appendix to this report shares some recent information showing how Iowa is ranked relative to other states

4 ACADEMIC WORK A recent study by three ISU economists provides specific measures of the negative impact of high marginal rates. 56 The study uses an econometric model of the value of output per worker (labor productivity) across US states and across time. The measure of labor productivity used will track state income (GDP) in the absence of changes in the size of the labor force. Iowa ranks 44 out of 50 states in terms of the distortionary impact of high marginal rates. A 10% reduction in the marginal income tax rate for income and capital gains (holding total tax revenues constant) would cause an increase in labor productivity (income per worker) of 0.3%. Key results from this study of relevance to Iowa are as follows. High marginal tax rates have a double dose on retarding the state s labor productivity, said Peter Orazem, a University Professor of Economics at Iowa State. The results of the Orazem et al. study are of immense importance because they suggest a way to increase incomes in Iowa and the total amount of taxes that are collected. All that has to be done is to flatten the income tax structure so that the new marginal rate is as low as possible while targeting a total income tax collection that is at least as large as it is today. The optimal tax structure is most likely flat across income levels; marginal tax rates should not rise and may even decline at upper income levels and capital income should be taxed at the margin. This study shows that studies of tax effects must use marginal and not average tax rates. Based on Orazem et al., a change in the Iowa marginal income tax rate from 8.98% to 3.27% would lead to an increase in output per worker of 2.65%. At the end of the adjustment period, productivity per worker would be $1,496 higher in 2008 dollars than if the changes were not implemented. 5 See and 6 For a comprehensive discussion of the academic literature on marginal taxes see

5 IRS DATA ON MIGRATION BETWEEN STATES Another way to explore the marginal tax issue is to look at the migration patterns of high income workers. The IRS publishes annual data on the annualized gross income of those who move from one state to another. This data is summarized below and refers to total AGI movement between 1992 and If an individual who reports $200,000 in annual income moves from Iowa to South Dakota and five people who make $20,000 move from South Dakota to Iowa, then the AGI measure will show a net outflow of $100,000 from Iowa. This measure is specially designed to pick up incentives (such as high marginal tax rates) that cause wealthy people to change addresses. The IRS data also shows that the nine states with the highest marginal tax rates lost $107.4 billion and that the nine states with the lowest marginal tax rates gained $142.2 billion 8. As can be seen, Iowa had a net outflow of almost $3.89 billion in annual gross income over the period and it has lost much of this to states with a better business tax reputation such as Florida, Arizona, South Dakota and Texas 7. South Dakota has benefited by a total inflow of $831 million over the same period, almost half of which is from Iowa. Had Iowa retained this $3.8 billion in AGI, the state s overall income would be 3% higher and its total personal income tax revenue would be more than $300 million greater. The $372 million that South Dakota gained from Iowa alone in 2013 is worth $436 to every person in South Dakota. The South Dakota comparison is of particular relevance because of climate and cultural similarities that make it unlikely that the net flow is driven by weather or quality of life. 7 To access this data visit 8 See Brown, Travis H. How Money Walks-How $2 Trillion Moved Between the States, and Why It Matters. How Money Walks, *AGI - adjusted gross income as defined by the IRS. For most people the AGI is starting point in calculating their table income. AGI stats above were gained (lost) between 1992 and How Money Walks

6 FLAT TAX SCENARIOS Table 1 below shows personal income and personal income tax data for Iowa residents in The state collected $2.766 billion in total income taxes from Iowa residents with a combined AGI of $ billion. 9 Treatment of taxpayers with incomes less than $10,000 Note that tax payers with an income less than $9,999 actually paid negative taxes. This is true because of child care and earned income credits. In the scenarios that follow, it is assumed that the state continues to provide these credits to low income people. The total of this negative income tax payments equaled $9.68 million. This brings the total tax collected from those with incomes above $10,000 up to $2.775 billon. TABLE 1-B RESIDENT PAY AND NO-PAY RETURNS 9 Iowa also collected $84.9 million from nonresidents but this is offset by the $87.7 million in tax credits provided to Iowans who paid taxes in other states.

7 FLAT TAX SCENARIOS (CONTINUED) This report uses 2013 data to approximate economic conditions in the year the tax simplification is implemented. Therefore, it should be clear that the proposed tax rates described below are subject to minor error. Further analysis may require some recalibration of the number. Removal of tax credits for those with incomes above $10,000 Iowans collected $347 million in tax credits in In the analysis that follows, these credits have been removed for those earning more than $10,000. The Out of State tax credit is maintained but revenues are replaced with the income taxes that Iowa collects from other states. The Taxpayers Trust Fund credit is also removed even though this is a temporary credit. This credit resulted from a surplus in the state budget that is reflected in the state financial picture in A Subchapter S apportionment credit of $40 million is retained. The net impact of these credits is to reduce the target income taxes collected by $333 million. As a result, the target income tax is reduced from $2.775 billion to $2.442 billion. Possible use of a sales tax increase to reduce income taxes Iowa collected $2.08 billion in sales tax in If this amount were increased by multiplying it by 7/6 then an additional $346 million would be collected. If 5/8 of this additional revenue were devoted to income tax reduction, then this would provide $216 million to lower flat rates. Dynamic scoring The motivation for flattening the income tax rate is to increase economic growth. The research cited earlier suggests that this is likely to occur. However, the research is not specific as to how long this will take or to the magnitude of the growth. A reasonable scenario is that at some point in the future the state GDP would be 4% higher than would otherwise have been the case. The AGI of residents is increased by 4% to $77.56 billion in the scenarios where this is considered.

8 FLAT TAX CALCULATIONS The calculation for the tax rates reported below is as follows: Divide the amount of taxes required to maintain existing tax collections by the total income to be taxed, multiply the result by 100 and use this as a tax rate on all AGI for all those with incomes above $10,000. This procedure will result in at least as much income tax collection as the existing system. BASE CASE: A FLAT TAX WITHOUT DYNAMIC SCORING OR A SALES TAX In the base case, the target revenue is $2.44 billion and the AGI is $74.58 billion. The flat tax that is required to maintain revenues is 3.27%. SCENARIO 1. A FLAT TAX WITH DYNAMIC SCORING In this scenario the AGI is $77.56 billion and the target tax collection is $2.23 billion. The required flat tax rate is 3.1%. SCENARIO 2. A FLAT TAX WITH DYNAMIC SCORING AND A 5/8 CENT SALES TAX With the additional $216 million in sales tax revenue used to lower the income tax rate, the required flat tax rate would be 2.86%. SCENARIO 3. AN EQUAL AND LOWER EFFECTIVE TAX RATE FOR ALL TAXPAYERS In Scenario 2, with a flat tax, sales tax revenue, and dynamic scoring, the 2.86% flat rate would be lower than the current effective tax rate for all tax payers with incomes above $40,000. Those with incomes between $30,000 and $40,000 would pay a similar tax and those with incomes below $30,000 would pay $143 million in additional taxes. If instead, those with incomes below $30,000 were effectively compensated for the change then the required flat rate would be 3.05%. SCENARIO 4. A FLAT TAX WITH FEDERAL DEDUCTIBILITY Iowans paid $19.79 billion in Federal Taxes in If this is deducted from the AGI then the flat tax required to maintain revenues is 4.2% with dynamic scoring and 4.4% without dynamic scoring. These rates would each fall by approximately 0.3% if the sales tax increase is implemented as well. Each of these scenarios can be further refined and adjusted. But they do provide a basis for a rigorous policy discussion on modernizing Iowa tax structure to encourage economic growth.

9 WATER QUALITY ALTERNATIVE At least one of these tax modernization scenarios includes raising the sales tax by 1% and plowing 5/8 of that revenue into reducing the income rate. Iowans overwhelmingly decided with a constitutional amendment referendum that the balance of any sales tax increase, 3/8 of a cent, should go to protect and enhance our natural resources. Approximately $80 million annually of that portion of the sales tax would be available to dedicate to more rapidly implementing Iowa s Nutrient Reduction Strategy to clean up our waterways. That 8-fold increase in the State s funding commitment could be used in targeted watersheds to make Iowa the model for the nation in protecting its waters while not unnecessarily burdening our highly productive ag sector. A taxpayer s only solution usually never works. The private sector must be involved. Every town across Iowa has a project they can point to that involves a successful partnership. Public/private partnerships work. By adding the corporate match piece to the sales tax, a powerful partnership would be created for water quality. A 50% match of the 80 million is a good starting point. Most large corporations have social responsibility scorecards as part of their annual reports. Iowa just needs to set up the mechanism to be the beneficiary of corporate resources dedicated to helping the environment. This should not be limited to just Iowa companies. This should be open to national and international commitments. However, this major commitment of public resources should not be made without a concomitant match of funds by the private sector.

10 APPENDIX HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

11 APPENDIX Figure 7 State-Local Tax Burden by Rank Fiscal Year 2011 HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

12 APPENDIX HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

13 APPENDIX HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT

14 APPENDIX HOW IOWA COMPARES TO OTHER STATES IN THE TAX FOUNDATION REPORT Iowa s 12 percent top corporate income tax rate is the highest in the county. Iowa has ranked 40th in the State Business Tax Climate Index for the last three years.