Thursday, April 02, 2009

Register: Democrats Botch Good Plan to End Federal Deductibility

The Des Moines Register wrote today that the Democrats have botched the handling of a bill that would end Iowan's ability to deduct federal income taxes. They, however, lay out a number reasons why the bill should pass.

Eliminating federal deductibility is a substantial change that would affect thousands of Iowans directly and personally, and legislative leaders owed them a fuller public discussion. That said, the idea makes sense, and the Democrats' goal of making Iowa's income-tax system more fair in the process is long overdue. In contrast to federal income-tax rates, which grow progressively larger with incomes, Iowa's income taxes fall too heavily on lower incomes.

Despite the overheated response from some critics, the Democrats' proposal would not result in tax increases for nearly everyone. According to the Iowa Department of Revenue, the change would result in increases for just over a third of Iowa households, with the most substantial increases affecting those with incomes above $125,000. For about two-thirds of households, there would be either no change or a tax cut. The net effect for the state treasury would be revenue neutral.

Another criticism is that the change would hurt small businesses. This complaint is made on behalf of owners of "Subchapter S" corporations, which are taxed differently from other corporations under the federal tax code. Under Subchapter S, a business's income is taxed not as corporate income but as personal income of the owners. Under the Democrats' plan, those individuals would lose their federal deduction, but their Iowa tax rates would go down. In general, they would pay more state income taxes if they earn more than $125,000. That's true for owners of any businesses, large or small.

According to some critics, eliminating federal deductibility means paying a "tax on a tax." For most, however, the change would not mean an increase in total tax bills. To account for the federal deduction, Iowa simply raised state rates. Which is why eliminating federal deductibility has been a goal of members of both political parties for many years: Compensating for deductibility has meant Iowa's income-tax rates look out of whack compared to other states. (Only two other states, Alabama and Louisiana, allow 100 percent deductibility.) By eliminating the deduction, Iowa can bring its rates down to be more in line with other states.

The Legislature could make this change in a way that does not raise or lower individual taxes, but that would miss an opportunity to make Iowa's income-tax system not only simpler and more competitive but more equitable for middle- and low-income Iowans. It's just too bad legislative leaders were not more open about the plan.

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