Iowa’s chronic budgeting crisis — driven substantially by weaknesses in the state revenue structure — leaves Iowa lawmakers in March 2010 with an opportunity to make fresh choices to an old problem. The Iowa Fiscal Partnership identified the challenge in its 2004-05 series of reports, “Our Vanishing Budgets”:

Iowa now is left with a chronic or “structural” deficit. As Iowa looks to the future, its government faces the challenge of restoring services and replenishing borrowed funds at the same time that a changing economy and outdated tax system will further strain the state’s finances.

Nothing in this equation has fundamentally changed five years later, except that the economic cycle has run a full course from the 2001 recession and the deeper 2008-09 recession. Entering the final weeks of the 2010 legislative session, state policy makers have left in place many of the policies that impeded an effective fiscal and economic rebound from the earlier recession.

Iowa’s policy makers do have choices to help with the immediate need to encourage a stronger economy, and the long-term need of fiscal policy that assures critical public services are strong when they are most needed. Responsible economic policy demands a balanced approach that recognizes state and local budgets are a function of both revenues and spending. While popular or conventional political discourse may avoid this reality, the voting public understands that a balanced approach makes the most sense for Iowa. [1][2]

Fundamental principles define responsible state budgeting (see box at bottom of page), and they are integral to a balanced approach applying to both the revenue and expenditure sides of the budget. Iowa Democratic lawmakers have introduced legislation in both chambers to review tax expenditures based upon some of these principles, but that proposed legislation stops far short of significant action on three tax expenditures and loopholes that fail to meet identified principles for tax policy.

Actions on both intentional and unintentional spending through the tax code — limiting the research activities credits, closing corporate tax loopholes by adopting combined reporting, and limiting capital gains benefits — make sense in good economic times, but are especially critical in today’s very tough ones.

The impacts of the recession coupled with the gaps in Iowa’s tax code have eroded state revenues and threaten further major cuts to essential public services in the 2011 state budget that will be felt deeply by all Iowans. These cuts also threaten to deepen and prolong Iowa’s recession by eliminating both state and local jobs at a time when program demand and need for oversight has increased.

While not a substitute for much broader tax reform and examination of all tax expenditures and credits, the following are actions that deserve immediate consideration.

Restructuring the Research Activities Credit (RAC)
Iowa’s RAC represents a complicated modification of the federal RAC. This credit does more than excuse tax liability, as any amount of credit over the amount owed by a corporation is paid as a state check to the corporation — in other words, as a direct subsidy. Currently, there is no regular disclosure of the recipients and individual amounts of these checks. Originally marketed as a way to stimulate research for start-ups and smaller businesses that may not be making a profit and owe state tax, Iowa Department of Revenue reports show that its primary beneficiaries instead are very large corporations that are multistate and even multinational in structure. The primary recipients, then, are firms that do not need such generous “refund” checks to be encouraged to do research in Iowa. This credit could be reformed to target assistance where it was originally intended, and save the Treasury many millions every year. Capping the amount any one firm could receive from the RAC to $250,000 would affect less than 2 percent of the 1,200 current claimants but generate over $39 million in 2013.

Reforming the Corporate Income Tax to Adopt Combined Reporting
One of the most egregious loopholes in state tax codes exists when corporations are allowed to transfer the profits they make within a state to a subsidiary corporation in another state. Corporate tax attorneys have found creative ways for large, multistate businesses to avoid much of their state tax liability by establishing limited liability corporations in such states as Delaware and Nevada, which do not tax corporate profits or do not tax certain kinds of income such as royalties. Iowa profits are then transferred to those subsidiaries, escaping tax in Iowa. Combined reporting levels the playing field for Main Street businesses that work and secure their profits within the state. The Iowa corporate income tax has declined dramatically over the last two decades in Iowa as a share of overall state tax collections, in part due to the absence of combined reporting. Adopting combined reporting in Iowa would affect less than 10 percent of corporate tax filers but capture $60 million to $120 million in corporate taxes that Iowa currently loses through loopholes.

Reforming Iowa’s Capital Gains Provision and Increasing the Earned Income Tax Credit
The Iowa tax code has a special Iowa provision regarding capital gains treatment that includes the total exemption of all profits made from the sale of a business from state income tax liability for those who materially participated. If Iowa simply limited the total exclusion of capital gains from income tax liability to the first $100,000 of gains, a distinct Iowa capital gains benefit would still be preserved, fewer than 1,000 Iowa tax filers would have a limit on their exclusion, and $28 million in revenue would be generated in 2011.

Summary of Budget Impacts of the Three Reforms
Table 1 provides Department of Revenue estimates of the impacts of adopting the three policies this year on the 2011, 2012 and 2013 budgets. Enacting them this legislative session would help to balance the 2011 state budget, but would have much greater impacts in 2012, when Iowa will need revenue to replace one-time federal funds and state rainy day funds used to balance the 2010 and 2011 budgets that are not likely to be available in 2012.


Economic Recovery Impacts of the Reforms
The $32.2 million in additional state revenue in 2011 could be used to fill gaps in Iowa’s current budget that otherwise will result in 500 fewer essential state government jobs, while retaining other essential services that contribute to local and state economic recovery. Leaving this revenue in the hands of large multistate corporations and wealthy tax filers results in little reinvestment in Iowa. The overall effects on economic recovery are much greater if the funding is used to maintain essential services rather than to continue to provide these tax breaks.

Conclusion
While these three actions are not a substitute for broader reforms, they are consistent with sound tax principles, contribute to meeting Iowans’ needs, and support overall economic recovery. Legislative actions would gain credibility with Iowans that lawmakers are taking a balanced and fair approach to state budgeting.

[1] Voter Views: Voter Survey on the Iowa Budget Crisis, Part One (December 2, 2009) PDF
[2] Voter Views: Voter Survey on the Iowa Budget Crisis, Part One (December 8, 2009) PDF