A proposed tax break on business income could cost Iowa more than $100 million next year, with wealthy Iowans reaping most of the benefits

Republican lawmakers are trying to pass a major tax break on business income that would largely benefit Iowa’s highest earners and would cost the state more than $100 million a year.

The tax break, called the Qualified Business Income Deduction, would apply to “pass-through income” that business owners derive from certain types of partnerships or sole proprietorships.

The deduction is included in the tax bill that the Iowa Senate passed March 1 and provides the same level of business-income tax relief that exists in federal law. Supporters say the bill is needed to keep Iowa competitive and spur investment.

But according to the Iowa Department of Revenue, the deduction would cost the state treasury $106.7 million in the fiscal year that begins in July, and $118 million the following year.

And nearly 80 percent of the lost revenue would benefit the richest 5 percent of Iowa households, the Revenue Department said.

State lawmakers haven't approved a tax-reform package, although some form of the business-income deduction is included in each of the two proposals under consideration in the Republican-controlled House and Senate.

Although $106.7 million represents less than 2 percent of the state's $7.2 billion budget, it's more than enough to offset the state's annual cost of running both the Department of Public Safety, which includes the Iowa State Patrol, and the Department of Inspections and Appeals.

Gov. Kim Reynolds’ proposed tax-reform package, which is now in the Iowa House, includes a scaled-back version that exempts 5 percent of pass-through income from taxation, rather than the 20 percent specified in the Senate bill.

If approved, the House bill would cost the state an estimated $25 million in lost revenue next year — enough to fund the Iowa Department of Agriculture and Land Stewardship for a year.

Total revenue loss could be higher than projected

Under both bills, the actual revenue loss could be much higher than the Department of Revenue projections.

Opponents say business owners are likely to take advantage of the deduction by shifting more of their pay from salary, which would be taxed at a higher rate, to pass-through income.

Supporters of the tax break say it will promote entrepreneurship by allowing individuals to retain more of the income they collect from the businesses they own and operate.

Kansas recently eliminated its exemption for pass-through income after the state reported no appreciable growth in new business.

However, John Stineman of the Iowa Chamber Alliance, which supports the deduction, said it’s probably not fair to compare Kansas’ experience to the tax cuts now being considered in Iowa.

Iowa plans to put in safeguards, he said.

“Revenues have to be at a certain level for the tax cuts to kick in," Stineman said. "You really do need to be prepared to either make spending cuts or have these safeguards in place that say, ‘Hey, we’re only going to continue to phase these tax cuts in if the economic conditions warrant that.'"

House Speaker Linda Upmeyer, R-Clear Lake, has expressed reservations about imposing such safeguards, saying they "don’t always work just the way you would predict them to."

Mike Ralston of the Iowa Association of Business and Industry said the deduction would be a positive move.

"Yes, there will be wealthy Iowans who qualify for this credit,” he said. “But, gosh, we think those folks — most of them — will put that money back into the business and back into facilities and into programs for employees.”

Debate continues on whether tax break will help or hurt

As for the two variations of the tax deduction now being considered, Ralston said the Senate version, with its exemption on 20 percent of pass-through income, parallels the federal tax law and would represent good public policy.

“But at the same time, we want a budget that is sustainable and is good for Iowa,” he said. “We have faith in those that are negotiating a deal to determine what that percentage may be.”

But Charles Bruner, a former state lawmaker who once chaired the Iowa Senate’s Ways and Means Committee, said the deduction could prove to be a windfall for business owners and create inequities in the tax system, even among people with identical jobs and incomes.

Bruner noted that under the Senate plan, a plumber who works for a small company and makes $120,000 would face a higher tax bill than a plumber who works for himself and, after expenses, makes $120,000.

The first plumber would be taxed on his full $120,000 salary, while the self-employed plumber would face taxes on income of only $96,000.

“When I think of implementing tax reform, I think one of the first things we ought to be doing is treating households equally,” he said.

Tax break comes as state cuts back budget

Lawmakers have had relatively little to say on the deduction, with most of the debate this year focused on the larger question of whether the state can afford to lower taxes, even as public officials impose mid-year budget cuts that are forcing reductions in state services.

Just last month, the governor approved $35.5 million in mid-year budget cuts to balance the state’s budget.

This is the second consecutive year the state has been forced to make mid-year spending reductions because of overly optimistic revenue projections.

When Senate Republicans rolled out their initial tax-reform bill in February, they dubbed it “The Iowa Working Families Tax Relief Act,” and said it would give “job creators the confidence to create career opportunities for Iowans.”

Senate Republicans say that overall their plan would lower taxes on Iowans by an average of $1,000 annually.

Democrats have expressed concern that the tax cuts are degrading government services and forcing the state universities to raise tuition.

What kind of tax deduction is this?

The Qualified Business Income Deduction applies to “pass-through” income that represents personal income from businesses that the owners claim on their individual tax returns. Pass-through businesses typically are limited-liability corporations, S corporations and partnerships. Personal income from those businesses used to be taxed in the same fashion as salary and wages. Now, people with this income can deduct up to 20 percent of it on their federal taxes. Iowa is considering a similar deduction for state tax purposes.

Have other states offered this type of deduction?

Yes, but they have generally failed to generate the growth in business and jobs the deduction is intended to promote. Kansas fully exempted all pass-through income for more than four years, with no corresponding economic growth — although supporters of the deduction argue the economy there would be in even worse shape absent the deduction.

Who benefits from this deduction?

Higher-income taxpayers benefit the most. At the federal level, for example, more than half of all pass-through business income belongs to the top 1 percent of tax filers, and the deduction costs the federal government about $50 billion a year. In Iowa, it’s estimated that 79 percent of the financial benefit would fall to the richest 5 percent of all households at a cost to the state treasury of more than $100 million per year.