Jon Muller is a semi-retired policy analyst and entrepreneur who previously was a tax analyst and revenue forecaster for Iowa’s Revenue Estimating Conference.
Iowa Republicans appear to be budgeting on pure hope. And that’s probably the only tool they have. That hope appears to be misplaced.
State government is piecing together a budget, but it’s like flying a plane with one engine gone. This piece is an effort to estimate how far they can fly the plane before it crashes.
The three-member Revenue Estimating Conference (REC) left the estimates largely unchanged at its December 11 meeting, with an additional $23 million for the current fiscal year and an extra $105 million for the budget they’ll appropriate next session.
Normally, that would be pretty good news. The state government historically worked on the premise that future expected appropriations could be funded with future expected revenues. Even when the income tax cutting regime got its foothold in the mid-1990s, both the legislative and executive branches used five-year forecasts of revenues and expenditures to make sure the long-term forecast was at least theoretically reasonable. There’s nothing inherently wrong with using reserves to fund tax cuts in the short run, if it’s reasonable to believe future revenue increases are sufficient to fund them.
I sincerely doubt the state government uses this approach anymore. Because they have committed fiscal malpractice the likes of which I have never seen in Iowa.
PLANS BUILT ON FAULTY ECONOMIC THEORY
We’ve all heard tales of what happened in other states, such as the “Kansas Experiment” in the early part of the last decade. Governor Sam Brownback started what he called the “March to Zero,” meaning zero income tax. Within four or five years, the parade took a turn down Credit Downgrade Street. School years were shortened, many essential services faced huge cuts, and the legislature ultimately over-rode the governor’s last tax cut in 2017, restoring some of the cuts—that is, increasing taxes.
These plans are all predicated on faulty economic theory. There is no basis for the belief that you can materially inflate macro-economic factors at the state level. There is considerable debate about whether it even works at the federal level. The only reason to conclude it might is that the federal government can print money.
Iowa can’t do that. Iowa has to pay, in the here-and-now, or close to it. A state can only kick the can down the road for a couple of budget cycles. Then the tab comes due.
And that’s problematic. It means each dollar you put into the economy by way of a tax cut is offset by a dollar you take out of the economy in government spending. Schools, parks, roads, hospitals, colleges, public health initiatives, and even social welfare transfers all have multipliers that are greater than 1. Some of them, much greater than 1.
It simply won’t work to cut taxes as severely as the state of Iowa has in recent years and end up with a government that’s remotely recognizable to the one you had.
DIGGING INTO THE NUMBERS
Let’s get into the numbers. Iowa’s top income tax rate in 2018 was 8.98 percent. By 2022, when the legislature really went to work (approving a flat tax plan), it had fallen to 8.53 percent. By 2023, the top rate had fallen to 6 percent. By 2024, it fell to 5.7 percent.
The transition to a flat income tax was scheduled for a couple more phases before reaching 3.9 percent. But in 2024, state lawmakers and Governor Kim Reynolds accelerated the timeline and reduced the income tax rate to 3.8 percent for all brackets for the 2025 tax year.
There are factors I won’t get into, such as the loss of federal deductibility, cutting all tax on pension income (thank you very much), or exempting income earned by some farmers over the age of 55. The point is the impact of the loss. Income tax revenue peaked at $5.8 billion in fiscal year 2022. That fell to $4.9 billion in FY 2025.
The REC projects that to fall to $4.4 billion this year, and grow to $4.6 billion in FY 2027.
The personal income tax is the tax most responsive to the economy. Even if the cuts managed to stimulate the economy (more on that below), they’ve removed the engine that most effectively recaptures that growth. But how bad is it?
Alright, House Majority Leader Bobby Kaufmann might say: So we’re just barely below the pre-pandemic level in 2027. That may sound like progress.
But again, this is one of the few tax sources we can count on to be responsive to the economy. Here’s what that picture looks like if you adjust the numbers for inflation.
The responsiveness of the personal income tax can be observed with the upward sloping trend from FY 2005 to FY 2021. The pandemic year was an outlier, but even that was quickly recovered.
Another way of viewing the responsiveness is to look at personal income tax as a percentage of total personal income.
It’s not as if the income tax was gobbling up more and more of our incomes. Brackets are indexed each year. It was relatively stable until FY 2021—again, the pandemic year being an outlier. Rarely broke 3 percent.
That’s hardly onerous, and it’s difficult to imagine what sort of economic surge Republicans thought they’d get by increasing disposable personal income by a lousy one percentage point. And even that assumes no cuts to pay for it.
If personal income tax had stayed at the FY 2021 level, General Fund receipts in FY 2026 (the current budget year) would be approximately $2.2 billion higher than where they are. That’s what a percentage point of personal income yields.
That’s what a March to Zero looks like.
A GROWING BUDGET SHORTFALL
But the income tax is only one piece of the puzzle. The real question is, how big a budget shortfall can we expect in the coming years? And that’s where we might regret trying the Iowa Experiment.
Let’s examine historical General Fund Revenues and General Fund Appropriations over a protracted period of time. The following graph shows Iowa Revenues vs. Iowa General Fund Appropriations since FY 1989.
It’s now almost quaint to see how that little blip in the early 1990s led to some really good budget reform, including the expenditure limitation and reserve funds, as well as a 25 percent increase in the sales tax rate. That of course led to a period of surpluses through the late 1990s, which filled the Cash Reserve Fund.
Republicans led the charge to cut the income tax, which led to annual deficits relative to current revenues. But as I mentioned earlier, they were doing five year projections, and a serious crash was never really in the offing.
Then came the pandemic and all its attendant rewards. Federal funds flowed into the state’s General Fund, just as they flowed into your private bank account and filled business’ cash reserves across the country. The state of Iowa decided to use it to cut taxes, the scale of which is described above.
The chickens came home to roost in FY 2025, when General Fund revenues were barely sufficient to cover the current year’s appropriations. Based on current projections, this year’s deficit will balloon to $1.3 billion.
Assuming the REC projected revenues and a 3 percent appropriation increase in FY 2027, we’ll be looking at another $1.2 billion gap between what the state spends and what it takes in.
The scale of the federal money during the pandemic was so large that for a while, it will cover the fiscal mismanagement in which we find ourselves. The projected surplus will drop from $4.9 billion last year to $3.6 billion by the end of the current year.
Assuming appropriations that only keep pace with inflation at 2.7 percent, even if revenues grow at 4.2 percent, and the surplus will drop to $2.5 billion by the end of FY 2027. It’s just a matter of time before the system hits the wall.
The following chart is a picture of the budget surplus over the subsequent five years after that, even if revenues march on at 4.2 percent (an optimistic scenario) and spending is held at 2.7 percent.
Just two years from now, the legislature will be coming into session hoping they can avoid credit downgrades and a deficit. Three years after that, they’ll be in the soup by almost $2 billion. And that’s really the best-case scenario. There’s never been a protracted period of time when revenue growth has exceeded spending growth by a point and a half.
This also assumes no recession. It assumes an uninterrupted period of growth exceeding inflation, year after year. Personal income growth will actually have to exceed revenue growth, because the system is now less responsive. In fact, even before all these cuts, revenue growth has not kept pace with growth in personal income. Consider the relationship over the past 50 years.
It’s been thirty years since the state system of revenues was responsive to growth in the economy, and that was only because the sales tax was increased a penny that year to solve a budget crisis.
Just prior to the pandemic, personal income and corporate income taxes accounted for 73 percent of General Fund revenue. That’s now down to 63 percent. So those two things have to happen: real personal income has to exceed 1.5 percent year after year, and revenues have to retain the current responsiveness to personal income. Let’s look at historical real personal income.
From 1983 through to 2019, real personal income increased from $106.1 billion to $205.1 billion, a compound annual growth rate of 2.5 percent, more than sufficient.
But since the peak in 2021, it’s fallen from $219.8 billion to $212.9 billion, a contraction of 3.1 percent. Keep in mind, this is the period sold as an expansion justifying a March to Zero in the state’s income tax.
LESS ROSY SCENARIOS
If assumptions of 4.2 percent revenue growth and 2.7 percent appropriations growth are the best-case scenarios, what are the range of possibilities? The following chart provides some context, and a warning for how fast things can get out of control.
I initially posed this as an exercise in estimating how long the state can remain solvent. It’s going to hit a wall in FY 2029 or FY 2030. It’s not really a question of how far they can fly the plane. It’s about how badly the plane crashes.
And even these scenarios mean we’re going to experience a bumpy ride for the foreseeable future. The state’s role in the economy will diminish, whether that’s education, public health, mental health care services, parks, everything. While personal income grows, if it grows, little of that growth will be experienced by those providing essential services to the people of Iowa.
There are so many other factors making it worse still. For example, a larger share of the state budget is going for things it never used to pay for, like private schools. That means even less of the low appropriation levels will be available for the services we’ve come to appreciate.
Additionally, we face the challenge of declining population as immigration continues to be curtailed. It’s difficult for a state to grow an economy without immigration when more than 100 percent of its past population growth has come from immigration.
But at least now we know how far they can fly this thing on one engine. All the way to the crash site.
Sources:
Inflation data: CPI-U from Bureau of Labor Statistics
Personal Income data: FRED, St. Louis Federal Reserve
History of Appropriations, Revenues, and REC estimates: Iowa Legislative Services Agency