While the local income surtax is meant to reduce property taxes, experience shows this swap has led only to higher overall tax burdens.
The State of Iowa has done a great job lowering our income tax rates, but did you know local governments in Iowa also impose income taxes on their residents? The local income surtax is added to individual income tax liabilities with the state government.
When filing state income taxes, residents of districts that choose to levy this tax will notice it at the very bottom of their income tax returns. The income surtax in Iowa pays for schools, with a maximum rate of 20%, or emergency medical services (EMS), at 1%, applied as illustrated in the following figure.
The Iowa Legislature created the income surtax in 1971 alongside the school finance formula to allow districts to increase their maximum budgets. As originally stated, lawmakers intended local income taxes and property taxes to provide equal amounts of funding for local public schools as a means of property tax relief.
“The Committee agrees that the measure of ability to pay is not primarily property ownership or a large income and proposes that both property and income indicate an ability to pay. Therefore, the Committee recommends that the local funding for school purposes should be based upon an equal effort from a local income tax and a local property tax.” — Final Report of the Taxation Study Committee 1971 (page 6)
Although this provision was later repealed, the income surtax remains. Today, school districts have the option to fund specified discretionary programs through local property taxes or a combination of local property taxes and income surtaxes.
Like school districts, counties also have the discretion to impose local income surtaxes. With voter approval, they may generate revenue in the form of a local income surtax, a local property tax, or a combination to pay for EMS.
In 2012, the total income surtax paid was approximately $95 million. Only Appanoose County used the surtax for EMS, but 291 of 351 school districts (83%) imposed income surtaxes, while 60 (17%) did not. Over half of districts (59%) applied an income surtax rate between 5 and 10%. Twenty-two (6%) imposed rates of 15% or greater, with two imposing the maximum rate of 20%.
Ten years later, in 2022, the total income surtax paid was approximately $115 million. Three counties, Appanoose, Pocahontas, and Winnebago, used the surtax for EMS, and 285 school districts (87%) imposed the tax, while 42 school districts (13%) did not. Fewer than half of districts (43%) applied a tax between 5 and 10%, while only six imposed rates higher than 15%. Only one demanded the maximum rate.
The estimated revenue from this source for fiscal year 2025 (FY25) is expected to drop to around $110 million. This reduction results from the state’s lowering its tax rates through recent reform legislation. A lower statewide income tax reduces Iowans’ tax liability and, as a result, the surtax.
Iowa’s property tax history explains why lawmakers allowed a local income surtax in the first place. The 1970s were a time of extremely high property tax growth, and Iowans demanded a response from the legislature. In 1971, the state created an education funding formula to lower property taxes, and policymakers included the local income surtax as an alternative source of funding. Half a century later, what may have been a laudable goal on paper has come with more undesired consequences than other local revenue sources, such as the local-option sales tax and the property tax.
A scheduling mismatch is one reason the surtax is suboptimal. Local governments budget for fiscal years, while income tax liability is calculated for calendar years. Therefore, the amounts received in FY25, for example, will be based on 2023 income tax return amounts.
While local income taxes are widespread across Iowa, they are not uniform as to rates, which can vary from 0 to 20% for school districts. Another inconsistency exists in that, while the local income surtax is not applied to corporate income taxes, it may include individual income tax resulting from partnerships, sole proprietorships, certain limited companies and corporations (Chapter S), and estates and trusts.
Additionally, because taxpayers pay the surtax based on the jurisdiction in which they resided on the last day of the tax year, a business that moves or operates in multiple school districts may face increased compliance issues. Similarly, Iowans may work in districts with much lower surtax rates than the rate they pay in their home districts — again, adding to the confusion of the tax.
Taxes tied to income can also make related tax collections more volatile than consumption or sales taxes. When the economy contracts and wage growth falls, income tax collections follow suit. Conversely, when the economy enters a period of rapid expansion, collections rise. This phenomenon was clearly seen during the Great Recession, when income taxes fell dramatically, while local taxes (property and sales) remained strong. This volatility can cause revenue estimation problems that hit smaller governments especially hard because of the relatively small number of residents and/or employers concentrated in their jurisdictions. This complicates the budgeting process and may force local leaders to impose higher rates than they otherwise would.
Local income taxes are not levied in a vacuum. School districts and counties considering or using local income taxes must remember that even a small percentage adds to the burden residents already face from federal and state taxes. Frequently, local income taxes do not offset property or other tax burdens so much as supplement them. Shifting the funding burden from property to income does not provide the anticipated relief to homeowners and has in fact increased the overall tax burden on Iowans over time.
Iowa created its local income surtax at a time when property tax burdens were overly oppressive and lawmakers were scrambling to find a solution. Schools did not have sales taxes as a revenue source (as they do now), and the school finance formula and property tax levies have changed significantly over the last 50 years. With our increased knowledge of the ways in which taxes affect our economy, serious consideration of reforming or eliminating Iowa’s local income surtax is necessary. Given that school districts increased their property tax collections 7.6% last year alone, there is not much evidence the local income surtax is relieving the property tax burden at all.
With recent income tax changes and property tax transparency measures at the state level, eliminating or substantially modifying income surtaxes makes sense. Only 16 states have local income taxes, and their existence in Iowa hurts our state’s overall tax climate. Taxpayers in districts rarely know or understand the context when local income taxes are being discussed. The school income surtax, in particular, is used for discretionary programs that can easily be scaled back or amended in upcoming years to adjust for different revenue streams.
Print a PDF