The Iowa Department of Revenue and Finance (IDORF) has proposed new administrative rules, effectively providing a tax cut worth tens of millions of dollars for Iowa manufacturers.  Absent a legislative response, the rule goes into effect January 1, 2016.

https://rules.iowa.gov/Notice/…

This is a serious overreach of executive power. The complexity of the issue, coupled with the unquenchable desire by the party in power to reduce taxes on business, provide the perfect climate to give a tax cut to manufacturers of some amount between $35 million to $80 million, perhaps more. This is an ongoing tax cut of increasing value. This action should be weighed against the Governor’s veto of $55.6 million of education funding….one-time education funding….because the State of Iowa ostensibly could not afford it.

And what is the stated purpose of this rule change? According to the notice, the rules are the “subject of a substantial confusion and controversy.” Furthermore, the change will eliminate “administratively burdensome distinctions…”

Periodically, a taxpayer will contest a ruling and win in court. When that happens, the Department provides a rule change that brings its practices in harmony with current law. That is not what is happening here. The Department is not losing cases in defense of the law. It simply finds the effort administratively burdensome.

How burdensome? The Department has identified 1,500 hours costing $85,000 that is required to enforce the Code of Iowa. That represents 0.24% of the revenue the Department claims to collect from this tax, and probably a lower percentage than that, for reasons discussed below. Interestingly, the Department’s budget is $17.8 million. They collect $8.4 billion in taxes. Their entire budget is 0.21% of each dollar collected. The Department should be commended for the efficiency with which it collects these complicated sales taxes owed by businesses to the State of Iowa.

A little historical context is in order. Generally speaking, manufacturers do not pay sales tax on machinery and equipment, supplies, and replacement parts that are part of the “value-added” process. Machinery and equipment was removed from the property tax roles in the late 1990s, a tax benefit of over $200 million, primarily to manufacturers. Most of this equipment is already exempt from sales tax. This latest administrative action continues the drip drip drip of the erosion of the tax base.

Normally, when the Governor wants to provide a tax cut to businesses or individuals, he makes a recommendation to the Legislature. The Senate and the House work out the details, and send a bill to the Governor to sign. That’s how it worked when they cut property taxes for commercial property owners by $200 million two years ago. That’s how it worked when they cut $200 million in property taxes for business in the late 1990s. That’s how it worked when they cut the sales tax on bailing twine, computers purchased by insurance companies with more than 50 employees, supplies purchased by greenhouses, or my personal favorite, the tax on sales of “tangible personal property sold to a nonprofit organization which was organized for the purpose of lending the tangible personal property to the general public for use by them for nonprofit purpose.”

The issues related to the tax itself are complicated. And the roles of the three branches of government in the execution of the sales tax are complicated as well. This combination makes it difficult to engage in a widespread public policy debate with anything beyond the soundbites. Soundbites, which in this case, are true. Namely, the Governor’s actions demonstrate that the State has enough money to give business a $365 million tax cut over the next ten years, but doesn’t have $55.6 million for schools, one time.

For those requiring a little more Inside Baseball, three factors need to be explored. First, do we really know how much this exemption will cost? Second, an explanation of why this rule is beyond the scope of the Department’s administrative authority. Third, a discussion of the process by which this rule will be implemented or overturned.

Fiscal Impact

The Department provided an estimate of the cost of this rule change.

FY 2016: $17.2 million

FY 2017: $35.1 million

FY 2018: $35.9 million

FY 2019: $36.8 million

FY 2020: $37.7 million

Keep in mind, fully 1/6 of these amounts are sales tax dedicated to Iowa schools for infrastructure.  Not only are there insufficient State resources to provide schools with $55.6 million, one time, schools will absorb a revenue cut of $5.8 million in FY 2017 due to this rule change. Over the next 10 years, this rule will take $60.8 million from Iowa school budgets. And that assumes the estimates are correct, which is a dubious prospect at best.

The non-partisan Legislative Services Agency (LSA), the policy analysis arm of the General Assembly, reviewed the Department’s methodology. One of LSA’s responsibilities is to act as a check on fiscal impact estimates provided by Executive Branch agencies. LSA provided some disturbing comments in the October 13 edition of “Administrative Rules – Fiscal Impact Summaries”:

https://www.legis.iowa.gov/doc…

“The current rule excludes supplies from the definition of replacement parts and specifically limits the exemption to “tangible personal property with an expected useful life of 12 months or more.” The new rule defines tax exempt equipment to include “supplies that do not qualify as replacement parts, such as drill bits, grinding wheels, punches, taps, reamers, saw blades, lubricants, coolants, sanding discs, sanding belts, and air filters.” The Department conducted a survey of 17 manufacturing companies “regarding purchases of relevant items (such as oils, greases, hydraulic fluids, coolants, filters, abrasives, and lubricants).” It is not clear whether the other supplies being added to the exempt equipment definition were also addressed in the survey. It is not clear whether the 17 companies included in the survey was a broad enough sample to represent expected usage of the exemption in the future.”

There’s a fair bit of nuance in that statement. First, keep in mind, the Department built its estimate on a survey of 17 companies, all of whom benefit if the rule is implemented. Secondly, we don’t even know if the survey itself was broad enough, either in terms of the number of firms surveyed or the content of the survey itself. In a previous estimate provided by the Department, they disclosed that some 2,000 companies will receive this tax cut. Related to that fact is the LSA’s most disturbing reaction to the fiscal implications of the rule:

“In addition, LSA has not been able to reconcile this estimate with the Department’s previous estimates regarding similar legislative proposals.”

In 2013, the Department employed a different methodology for the same tax cut. The Department provided a “lower bound” estimate of $32.7 million for FY 2017 and an “upper bound” estimate of $78.1 million. It would appear the Department’s “lower bound” has suddenly become its “best guess.”

Not only did the Department change its methodology and reduce the cost of the tax cut, it cut its inflation factor on the future cost. A 3.2% average factor in 2013 has now become a 2.4% average factor. If we simply apply the 2013 factor to Department’s new “best guess”, the cost over ten years grows another $12.3 million.

We do not know the cost of this rule. But we should not be surprised if the real cost vastly exceeds the amount estimated by the beneficiaries themselves and subsequently aggregated by an Administration that has been pushing the tax cut for years. Furthermore, do not assume this will be the end of the story. As noted in the following section on the Scope of Department Authority, many other companies and industries will want an expansion similar to the one enjoyed by manufacturers (and some non-manufacturers who benefit) covered by this rule. Those companies and industries will have a very good argument based on fairness. Coupled with an effective lobbying effort, the extent of these exemptions is almost certain to grow.

Scope of Department Authority

As stated above, when the Governor wants to enact a tax cut, he makes a recommendation to the Legislature. The Senate and the House work out the details, and send a bill to the Governor to sign.

Chapter 423.3 of the Code of Iowa details every exemption from the sales tax. Printed out on standard 8 ½ by 11 paper, it takes 24 sheets. There are 95 such exemptions, laid out in various levels of detail. The specificity of these exemptions is staggering, both in number and scope.

https://coolice.legis.iowa.gov…

Sales tax exemptions are a testament to how the Code of Iowa became a business model for lobbyists. It works like this: A company in an industry is hit with a sales tax it didn’t know it had to pay. In many cases, they sincerely thought the purchases should have been exempt. After failing to persuade the Department and the courts of their position, they go to their trade group and hire a lobbyist (or directly hire a lobbyist if it’s a large company) and work over the course of some years to secure an exemption from the tax they didn’t think they should pay in the first place.

Typically, and in the case of the administrative rule being implemented by the Department this time, the exemptions relate to a “Processing Exemption.” Sales taxes are not owed on those things that are “value-added” to a finished product. But sales taxes are owed on those things that are consumed during the manufacturing process, and on those things that are not directly related to the process. For example, a company that restores old cars does not pay sales tax on the paint it applies to the cars. But it does pay tax on the sandpaper it “consumes” as part of the process. The paint remains with the car (ie. it is value-added). The sandpaper does not remain part of the finished product.

I have not read through the entire statute for years, and it’s quite possible that auto restoration companies have by this time secured a specific exemption on their sandpaper. But if sandpaper is exempt, that’s how it happened. The Legislature passed a bill and the Governor signed it.

Indeed, the exemption that is the subject of this paper started out on the same path. In 2013, the legislation was offered in the Department clean-up bill, but was rejected by the Legislature. In 2015, it was offered up again in much the same manner, and met the same end. After at least two unsuccessful attempts, the executive branch is bypassing the law-making branch of government, and simply redefining the Code of Iowa to exempt manufactures from paying sales tax on supplies consumed in the manufacturing process.

The past 30 years are littered with examples where it was difficult to clearly define whether or not something is consumed in the manufacturing process. In all cases, the Department renders a judgment, typically a judgement that is consistent with past rulings. For example, printers and publishers once found out they had to pay tax on the purchases of all kinds of consumables. They got an exemption that is so pedantic in its application, it specifically mentions acetate, anti-halation backing, light sensitive emulsions, blankets, blow-ups, bronze powder, and 111 other unique inputs.

Nothing in 423.3 gives the Department of Revenue and Finance the authority to simply change the definition to include an exemption for those things that are not part of the manufacturing value-added process. Or we can put it in laymen’s terms.  Sometime, over the past 30 years, if they coulda, they woulda.

Process for Implementation of Rule

By using administrative rules, the Governor has flipped the process on its head. The Administrative Rules Review Committee (ARRC) is the Legislative Branch’s check on the Executive Branch. The Committee is comprised of five Democrats and five Republicans. The members of the committee can be found here:

https://www.legis.iowa.gov/com…

With six votes (ie. at least one Republican), the ARRC can object to the rule. While doing so will not delay the implementation of the tax cut, it will shift the burden of proof to the Department to show its actions are not unreasonable, as described in further detail below. Alternatively, the Committee can object with seven votes and delay the effective date until the Legislature has had an opportunity to act. But this is where the flip comes into play. It now will require the Legislature to vote to NOT cut taxes. If the Legislature does not pass a bill denying the rule, the rule will likely go into effect.

There is one other check. The Attorney General can also weigh in and object to the rule as being “unreasonable, arbitrary, capricious, or otherwise beyond the authority delegated to the agency.” In a court proceeding reviewing the rule, the burden of proof would be on the Department to prove that the rule is not unreasonable, not arbitrary or capricious, and within the authority of the agency. Attorney General Miller may conclude that objecting to this unprecedented rule will serve the best interest of Iowans, even though his office has the responsibility of defending the Department in the event of a court challenge.

It’s easy to look at political discourse today and conclude everything is a battle between Democrats and Republicans, the left and the right, liberals and conservatives. But far more is going on with this issue. There are also natural adversarial relationships between the General Assembly and the Executive Branch, and between the House and the Senate, irrespective of party. As a practical matter, some Republicans in the General Assembly will have to take an action that is anathema to their beliefs on taxation to preserve the power of their role as lawmakers. That’s a nuance legislatures of old, regardless of party, insisted on preserving. A Democrat will surely be Governor again someday, and it would be a mistake to set a precedent that allows the Executive Branch to so drastically change the tax climate. If Republicans in the Legislature do not stand up against this unprecedented over-reach of power, they will almost certainly live to regret it.

Concerned Iowans should ask their elected officials, especially those on the ARRC, to object to the rule and delay implementation of the rule until the General Assembly has had an opportunity to act on this measure.