Arizona Legislators Consider Lower, Flatter Income Tax

Arizona legislators are considering taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. changes as part of the fiscal year 2022 budget process that is underway. Companion omnibus taxation bills HB 2900 and SB 1828 would reduce individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rates for all taxpayers, consolidate the state’s graduated-rate income tax brackets into what would effectively be a two-rate structure by 2023, and reduce the assessment value for most commercial property, in addition to other smaller tax changes.

The income tax changes in HB 2900 as introduced would improve Arizona’s individual income tax structure and economic competitiveness, making the state more attractive to individuals and pass-through businesses that pay taxes under the individual—rather than corporate—income tax code.

Currently, Arizona has four individual income tax bracketsA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. with rates ranging from 2.59 percent to 4.5 percent. In addition to those rates, under Proposition 208, which was adopted by voters in November 2020, a 3.5 percent tax is levied on taxable income exceeding $250,000 (single filers) or $500,000 (married couples), meaning income above that threshold is taxed at a total state rate of 8 percent. While revenue from the general rates goes to the general fund and is then allocated to various state programs, revenue from the Prop. 208 tax is dedicated specifically to education programs.

The constitutionality of Prop. 208 is being challenged before the Arizona Supreme Court, with oral arguments heard in April and a decision expected sometime this year. If Prop. 208 is upheld in court, it could be reversed only by another vote of the people; the legislature does not have the authority to amend or repeal policy decisions made by voters on the ballot. As such, legislators are working within these constraints as they consider legislation that moves in the direction of a single-rate tax structure.

Under HB 2900, Arizona’s four general individual income tax brackets would be consolidated into one by 2023. In tax year 2022, the 4.17 and 4.5 percent rates would be eliminated, and the remaining 2.59 and 3.34 percent rates would be reduced to 2.55 and 2.98 percent, respectively. In tax year 2023, the 2.98 percent rate would be eliminated, leaving just the lowest of the current brackets at a reduced rate of 2.5 percent.

Because the legislature cannot alter the tax created by Prop. 208, HB 2900 continues to levy that tax but specifies that the combined rate on income subject to the highest income tax rate and the surcharge may not exceed 4.5 percent, thereby allocating revenue from the 3.5 percent Prop. 208 tax to education and allocating the remaining revenue to the general fund. Functionally, this results in two rates, of 2.5 and 4.5 percent.

The following table shows Arizona’s current and proposed individual income tax rate schedules and identifies how the structure would look both with and without the Prop. 208 tax.

Arizona Budget Bill Would Create Lower, Flatter Income Tax by 2023

Arizona’s Individual Income Tax Rate Schedule, Current and Proposed (2021-2023)
Single
Current (Tax Year 2021)				Proposed (Tax Year 2022)				Proposed (Tax Year 2023)
2.59%	>	$0		2.55%	>	$0		2.50%	>	$0
3.34%	>	$27,272		2.98%	>	$27,272		4.50%	>	$250,000
4.17%	>	$54,544		4.50%	>	$250,000
4.50%	>	$163,632
8.00%	>	$250,000
Married Filing Jointly
Current (Tax Year 2021)				Proposed (Tax Year 2022)				Proposed (Tax Year 2023)
2.59%	>	$0		2.55%	>	$0		2.50%	>	$0
3.34%	>	$54,544		2.98%	>	$54,544		4.50%	>	$500,000
4.17%	>	$109,088		4.50%	>	$500,000
4.50%	>	$327,263
8.00%	>	$500,000
Note: Brackets are adjusted annually for inflation, but tax year 2021 inflation adjustments were not available as of publication, so inflation-adjusted amounts for tax year 2020 are shown. Rates shown in italics include Arizona’s 3.5 percentage-point surcharge on marginal income above $250,000 (single filers) or $500,000 (joint filers). Unlike Arizona’s base income tax rate schedule, the surcharge threshold is not adjusted for inflation. The ballot measure that created the surcharge, Proposition 208, takes effect upon proclamation of the governor and is currently being challenged before the Arizona Supreme Court.
Sources: Tax Foundation; state tax statutes, forms, and instructions; Bloomberg Tax.

Nine states tax wage and salary income using a single-rate rather than a graduated-rate tax structure. From an economic standpoint, single-rate structures are preferable, since they avoid introducing distortionary effects that are prevalent under graduated rate systems.

Arizona’s current practice of imposing higher rates on higher levels of marginal income reduces the payoff to work on the margin. Under Prop. 208, Arizona’s top marginal rate of 8 percent is higher than the top rates of all but eight states and the District of Columbia. Before Prop. 208 was adopted, Arizona’s top marginal rate of 4.5 percent was competitive regionally and nationally, lower than 36 states and D.C. (including neighboring California, Utah, Colorado, and New Mexico).

The changes in HB 2900 would thus restore the state’s top individual income tax rate to make it similar to the one that was in place before Prop. 208, while reducing and phasing out the lower marginal rates to provide tax relief to low- and middle-income taxpayers.

Some critics have expressed concern that HB 2900 provides more tax relief, in the aggregate, to higher-income taxpayers than to lower-income taxpayers, but this is because middle- and higher-income taxpayers, by default, pay much more in income taxes than lower-income taxpayers. According to the Arizona Department of Revenue, in tax year 2017 (the most recent year of data available), 45 percent of the state’s individual income tax collections were generated from just the top 4 percent of resident income earners (those with federal adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” of $200,000 or more).

Furthermore, even if Prop. 208 is struck down in its entirety and Arizona moves to a single-rate structure, various deductions, credits, and exemptions inject progressivity into the tax code, reducing the effective rate paid by lower- and middle-income individuals compared to higher-income individuals. In tax year 2017 (pre-Prop. 208), the bottom 60 percent of Arizona resident income earners paid an effective rate of 1.4 percent, while the top 40 percent paid an effective rate nearly twice that (2.6 percent). Meanwhile, the top 0.7 percent of income earners paid an effective rate of 3.7 percent.

Given that much of the revenue loss associated with HB 2900 is really just the reversal of Prop. 208 revenue increases, however, lawmakers might consider adopting a provision to adjust the new rates in the event that Prop. 208 is struck down, avoiding a deeper-than-anticipated cut.

In addition to reducing rates and improving the individual income tax structure, HB 2900 also increases the dependent tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. from $100 to $150 per dependent under the age of 17 and from $25 to $75 for dependents age 17 and older. These changes would build upon the tax changes Arizona adopted in 2019 that more than doubled the state’s standard deduction to bring it into conformity with the more generous federal standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. that was adopted as part of the 2017 federal tax reform law.

HB 2900 would also reduce the property tax assessment ratio for most commercial property from 18 percent under current law to 17.5 percent in 2022 and 17 percent in 2023. Currently, Arizona’s split roll tax system gives preferential treatment to residential properties, taxing them based on 10 percent of their cash value while most commercial properties are taxed based on 18 percent of their market value.

Some stakeholders have expressed concerns about how a reduction in state individual income taxes would impact cities, since 15 percent of the state’s individual income tax collections are distributed to localities under Arizona’s urban revenue sharing program. While revenue sharing programs are not uncommon, the benefit principle of taxation holds that taxes paid should relate closely with benefits received, so local taxes are preferable to state taxes as a source of revenue to fund local services. To offset the reduction in state revenue received by localities, local governments could raise additional revenue from their property and/or sales taxes, which are less economically harmful than income taxes. Lawmakers are also discussing other ways to address a reduction in city revenues.

It is also important to keep in mind that localities received a substantial amount of direct federal aid under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, as well as the American Rescue Plan Act (ARPA), so some of that aid is helping local governments offset costs and make investments they otherwise would have had to use their own tax revenue to make, including long-term investments in infrastructure. Arizona’s local governments received roughly $1 billion in aid under the CARES Act and an additional $2.6 billion in direct aid from ARPA. This assistance is, of course, temporary in nature.

While the tax cut proposed in HB 2900 is sizable, the state has a surplus of historic proportions despite the pandemic, with a projected ending balance at $3.9 billion for fiscal year 2022. Arizona received $2.8 billion in direct Coronavirus Relief Fund aid under the CARES Act and approximately $4.2 billion in state Fiscal Recovery Fund money under ARPA. Some of that money can also be used to cover longer-term expenses, such as infrastructure spending, that otherwise would have relied on tax revenues. The state cannot use Fiscal Recovery Fund dollars to offset tax reductions but has more than enough revenue growth to make reductions out of existing resources.

If, however, stakeholders are concerned that the current size of the proposed tax cut is larger than desired, policymakers should first consider paring back some of the other tax expenditures included in HB 2900, such as the creation and extension of various targeted tax credits. Targeted tax credits do little to promote economic growth compared to the reduction in income tax rates and the consolidation of brackets that will benefit all taxpayers.

As Arizona emerges from the COVID-19 pandemic, reducing individual income tax rates and reducing brackets would encourage in-state investment and aid the state’s economic growth, especially in a state that had positioned itself as an attractive alternative to high-tax California before the adoption of Prop. 208.

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