Arizona Delivers Rate Cuts and Tax Conformity

Arizona entered 2019 as one of four states (along with California, Minnesota, and Virginia) conforming to a pretax reform version of the Internal Revenue Code (IRC) for both individual and corporate income tax purposes. With the signature of Gov. Doug Ducey (R) on House Bill 2757, Arizona becomes the latest state to conform to the new IRC, cutting tax rates and raising the standard deduction in the process.

Because the Tax Cuts and Jobs Act (TCJA) expanded the tax base, and most states—including Arizona—use federal adjusted gross income as the starting point for state tax calculations, updating the state’s conformity date without making any other changes would have represented a net tax increase. In fact, it already had: the 2018 tax forms assumed tax conformity, even though an updated conformity date was never adopted, and resulted in an estimated $155 million in higher tax collections, which the new law allows the state to keep and use to pay down state debts.

Going forward under H.B. 2757, however, Arizona will return that additional revenue—along with the anticipated new revenue from online sales tax collections—to taxpayers through rate cuts, a higher standard deduction, and the replacement of dependent exemptions with a new child tax credit. Arizona’s individual income tax rate schedule drops from five brackets to four with the elimination of the second-lowest bracket, which is now taxed at the existing lowest rate of 2.59 percent. The top three brackets see modest rate reductions: 3.36 to 3.34 percent, 4.24 to 4.17 percent, and 4.54 to 4.50 percent.

The new law increases the standard deduction from $5,312 (single filer) last year to the new federal deduction amount (currently $12,200), while replacing the dependent exemption ($2,200) with a child tax credit of $100 per child, which is slightly more generous.

Note here that an exemption represents a reduction in taxable income whereas a credit is a dollar-for-dollar reduction in tax liability. This also makes a credit more progressive than the exemption it replaces. Within the lowest bracket, a $2,200 deduction is equivalent to a $57 credit; within the second, $73; within the third, $92; and for the top bracket, $99. Under the new law, a $100 per-dependent credit is available for all filers.

The bill provides across-the-board rate reductions, paid for through tax conformity and online sales tax revenue, and represents a 27 percent tax cut for the median filer. The following figure illustrates the effect of these tax cuts, showing liability under the 2018 tax code, the lower liability under the new law, and the percentage reduction in tax liability (the overlaid line), for a family of four. (For the sake of simplicity, adjustments only include the standard deduction, personal exemption, the old dependent exemption, and the new child tax credit.) The greatest tax relief, on a percentage basis, is for lower- and middle-income families.

Importantly for businesses, the law also makes clear that Arizona will not follow the federal government in imposing the new tax on Global Intangible Low-Taxed Income (GILTI), which makes a certain amount of sense as a guardrail within the new federal tax code, but represents an unwarranted expansion into international taxation at the state level. Under H.B. 2757, GILTI income is classified as foreign dividend income, which is fully deductible in Arizona.

The bill does not, however, address two other provisions of the federal tax law, full expensing and the net interest limitation. At the federal level, these provisions are meant to counterbalance each other, with § 168(k) allowing businesses to deduct the full cost of machinery and equipment purchases in the first year (rather than depreciating them over time), while § 163(j) limits the deductibility of interest for business debts with the goal of reducing a bias in the tax code for debt over equity financing.

While these provisions counterbalance each other at the federal level, many states, including Arizona, automatically conform to § 163(j), which increases business investment costs, without conforming to § 168(k), which eliminates a tax penalty on investment. The new law does not address this imbalance.

With the enactment of H.B. 2757, Arizona becomes the sixth state to cut income taxes using the additional revenue from tax conformity, following Georgia, Iowa, Missouri, Utah, and Vermont. Following a conformity update in Virginia earlier this year, Arizona’s actions leave only California conformed to a pre-TCJA version of the IRC for both individual and corporate income tax purposes.