The saga of Proposition 208, Arizona’s income surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. , appears to have finally reached its conclusion. The only uncertainly that remains concerns the timing of Arizona’s transition to a flat-rate individual income tax.
The initiated state statute, which assessed a 3.5 percent surtax on income over $250,000 ($500,000 for joint filers), was approved by voters on Election Day 2020. But by the end of November, a lawsuit (Fann v. Arizona) was filed, which challenged its constitutionality. As Proposition 208 wound its way through the adjudication process in the summer of 2021, the Arizona legislature passed four bills that curtailed the reach of the surtax.
Proposition 208 reached the Arizona Supreme Court on August 19, 2021, but it was ultimately declared unconstitutional to the extent it mandated expending 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. revenue in excess of a constitutional cap on education spending. The Maricopa County Superior Court was left to determine whether appropriated education expenditures with Proposition 208 revenue would truly exceed the cap. On March 11, the lower court confirmed the measure did, in fact, violate the expenditure limit. Although the legislature’s response to Proposition 208 had already counteracted the surtax, it also sparked counter-initiatives which contributed to confusion around the state’s 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. system. As the dust settles around the Superior Court’s ruling, it is worth examining where Arizona’s individual income tax is now and what is likely in store for the future.
Four bills—H.B. 2838, S.B. 1783, S.B. 1827, and S.B. 1828—were passed by the legislature while Proposition 208 worked its way through the court system. All interacted with the Proposition 208 surcharge. Three of the signed bills were implemented without delay, but a petition successfully gathered enough signatures to convert a fourth bill into a ballot measure intended for the November 2022 election.
Under provisions of H.B. 2838, signed into law July 9, 2021, Arizona began to allow partnerships, limited liability companies (LLCs), and S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s to pay a 4.5 percent tax at the entity level in lieu of all business-related income passing through to the individual income tax. The law was passed as a SALT deduction cap workaround, but because it isolates certain business income from the regular tax on Arizona adjusted gross income (AGI) it was also possible for certain businesses to sidestep the 3.5 percent surtax of Proposition 208. H.B. 2838 was unaffected by the Proposition 208 ruling and remains in effect.
A second law, S.B. 1783, was enacted the same day. It established a system under which individual small business taxpayers could elect to report the taxpayer’s share of Arizona small business AGI separately from their Arizona gross income. Under the election, small business income is taxed at a rate distinct from the standard individual rate, and small business AGI is deductible from Arizona gross income. In 2021, the tax rate on small business taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. was a flat 3.5 percent whereas the standard top marginal individual rate was 4.5 percent. The small business rate is 3 percent in tax year 2022 and is scheduled to decrease to 2.8 percent for tax years 2023-2024 before settling at 2.5 percent in tax year 2025. At one time, a campaign was underway to force S.B. 1783 onto the ballot in November, but the petition effort fell short of the qualifying threshold by 18,000 signatures.
Since the lower court and the Arizona Supreme Court allowed Proposition 208 to continue in force throughout the adjudication process, the 3.5 percent surtax remained in effect. This would have resulted in a top marginal individual income tax rate of 8 percent. In response, policymakers enacted S.B. 1827, which reduced the top marginal rate by an amount that kept the combined surtax and top rate from exceeding 4.5 percent. In the aftermath of the Proposition 208 judgment, S.B. 1827 remains in effect, but its surtax offset provision is moot. In the absence of the surtax, the top marginal individual income tax rate effectively reverted to its tax year 2020 level of 4.5 percent.
S.B. 1828 is perhaps the most consequential of the counteracting policies, but until a recent ruling by the Arizona Supreme Court its future hung in the balance. The bill would have begun the state’s conversion from a graduated individual income tax to a flat individual income tax on January 1, 2022. However, due to a successful petition campaign S.B. 1828 was suspended pending voters’ input on the ballot measure (Proposition 307) in the November elections.
Of note, Proposition 307 itself soon became the subject of two lawsuits. One suit claimed the tax cuts in S.B. 1828 could not be contested on the ballot, while the other challenged the veracity of the petition’s signatures. The Maricopa County Superior Court ruled that tax bills are referable as ballot measures, but that decision was appealed to the Arizona Supreme Court.
In April, the state supreme court reversed the lower court’s ruling, and declared the Proposition 307 ballot measure unconstitutional. Because S.B. 1828 deals with the “support and maintenance” of state government, the law was deemed un-referable as a ballot measure. This decision effectively cleared the way for the immediate implementation of S.B. 1828.
Effective this year, Arizona’s four marginal individual income tax brackets collapsed into two. Single tax filers with taxable income up to $27,272 (double if filing jointly) will be taxed at a rate of 2.55 percent. Any taxable income exceeding that amount will be taxed at a rate of 2.98 percent. Pending revenue triggers, the tax will eventually be reduced to 2.5 percent for all income levels.
Arizona now joins a growing cohort of states that currently tax or are moving to tax wage and salary income using a single rate rather than graduated income tax rates. Presently, nine states have a flat income tax structure for wage and salary income. Mississippi and Iowa will join those ranks in 2023 and 2026, respectively. Georgia recently enacted legislation that will get the Peach State to a flat rate pending revenue triggers, and Oklahoma is actively debating its own transition.
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.
Some critics have expressed concern that S.B. 1828 would provide 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 income of $200,000 or more).
Furthermore, even if Arizona achieves a single-rate structure, various deductions, credits, and exemptions will continue to inject progressivity into the tax code, reducing the effective rate paid by lower- and middle-income individuals relative to higher-income individuals. In tax year 2017 (pre-Proposition 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.
Arizona’s old top marginal rate of 4.5 percent was already competitive regionally and nationally, lower than 36 states and D.C. (including neighboring California, Utah, Colorado, and New Mexico). The state’s long efforts to promote regional competitiveness have paid dividends: the income tax produced 185 percent more revenue in 2019 than it did in 1992 (inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. -adjusted) despite—or arguably because of—substantial rate reductions. Arizona has seen a population boom, benefiting from outmigration from high-tax California, and inflation-adjusted collections have grown at nearly twice the rate of population increases. If the Grand Canyon State successfully transitions to a flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. , the 2.5 percent rate would be the lowest top rate of any state with an individual income tax.
And it’s possible that policymakers won’t stop there, with favorable revenue outlooks lending themselves to considerations of even further reductions. Arizona lawmakers are embracing their status as an anti-California, a state committed to a competitive low-tax environment—and reaping the benefits.