With passage of SB1 in the General Assembly’s third special session, Arkansas last week became the 13th state to authorize an individual income 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. rate reduction this year. This round of Arkansas income tax cuts effectively accelerated reforms policymakers enacted eight months ago.
The December 2021 changes set the state on course to lower its top individual and corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rates from 5.9 percent and 6.2 percent, respectively, to 4.9 percent and 5.3 percent as early as 2025. However, the state’s $1.6 billion surplus in fiscal year 2022 made it possible to advance the timeline by three years for the individual tax and two years for the corporate income tax.
The passage of SB1 marks the fifth round of reforms spearheaded by Governor Asa Hutchinson (R) since 2015 that have primarily dealt with rate reductions. Nested inside the past two reform bills, however, have been seemingly minor policy changes that, while less headline grabbing, actually make Arkansas’s tax structure significantly more neutral and competitive. It is these somewhat less intuitive reforms that Arkansas policymakers should prioritize in the future. Rates are important, but even more are how those rates interact with the rest of the code.
During the special session of December 2021, the legislature designed tax reforms to include immediate 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. cuts supported by well-designed corporate income tax reform, revenue triggers, and inflation indexingInflation indexing refers to automatic cost-of-living adjustments built into tax provisions to keep pace with inflation. Absent these adjustments, income taxes are subject to “bracket creep” and stealth increases on taxpayers, while excise taxes are vulnerable to erosion as taxes expressed in marginal dollars, rather than rates, slowly lose value. . The state was in the enviable position of having a $946 million surplus from FY 2021, a projected $263 million budget surplus in FY 2022, a $1.2 billion reserve, and full funding of essential obligations under the state’s Revenue Stabilization Act.
The incremental, revenue-based approach allowed Arkansas to chart a responsible path to regional competitiveness while guarding against unforeseen economic downturns or 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. -related costs. In accordance with the 2021 reform package, provided the state did not draw on its Catastrophic Reserve Fund between July 1, 2022 and January 1, 2025, the top individual rate would have decreased to 4.9 percent at the beginning of 2025.
The Department of Finance and Administration (DFA) projected that if fully implemented by FY 2026, the 2021 rate cuts would cost the state approximately $1.9 billion in forgone revenue over the period, costing $523 million per year by FY 2026. The state had been projecting a $263 million surplus in FY 2022, but the DFA noted that the income tax reforms would likely result in a $135.2 million general revenue reduction the same fiscal year, effectively cutting the anticipated surplus in half.
In stark contrast to the projection, Arkansas ended FY 2022 with a $1.6 billion surplus—roughly six times larger than expected. Relatedly, the scored revenue costs for 2023 have been all but imperceptible in the revenue reports released since the cuts were enacted. After accounting for the FY 2021 and FY 2022 surpluses, the entire amount of the estimated forgone revenue can be paid for immediately, with $300 million remaining. The surpluses alone should go a long way to alleviating concerns over the long-term stability of the rate cuts. But just as important is the point that the revenue department’s estimates were not dynamic and thus did not account for the effects the tax savings would have on the economy.
It is well established that marginal rate cuts lower economic barriers to productivity. As workers and business owners consider the impact of taxation on their next dollar of income, they consider the extensive and intensive effects of taxation (that is, whether to work/invest and how much to work/invest). Thus, lowering the individual income tax rate from 5.9 percent to 4.9 percent should promote in-migration on the margin and increase employment.
The accelerated rate cuts are also likely to influence the amount of work people choose to perform. When workers can take more of their next dollar home, it will, on the margin, incentivize those already employed to work an additional term (hour, week, full time vs. part time).
All this is not to suggest that the tax cuts alone would have paid for themselves. They would not. But it would be incomplete to propose that lower rates, inflation-adjusted brackets, and $1.9 billion of additional discretionary spending amongst individuals, small businesses, and corporations will not feed back into the state’s general fund to a significant degree in the form of new revenue from additional purchases, larger wages and salaries, and higher employment levels on the extensive and intensive margins.
Since tax reforms in Arkansas began in earnest in 2015, most of the attention and energy has been focused on increasing the competitiveness of the state’s individual and corporate income tax rates—and with good reason. As we have previously written, Arkansas’s rates were rapidly becoming regionally uncompetitive. In 2021, even after three earlier rounds of rate reductions, each of Arkansas’s border states, with the exception of Louisiana, had a top individual income tax rate that was at least 0.5 percentage points lower and at most 5.9 percentage points lower than that of the Natural State.
With the state’s top individual and corporate rates now set at 4.9 percent and 5.3 percent, respectively, Arkansas’s rates are the regional median. And while a state’s rates are important, just as important are how those rates interact with the less headline grabbing components of a state’s tax code. Perhaps significant tax pyramidingTax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action. occurs in the sales tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , or firms are unable to deduct operating losses and capital investment due to the absence of well-designed net operating loss and expensing provisions, for instance. A state may have very low or even no individual income tax but still be unable to generate sufficient economic activity due to other tax policies that are incompatible with a healthy business climate.
Recently, Arkansas policymakers have taken important steps toward a more neutral and stable tax code that do not rely on rate reductions alone. The state had earlier indexed its individual tax bracketA 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. s to inflation, and during the December 2021 special session it indexed the 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 as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and consolidated its two lower income tax tables into one. Although the headline of the most recent special session was rate reduction acceleration, an equally important but less-publicized component will conform the state treatment of capital investments to Internal Revenue Code provisions that allow for the immediate expensing of capital investments in the year the investments were made.
Consider how our State Business Tax Climate Index scored the impact of SB1 on the state’s tax competitiveness. Prior to the most recent special session, Arkansas’s tax structure ranked 43rd out of 50 in overall structural competitiveness. Its corporate income tax (CIT) and individual income tax (PIT) ranked 30th and 37th, respectively. If the rate acceleration were factored in alone, the state would improve one place, to 42nd, its CIT would improve marginally to 29th, and its PIT would remain unchanged.
When Arkansas’s conformity of capital investment treatment to IRC Sections 168 and 179 is included, the state’s rankings rise appreciably. This less dramatic, below-the-fold structural change, combined with the rate reductions, propels the state to 38th overall, to 22nd for the CIT, and to 34th for the PIT, reflecting that allowing companies to immediately expense capital investment in the year it was made has an outsize impact on economic growth.
As policymakers in Little Rock discuss how to leverage future tax reforms to facilitate greater economic activity, they should look beyond rates and focus on a broader range of policy changes—on elements that may be tucked away in the inner folds of the code. These policies may be less well-known among the public, but businesses are intimately aware of them. They are integral to every competitive tax system, and they are often significantly cheaper to implement than broad base rate cuts.
At the top of the list of reforms for future discussion could be the redesign of the state’s treatment of net operating losses—a change that would remove barriers to entrepreneurship, reduce income volatility, and remove conditions that disadvantage low-margin industries. A second reform may include the elimination of the state’s throwback rule—a policy that risks double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. and incentivizes relocation outside the state. Third, policymakers could repeal the franchise tax (also known as a capital stock tax), which acts as a tax on business wealth and disincentivizes investment. Many of these reform options and other ways to stabilize revenue can be found in the Tax Foundation’s Arkansas tax reform guide.
In the meantime, Arkansans have reason to be encouraged by the recent, accelerated tax reforms coming out of Little Rock. Annual, incremental tax changes have played a significant role in the economic and population gains many states have realized over the past decade—states that include Arizona, Indiana, North Carolina, and Utah just to name a few. There are many reasons for residency and relocation, but of the variables state governments can affect, tax policies are among the most influential.