Arkansas Lieutenant Governor Looks to Eliminate Income Tax

December 16, 2020

Arkansas Lieutenant Governor Tim Griffin (R) recently announced his goal for the state to eliminate its income tax. He did not outline any specific plan but indicated that this would be a long-term process with the “conversation begin[ning] today” to make sure tax-related decisions would be made with this goal in mind.

Lt. Governor Griffin’s desire to make the Arkansas tax code more competitive is praiseworthy. Currently, Arkansas ranks 45th overall on the Tax Foundation’s 2021 State Business Tax Climate Index, so the state has a long way to go before it becomes the tax envy of its neighbors. However, eliminating an income tax is a long and difficult process, so the state should carefully think through the path forward and consider the trade-offs involved if it intends to make this its goal.

Arkansas’s income tax is unique among states in that, instead of simply having different brackets for different levels of income, the state has three separate rate schedules that apply according to the taxpayer’s total income. For middle-income earners the top rate is set at 5.9 percent for income above $37,200. For high earners, a top rate of 6.6 kicks in at income above $79,300. Those making less than $22,200 see a top rate of 3.4 percent.

While the system remains complex, and while 6.6 percent is still significantly higher than the top rates of its neighbors, Arkansas’s current rates represent improvement in the system. At the beginning of 2020, the top rates for middle-income and high-income earners fell from 6.0 and 6.9 percent, respectively, and the high-earner schedule saw a reduction from six brackets to four.

In the midst of conversations about eliminating the income tax, it is important to note that Arkansas’s individual income tax was responsible for 28 percent of state tax collections in 2018. This is not an insurmountable roadblock. Nearby Mississippi is putting together a plan to eliminate both its individual and corporate income taxes but it does represent a significant share of the state budget.

It is good to see that the lieutenant governor is prepared for the process to take a long time, because one of the most manageable ways to reduce income tax rates is to rely on revenue triggers. In other words, the state would schedule incremental rate reductions for when revenues pass specified thresholds. In this way, a state can gradually make adjustments as the budget allows. Florida, for example, has used tax triggers to reduce its corporate income tax from 5.5 percent to 4.458 percent through 2021 because its collections exceeded the projected forecast by at least 7 percent.

There are a number of ways to set up these tax triggers, and if Arkansas means to adopt such a system, it should take care to measure growth against an established baseline, rather than just looking at year-over-year growth.

But even with well-designed revenue triggers, the forgone income has to come from somewhere—likely a combination of natural revenue growth, spending cuts, and a heavier reliance on other taxes—in order to meet those revenue goals. This need may lead Arkansas to hit a large roadblock: the state’s uncompetitive sales tax. The state’s combined state and local sales tax rate of 9.53 percent is the second-highest in the nation, only surpassed by Tennessee, which does not have an income tax. The combination of high rates and a narrow base that includes a number of business inputs has placed Arkansas’s sales tax code at 46th on the Index. Placing more weight on the sales tax in the absence of an income tax will only make it more difficult to lessen that particular burden.

It is worth noting that, even stopping short of a complete elimination, there are many ways to make Arkansas’s income tax more resident-friendly. Simplifying the three-schedule system or further reducing rates and eliminating brackets would be a positive step toward competitiveness.

In short, Lt. Governor Griffin’s goal to eliminate the income tax is a commendable one that should be considered with cautious optimism, though with the understanding that even a well-designed process may end up putting more weight on an already uncompetitive sales tax. In the meantime, there is plenty of space for incremental improvements in Arkansas’s income tax that will make the state more competitive.

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A sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding.

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