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Arkansas: The Road Map to Tax Reform

8 min readBy: Nicole Kaeding, Scott Drenkard, Jeremy Horpedahl, Joseph Bishop-Henchman, Jared Walczak

Executive Summary

Arkansas’s 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. system is at a crossroads. After years without meaningful reform, the state seems poised to finally tackle the long-running issues within its tax code. The last several years have seen several ad hoc reforms, but the last comprehensive tax reform was in 1971; the one before that was in 1929.

Over the course of six months, our team of economists met with stakeholders from all walks of Arkansas life, including small business owners, local government officials, tax practitioners, in-state academics, trade associations, industry representatives, state officials across the political spectrum, and ordinary taxpayers. We reviewed the history of the state’s fiscal system, previous tax reform studies, and historical revenue and economic trends.

The result is this book, which is meant to help Arkansas achieve the goal of true tax reform—reform that benefits all taxpayers by addressing the many long-term hurdles the state faces. It’s meant to start the conversation about what Arkansas does well, but also what it could do better—by recognizing strengths, diagnosing challenges, and prescribing real, workable solutions. Our book seeks to be The Road Map to Reform.

We undertook this project as an independent national organization familiar with tax developments in many states, with the view that tax systems should adhere to sound economic principles. To the greatest extent possible, taxes should be simple, transparent, neutral, and stable, and the best tax structures are those with low rates and broad bases. We formulated these recommendations in the spirit of providing useful information and observations for Arkansas policymakers, journalists, and citizens as they evaluate and reform Arkansas’s tax structure. We also had the assistance of local tax experts at the Arkansas Center for Research in Economics at the University of Central Arkansas in both the research and writing of this book.

During our travels across Arkansas, several key themes emerged:

  • Arkansans take pride in their state’s relative conservative budgeting approach. Many individuals discussed Arkansas’s unique approach to budgeting through the Revenue Stabilization Act (RSA), and how the RSA ensures that adequate services are provided by the state by prioritizing where state funds are spent.
  • At the same time, Arkansans were quick to point out the challenges to tax reform, largely due to Amendment 19 to the Arkansas Constitution, which requires that any tax rate increase for most taxes requires a three-fourths vote in both legislative chambers. Amendment 19 is an important check on tax increases, but does stymie efforts to embark on comprehensive tax reform.
  • Equity is a concern present among all interested parties in tax reform. Individuals expressed concerns regarding the prevalence of tax credits that benefit large, established businesses or firms relocating to Arkansas. They commented frequently on the special tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. given to residents of Texarkana. Others were concerned about the tax penalties assessed on high-income individuals and corporations through the state’s benefit recapture provisions for both individual income and corporate income.
  • Residents are concerned about competition. Arkansas trails many of its neighbors on tax competitiveness. Tax rates are higher in Arkansas for both individuals and corporations than in most neighboring states. Two neighboring states, Texas and Tennessee, have no income tax, which presents a direct challenge to Arkansas’s tax competitiveness. Above all else, Arkansas’s tax system should retain, and enhance, elements that allow Arkansas to improve its regional, national, and global advantages.

In the following pages, we provide background on Arkansas’s economy and Arkansas’s budget (Chapters 1 and 2). We then review each major tax—individual income, corporate income, sales, and property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. es—outlining concerns, and proposing options for reform (Chapters 3, 4, 5, and 6). Chapter 7 examines additional tax considerations that fall outside of the four major tax types but still deserve attention.

A Menu of Tax Reform Solutions

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.

The individual income tax in Arkansas needs reform, as tax rates are high, the highest in its region. A complicated, “middle-class” tax cut was passed in 2015, but instead of making the system easier to understand, it moved the state in the wrong direction. The state now uses three different rate structures, plus one for low-income individuals—an uncommon approach. In meeting after meeting, Arkansans expressed confusion about recent tax changes, and noted the headaches associated with the state’s code.

Our individual income tax solutions improve the tax code by broadening the 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. and reducing tax rates, making the state more competitive with its neighbors and rendering the system more neutral and fair. Arkansas’s present system is inefficient and complex, making tax compliance difficult for Arkansas residents and families. Our proposals address these concerns.

Lowering rates and consolidating rate schedules. We offer a menu of options for broad-based reform, all of which include, at a minimum, lowering tax rates and consolidating the three rate schedules into one straightforward rate schedule:

  • Repeal the current three rate schedules and transition 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. of 4.95 percent, a revenue-neutral change (Option A).
  • Repeal the current three rate schedules and transition to one rate schedule with rates of 0, 2, 4, and 5 percent. This option would reduce taxes for every Arkansan (Option B).
  • Repeal the current three rate schedules and transition into one rate schedule with rates of 0, 2, 3, 4, 5, and 6 percent (Option C).

Enhancing tax neutrality. Arkansas’s individual income tax consistently fails to treat taxpayers evenhandedly. Our solutions for improving neutrality would:

  • Eliminate the Texarkana border city exemption.
  • 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. -adjust Arkansas’s individual income tax brackets, 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. , and personal exemption credit.

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.

Lowering tax rates and consolidating brackets. Arkansas’s top marginal income tax rate of 6.5 percent is the highest in the region, save for Louisiana, limiting Arkansas’s competitiveness for attracting and retaining firms into the Natural State. Our solutions would:

  • Repeal the current rate schedule and transition to a flat tax of 4.95 percent (Option A).
  • Repeal the current rate schedule and transition to a two-bracket system with a top rate of 5 percent (Option B).
  • Repeal the current rate schedule and transition to a three-bracket system with a top rate of 6 percent (Option C).

Rolling back credits. Arkansas provides a number of tax credits for corporations, both through the corporate income tax and the sales taxA 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. . Evidence suggests that these 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. s provide minimal return to the state, and that a policy of picking winners and losers is ultimately counterproductive as well as inequitable. We propose that Arkansas:

  • Repeal all corporate credits and use the new revenue to reduce the corporate income tax rates.

Improving tax structure. Other provisions within Arkansas’s corporate income tax structure diverge from best practices in a number of ways which yield relatively little revenue while substantially increasing compliance costs and taxpayer uncertainty. We recommend that Arkansas:

  • Eliminate the state’s throwback rule.
  • Extend the state’s net operating loss carryforwards from five to ten years.

Sales Tax

Arkansas’s sales tax is a critical source of both state and local revenue. Currently, many goods and services are unnecessarily exempted, while some business inputs are subject to tax, which can lead to multiple layers of taxation being imposed on the same final product at different points along the production process. Similarly, tax structure and administration is complex and introduces needless compliance costs. Our solutions strive to simplify the sales tax and include a range of base-broadening options.

Right-sizing the sales tax base. A well-structured sales tax applies to all final consumer transactions, both goods and services, while exempting business-to-business transactions. Arkansas’s sales tax exempts many services, making the base overly narrow. In other ways, the base is too broad, by taxing business-to-business transactions. Accordingly, we offer a range of options for both service expansion and the exemption of business inputs. Our options include:

  • Exempt business inputs, such as the sales tax on machinery and repair parts.
  • Repeal sales and use credits, such as InvestArk and TaxBack.
  • Modest base expansion to exempted goods such as newspapers, coin-operated car washes, and the sale of durable medical equipment.
  • Intermediate base expansion to also include personal transportation services, gasoline, self-storage, among other items.
  • Broad-base expansion to also include prescription drugs, membership fees for private clubs, and the trade-in deduction for motor vehicles, along with a number of personal services.

Options to address local sales tax base expansion. Because Arkansas’s state and local sales tax bases are the same (which is the proper tax structure), any expansion of the sales tax base at the state level would result in increased revenue for localities. We provide a number of recommendations for policymakers to address this additional revenue windfall. Our options include:

  • Eliminate the state’s inventory tax.
  • Reduce the sales tax rates charged by cities and counties through some sort of temporary moratorium on local option sales tax elections.
  • Dedicate new funding to functions currently subsidized by the state.

Property Tax

Property taxes account for a large portion of local revenue in Arkansas. Property taxes are among the least economically harmful taxes, and Arkansas has relatively low effective property tax rates. For this reason, we do not suggest any major reform to residential or commercial property tax systems. However, Arkansas does use both a capital stock tax (franchise tax), and an inventory tax, both of which are destructive to economic growth.

Our recommendations would eliminate these duplicative, economically harmful taxes:

  • Repeal the state’s franchise tax.
  • Consider repealing the inventory tax.

Additional Important Improvements

Below, we provide recommendations that do not fit into the four major tax categories above, but warrant their own separate discussion. We provide solutions that would address lackluster transportation infrastructure and address Arkansas’s soda taxA soda tax is an excise tax on sugary drinks. Most soda taxes apply a flat rate per ounce of a sugar-sweetened beverage. . Our recommendations include:

  • Consider repealing the state’s soda tax.

Our Objective

We hope these solutions continue the tax conversation in Arkansas by providing a framework upon which legislators and citizens can make important decisions. The menu of choices we present all ensure that the state builds a tax system for a diversified economy and positions itself as a destination for investment, entrepreneurs, and talented individuals in the years ahead. If the most robust of these reform recommendations were implemented, Arkansas’s ranking on the Tax Foundation’s State Business Tax Climate Index would move from 38th to 15th best in the nation.