The Future of Arkansas Tax Reform: Next Steps on the Road Map to Competitiveness

Arkansas 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. Reform Then and Now

Major Changes to Arkansas’s Tax System since 2016

At the close of fiscal year 2023, Arkansas’s state general revenue fund stood with a surplus of over $1 billion. Despite the fiscal uncertainties of the past three years due to the COVID-19 pandemic and 2020 recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. , this was the third straight year that Arkansas finished with a sizable budget surplus. The prior fiscal year was even larger, at $1.6 billion.

While there was much discussion of what to do with these large budget surpluses, fundamentally they point to a needed policy change for Arkansas: tax reform. These surpluses indicate that the current Arkansas tax system is generating much more revenue than recent legislatures have wanted to spend. In the most recent fiscal year, the legislature enacted a general revenue budget of just $6 billion, while the state tax system generated over $7.1 billion in net revenue.

But how should tax reform proceed? This is not a new question for the Arkansas General Assembly. Multiple times since 2015, the legislature has enacted tax reforms and reductions. A recurring reform has been to reduce the top marginal income tax rates on corporate and personal income taxes, though this is by no means the only reform that Arkansas has enacted.

In 2016, near the beginning of the recent wave of tax reductions in Arkansas, experts from the Tax Foundation and the Arkansas Center for Research in Economics conducted an extensive research project to produce the joint publication Arkansas: The Road Map to Tax Reform. Many of the reforms we recommended in that publication were implemented in subsequent legislative sessions.

In 2016, Arkansas’s top marginal personal income tax rate stood at 6.9 percent, just slightly below its all-time high of 7 percent, which was implemented in the 1970s. This rate was by far the highest among Arkansas’s neighboring states, which were at 5 or 6 percent, or zero percent in the case of Texas and Tennessee.[1] Furthermore, Arkansas’s 6.9 percent rate was the 2^nd highest in the South, with only South Carolina marginally higher at 7 percent. Arkansas’s 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. rate was similarly high at 6.5 percent in 2016, though not quite as much of an outlier: Louisiana was higher at 8 percent, and several other southern states were at 6.5 percent, including neighboring Tennessee.

The 2016 book recommended several paths that Arkansas could take to get the personal and corporate rates down to either 5 or 6 percent, more in line with regional competitors. On this measure, the legislature has achieved the full measure of our suggested reform and more on the personal income tax, lowering the rate to 4.4 percent as of 2024, and will come close on the corporate side with a rate of 4.8 percent. The lowering of rates was done gradually by several subsequent legislatures, and in some cases only when certain revenue targets were achieved (referred to as “tax triggers”). But the cumulative effect is a large reduction in income tax rates.

Beyond the top income tax rate reductions, our 2016 book suggested a number of other reforms, many of which have been enacted. On the 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. side, we suggested 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. -adjusting 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 (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. (most other parts of the tax code already were adjusted). This reform was achieved in the 2021 special legislative session (which also enacted one of the key rate reductions). In 2016, Arkansas’s individual income tax also included a complicated set of three different groups of tax bracketsA 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. , totaling 16 different tax brackets depending on one’s income level. While many states have progressive income tax systems, no state had a system as complex as Arkansas, where rates could retroactively increase as one’s income passed certain thresholds ($21,000 and $75,000). Complex credits were inserted into the tax code to smooth out the “tax cliffs” that this system created. We recommended that this system be consolidated down to a single set of tax brackets, even if still progressive in nature. While that goal has not yet been fully realized, Arkansas is now down to two sets of tax brackets, with 8 tax brackets instead of 16. For taxpayers with 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. over $25,000, Arkansas essentially has a flat income tax system as of 2023.

For the corporate income tax, we also recommended several changes beyond the headline rate reductions. For example, we recommended a repeal of the state’s throwback rule, which places an excessive burden on certain businesses based in Arkansas with many sales outside of the state. This rule was repealed in 2023. We also recommended extending the state’s net operating loss carryforwards from 5 to 10 years as a first step toward treatment in line with national norms (most states and the federal government use 20 years or set no limit on years). This tax provision is extremely important for businesses that have profits that vary from year to year. This first-stage reform was also achieved starting in 2021.

As with the individual income tax, there are still much-needed reforms that have not been fully implemented yet. Our 2016 book recommended that Arkansas end targeted corporate tax incentives. These credits often benefit politically favored firms, without providing a noticeable benefit to the overall economy. While some progress has been made, such as the repeal of the InvestArk credit (the largest such program at the time), much work remains to be done on this front.

Beyond the income tax, the 2016 reform book suggested several reforms to the state’s 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. systems. Arkansas stands out here as well, but in two different ways: the state has one of the nation’s highest 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. rates, but also some of the lowest effective property tax rates. One of the reasons for the state’s high sales tax rates is the broad availability of local-option sales taxes for cities and counties in Arkansas, with few limits on the types of functions the taxes can fund and how they can be enacted through special elections. Some progress was made to limit future increases in local-option sales taxes by limiting the dates each year when these elections can be held, through legal changes in 2021 and 2023.

The Future of Arkansas Tax Reform

Many changes have been made to the Arkansas tax system since 2016. But what should come next? One thing is clear, as mentioned above: despite recent cuts to tax rates and other changes, Arkansas’s tax system still brings in way more revenue than recent legislatures wish to spend. While surpluses will probably not continue on the magnitude of $1 billion a year, the legislature has enacted a budget of $6.2 billion for the 2024 fiscal year, while the tax system is projected to raise about $6.6 billion. That’s less than the $7.1 billion last year, but still well above enacted spending. Reforming the tax system so that it is raising closer to $6.2 billion is a clear step that could be taken in the immediate future and could pay for the implementation of several fundamental reforms. It was a rationale for tax cuts adopted in special session, and to the extent that Arkansas continues to experience revenue growth, it can facilitate further reforms in future years.

There is always uncertainty about the prospects of a national recession and the effects this will have on state budgets. But one other important change that Arkansas has made since 2016 is to establish a true “rainy day fund,” officially called the Catastrophic Reserve Fund. That fund holds about $1.5 billion currently, more than enough to offset any declines in state revenue due to a recession. Additionally, in special session, lawmakers established another reserve fund, with an initial deposit of $700 million, as a buffer in case any future tax revenue comes in below forecast. Tax reform should not focus too much on short-term fluctuations in the business cycle, but instead should look at the steady state levels of tax revenue generated by the system, and the current demands for state spending based on the democratically elected legislature and executive branch.

Another important factor to consider is that neighboring and competing states have not stood still while Arkansas has reduced income taxes in recent years. Arkansas faces stiff competition on the tax front both regionally and nationally. Over the past three years, 25 states have reduced individual income tax rates, including five of the six states that border Arkansas (Texas is the lone exception because it lacks an individual income tax). All of Arkansas’s neighboring states now have rates that are below 5 percent or will be in the next few years (Mississippi will have a flat 4 percent rate in 2026). For Arkansas to continue to attract workers, families, and businesses, it must continue to be competitive on the tax front, as well as in other areas, such as education, criminal justice, and infrastructure (e.g., rural broadband)—all areas that recent legislatures have sought to address.

This publication picks up where our previous book left off, offering policymakers a roadmap for continued reform. It shines a spotlight on work left undone, proposes next steps where some efforts have already been made, and helps lawmakers explore the trade-offs involved in some of the new ideas—including the potential phaseout of the individual income tax—that have entered the tax conversation in Little Rock.

Summary of Options

While individual income tax rate reductions have received the most attention from lawmakers, business tax reforms can provide substantial “bang for the buck” in facilitating greater economic growth and opportunity. In addition to corporate income tax rate reductions in line with any individual income tax rate cuts, lawmakers can and should:

• Implement permanent full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. , thereby reducing the tax code’s penalty on new capital investment
• Repeal the franchise tax, an archaic tax on a business’s net worth that bears no relation to its profitability or ability to pay
• Eliminate its nationally anomalous inventory tax, a highly nonneutral tax with substantial compliance costs which targets select businesses which must keep substantial inventory on hand
• Improve its treatment of net operating losses to better align with the taxation of long-term profitability, consistent with how most states treat such losses

For individual income tax rate reductions, we explore three options:

• Triggered individual income tax rate reductions subject to revenue availability, with an estimated 7 years to get to 3 percent and 22 years to phase out the tax entirely
• Triggered individual and corporate income tax rate reductions in tandem, taking an estimated 8 years to reach 3 percent for the individual income tax, and 27 years for full repeal should lawmakers allow the reductions to continue
• Consolidation of the current dual tables into a single schedule based on the low-income filer rate

Each of these plans, and their revenue implications, are discussed in turn, along with revenue offsets should lawmakers wish to accelerate reductions (rather than waiting to phase them in slowly, paid for out of economic growth) or use other taxes to allow them to retain more of that growth. We also demonstrate a plausible rate reduction pathway should lawmakers choose to implement spending cuts. The trade-offs of each approach are considered, and a projected rank on the Tax Foundation’s State Business Tax Climate Index (a measure of the competitiveness of states’ tax structures) is provided.

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[1] At the time, Tennessee did have a 6 percent tax on investment income, rather than wages and salaries, but the “Hall tax” has been subsequently phased out as well in Tennessee.