It isn't flat, but it is a tax cut. Here's a closer look at what the Legislature's tax plan would mean for you
Arizona’s flat income tax proposal has been called many things since it was unveiled last month: Historic. Game-changing. Risky. Immoral.
One thing it is not, though: Flat.
The proposal would create two tax brackets to feed the state's general fund: A 2.5% rate for incomes less than $250,000, and 1% for any income earned above that mark.
“That’s not a flat tax," said Richard Auxier, senior policy associate for the Tax Policy Center in Washington D.C. "You have two rates. Technically, if you have more than one rate, you do not have a flat tax.”
The plan also lacks another hallmark of a classic flat tax: The ability to file an Arizona return on a postcard.
That would require a super-sized postcard, as the plan allows taxpayers to continue taking deductions from their pre-tax income, and actually adds a new tax credit and increases the amount of the standard deduction for charitable donations.
Even the plan's biggest proponents concede it's not a classic flat tax, but say the label is not important.
What is important, said Chad Heinrich, state director of the National Federation of Independent Business, is a provision designed to protect higher-income earners from the effect of Proposition 208, a voter-approved measure that imposes a 3.5% percent surcharge on federally adjusted income earned above $250,000 ($500,000 for joint filers) to help pay for schools. That boosts Arizona's top rate to 8% from 4.5%.
To buffer these taxpayers from the higher rate, the plan caps their tax liability at 4.5% without disrupting the surcharge. The remaining 1% of their tax liability would go to the state general fund.
Tax cut bogs down budget work
The reduced tax rate, the cap, a tax credit for dependent children and several other provisions add up to a tax cut that is estimated at $1.5 billion to $1.9 billion, one that Gov. Doug Ducey has called historic and gives every single taxpayer a break.
But the size of the cut, and what that would do to state programs, has stalled this year's legislative tax-cutting endeavor.
Republican legislative leaders are working behind the scenes to get all of their members on board so they can pass a new state budget that includes the tax cut. Democrats say they are steadfastly opposed. A June 30 deadline looms.
A single rate, not a flat tax
Rep. Ben Toma, the House majority leader, has pushed for a single tax rate for two years. To him, a 2.5% rate would increase Arizona's economic competitiveness, as some Western states, such as Nevada, have no income tax, while others have moved from a progressive tax rate to a flat tax.
“I don’t know how we can expect to be competitive in our state," he said, surveying the neighboring tax landscape.
While Toma no longer refers to the plan as a flat tax, instead calling it a flat rate, 2.5% would make Arizona lower than any of the 10 states that currently call themselves flat-tax states.
There is evidence that lower taxes attract talented people and business to a state, said Benjamin Lockwood, assistant professor of business economics and public policy for the Wharton School at the University of Pennsylvania.
But since Arizona already is a low-tax state, there’s some question about how effective a further reduction would be, he said.
Do tax cuts = more growth?
Other research has countered the narrative that cutting higher marginal tax cuts brings more job opportunities.
“You see substantive employment gains when you cut taxes for the lower tax ranks," Lockwood said, citing a study from the National Bureau of Economic Research.
Another study, from the Tax Policy Center, a joint effort of the Urban Institute and the Brookings Institute, concluded there is not a straight line between tax cuts and job growth. Its study cautioned that the benefit of tax reductions could be offset by cuts to state budgets, especially when state tax collections decline.
That argument is central to the debate over Arizona's proposal, with former Gov. Jan Brewer warning about the painful cuts in state spending she oversaw as the Arizona government tried to climb out of the Great Recession.
Last week, the locally based Grand Canyon Institute issued a report that found 25 years of tax cuts in Arizona did not spur economic growth; instead, productivity fell 5% compared to the national average.
It found that Western states with higher tax rate, specifically California and Oregon, posted higher productivity gains than Arizona with its comparatively lower rates.
"Arizona’s experience with tax cuts provides no evidence to suggest that further reducing the personal income taxes of the more wealthy households will improve the state’s productivity per job compared to other states or the national average," the report concludes.
Proposition 208: A gamechanger
National rankings have shown Arizona's income tax, with its top rate of 4.5%, was already competitive, especially among Western states.
But that changed last fall, when voters approved Proposition 208, raising the top bracket to 8%.
That gave new fuel to the single rate argument Toma was promoting. Business groups and many Republicans scrambled to blunt the impact of the tax, which they argued would deter economic growth.
"In some ways, 208 spurred the discussion along," Toma, R-Peoria, said.
But it's a mixed blessing for supporters.
"It complicated the issue in many ways," he said. "It added to the expense, for sure."
Among other things, it increased the size of the cut to state revenues. To guarantee the 4.5% cap on tax liability for high-income earners, the plan would use the state general fund to cover part of the bill these taxpayers would owe. That adds up to about $800 million, bringing the total cut to state revenues to as much as $1.9 billion.
Cities and towns have complained a cut of that size will have ripple effects on them, since the state shares income-tax collections with local governments. A $1.9 billion cut would reduce the share to cities and towns by about 31%, a reduction the local governments say would most likely require them to reduce some basic operations, such as public safety.
Democrats have solidified against the plan, arguing the cut was too deep and defied the will of voters who approved Proposition 208. Republicans splintered in their critiques: Some said a more modest tax cut would free up money to further reduce debt; others said the budget had unnecessary spending.
There's another wild card at play: The state Supreme Court has yet to rule on a case that challenges the constitutionality of Proposition 208.
Some have argued it would be prudent to wait for the court's ruling, to provide clarity to the tax landscape. For example, if the court strikes down the initiative, there would be no 3.5% surcharge to protect against, potentially shrinking the size of the tax proposal.
But lawmakers, eying the June 30 deadline to have a new budget in place, say they can't afford to wait. The court heard arguments on the matter two months ago.
From 5 tax tiers to 2
The tax plan would move Arizona from its current five-tier tax rates to two, phasing it in over two years.
For taxes due on income earned in 2022, there would be three categories, the plan anticipates:
• 2.55% for income up to $27,271
• 2.98% for income of $27,272 and above, and
• 4.5% for income earned above $250,000
For 2023 earnings, there would be two categories:
• 2.5% for all income up to $250,000, and
• 4.5% for income above $250,000
By moving to a flatter tax structure, the bigger savings will naturally occur at the higher-income levels because under the current progressive tax structure they are taxed at a higher rate than lower-income earners.
The Legislature's budget staff has estimated savings would range from $4 at the lowest levels of federally adjusted gross income to $350,000 for incomes of $5 million and above.
For single filers with adjusted incomes of $40,000 to $50,000, the savings would be $39; for those with an income of $75,000-$100,000, $231, according to the Joint Legislative Budget Committee.
The biggest beneficiaries, dollar-wise, would be those earning above $250,000 in adjusted income because they are sheltered from the jump to an 8% rate. For example, taxpayers with adjusted incomes of $500,000 to $1 million would save $12,133, the analysis shows.