The Less the Merrier: More Thoughts on Arizona’s Flat Income Tax

By Kyle Rose

In 2021, Arizona passed a budget that dramatically reworked Arizona’s tax policies. To name but a few changes, it aimed to increase the state’s budget surplus by $4 billion by 2025 and protect Arizona small businesses from a 78% tax hike. Most notably, it also aimed to flatten Arizona's state income tax from four brackets with a maximum rate of 4.5% to a single rate of 2.5% regardless of income. Overall, the plan touted that the average Arizonan would see a $300 average reduction in state income tax payments. However, the impact of this policy will be felt far beyond people’s bank accounts. Although our previous briefing paper addressed some of these aspects and potential outcomes of the plan, looking into other areas now that we know exactly what, when, and how these changes will be implemented will likely shed fresh light on its other consequences. 

Background: A Short History and Analysis of Arizona’s Budget

At the start of the last decade, Arizona was in a budgetary hole. A 2008 analysis by the Center for Budget and Policy Priorities found that Arizona at the time had the worst budget deficit in the United States, standing at 16.2% of state spending. The deficit was created by a combination of the 2008 Financial Crisis, which tanked income and sales tax revenues, and unfunded tax cuts and spending increases by the state government and Arizona voters. Starting in 2009, former governor Jan Brewer and governor Doug Ducey began to reduce the deficit with a combination of spending cuts, temporary state sales tax increases, and hiring freezes on government workers. The governors’ policies, combined with sustained economic growth and ever-lower unemployment rates over the course of the 2010s, not only eliminated the deficit by 2020, but turned it into a billion dollar surplus. 

The consequences of this restructuring can be seen in the composition of the state’s budgets between 2008 and 2021, specifically its General Fund. First, sales and income taxes have always made up the vast majority of Arizona’s General Fund revenue, with combined yearly percentages averaging around 87% of all revenue. Of these averages, sales taxes have almost always constituted the larger of the two, standing at 47% on average compared to income taxes’ 40.6%. Second, income taxes as a proportion of taxes collected has increased over time, from 37.7% in 2008 to 45.5% in 2021, while sales tax revenue has largely remained constant. This has led to an overall increase in the importance of income taxes for Arizona’s budget. For instance the difference in revenue shares between sales taxes and income taxes has dropped from 10.8% in 2008 to near parity in 2020. Finally, since 2010, revenues have almost doubled from $7.4 to $14.3 billion, due almost exclusively to increased sales and income tax revenues. These revenue increases came primarily from economic and population growth generated by Brewer and Ducey either eliminating or cutting various sales and income taxes during their governorships.

More Jobs, Better Economy

If the new tax rate is more efficient for higher income brackets, we should see an overall increase in jobs as the cost of employing workers decreases. The growth rate should be highest  in high income jobs where the previous tax rate was highest. Arizona’s rapidly growing and well-paid tech sector will likely benefit the most, as it has already grown almost a quarter from 2015 to 2020. The lower rate should also increase productivity as the marginal rise in income from working more incentivizes non-salaried employees to work harder and for longer hours. This in turn would increase firm profitability and allow them to expand. In the medium to long term, this would permanently decrease the unemployment rate and add billions of dollars to the state economy. For example, an analysis by the Common Sense Institute found that the simplified tax structure and lower rate would create over 8,000 jobs and increase the state’s GDP by $1.8 billion.

More Migration

The new rates will likely increase migration into the state. All else being equal, taxpayers gravitate towards states with lower taxes and higher-paying jobs, since they are likely to make more money than they would back in their home state. For instance, the top 10 states for inbound migration in the country are all states that either have flat income taxes or no income taxes at all. From this, Arizona’s flat rate is likely to attract urban professionals from high tax states like California and New York, with tech sector employees likely being the most common migrant due to the growth in the tech sector. These effects would also be magnified by the aforementioned increase in job openings and economic boom. All of these will in turn accelerate Arizona’s already substantial population growth, which ranks 5th in the nation for inbound migrants. Furthermore, the increased labor pool will magnify agglomeration effects and make it easier for businesses to create economies of scale, which should further improve Arizona’s long-term economic pull and competitiveness.

Ambiguous Effect on the State Budget

The final effect of the flat tax on revenues depends on the efficiency of the rate relative to the size of the tax base and the rates of other taxes. If the predicted economic and population growth expands the tax base sufficiently, revenues will either remain neutral or expand as the state will have more people to tax. The new rate should also reduce incentives to dodge tax, which should expand the tax rolls even further. However, since the flat tax removes the ability to tax richer Arizonans more, increased population would now be the only way for the tax to generate the same or more revenue bar raising the rate. If migration or economic growth is below expectations, we may see an overall decrease in revenues as new entrants to the system cannot overcome the narrower slice being gathered. It will also increase the importance of sales tax should the new tax rate not produce as much revenue as expected. Arizona’s constitution also has debt limitation provisions, so lower tax revenues would increase the likelihood of state and local budget cuts in this scenario.

Conclusion: Flat Income Tax is here to stay, but its current rate might change

Overall, Arizona’s flat income tax will likely be a net benefit for the workers and businesses while having an ambiguous effect on Arizona’s budget depending on the tax’s efficiency and the state’s economic fundamentals. If revenues remain constant or expand, it is likely that Arizona’s income tax will be lowered even further, although it is unlikely to ever be eliminated entirely due to the critical importance it has in balancing the budget. This will in turn generate more economic growth and attract even more residents to the state. If revenues fall, the income tax rate will likely remain at 2.5% and the government may implement budget cuts. In time, however, if Arizona keeps attracting high-income residents from other states, it is unlikely that Arizona will return to a progressive income tax unless there is a severe budgetary shortfall or there is a sea-change in public opinion.

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