Tax Reform Principles for Arizona in a Post-Pandemic World

Good tax policy is important in normal times. It’s certainly even more important in the unusual times we live in today.

Businesses and workers are experiencing substantial hardship due to the pandemic and various  government mandates to temporarily cease operations. The economic recovery that will take shape as the pandemic begins to wane will be shaped by how state policymakers deal with new economic realities.

Remote work appears poised to be a more permanent feature of tomorrow’s workforce. Technology has allowed businesses and employees to make decisions about where to live and work in ways unanticipated years ago: a worker may be more likely than ever before to derive their income from a business that isn’t located in the same state as their residence. Couple that with new business models (like home-based businesses) and the rise of non-traditional employment (freelancers and “gig economy” workers). It soon becomes obvious that re-assessing tax policies, particularly those that pertain to personal income taxes, is warranted.

Meanwhile, the competition between states for workers, entrepreneurs, and investment is likely to become even more significant. Arizona is uniquely positioned to take advantage of much of this. It’s already among the favorite destinations of entrepreneurs fleeing more hostile business environments. However, further policy reforms are needed for the state to continue to compete with other states in that tier over the long term.

Personal income tax reform should be a key part of that approach. Governor Ducey’s budget proposal includes a placeholder for substantial net tax cuts over the next two years, but no substantive detail about what those reforms should look like, leaving those to state legislators. As the state legislature considers tax reform proposals during the budget process, it’s critical to keep in mind what tax policy principles have the most salience in the new post-pandemic world in which we live.

It’s also important to realize that most businesses in Arizona (mainly small and medium in size) pay their tax bill every year through the personal income tax system. According to U.S. Census Bureau data, “pass through businesses” - sole proprietorships, S-corporations, and joint partnerships - make up over 70% of the total number of private businesses in the state and around half of all private-sector employment. As such, the quality of the personal income tax system - both in terms of the tax rate as well as how that system treats income growth - can have a significant impact on job creation by employers as well as the economic well-being of the workers who earn a paycheck in those jobs. 

What follows is a guide to important principles that should be kept in mind as legislators deliberate. There are some proposals here too. They are meant to be a guide but not a comprehensive list or an attempt to model or estimate the revenue or economic impacts of each. Additionally, the items below are directed at weighing the costs and benefits of changes specifically to the personal income tax system in Arizona. Reforms to other taxes could also benefit by measuring them against the principles outlined here. 

Principle 1: Pursue the Path of Least Distortion

Taxes by their nature are distortionary - taxed activities are comparatively more expensive to embark on than non-taxed activities and, consequently, you should expect less of those activities in a world where it is taxed than one in which it is not. Meanwhile, taxes are needed to fund important government functions. So, although some amount of tax distortions need to be tolerated, minimizing those distortions as much as possible is desirable and necessary at least because of the competition between states to attract workers, businesses, and investment.

Two factors to consider during any tax reform is what activity is taxed and the rate at which that activity is taxed. The rate at which something is taxed is a fairly straightforward concept to comprehend: simply put, what percentage-rate will the government apply? The “base” for taxation is a bit trickier. When thinking about the base of activities that can be subjected to a tax, the answer can be either taxing the earning of income, the spending of income, or a combination of both. Most states, including Arizona, have opted to focus on a hybrid system that taxes a bit of both - income through the personal and corporate income tax system (and, relatedly, at the local level through property taxes) and taxing consumption through a sales tax.

A general consensus among economists is that consumption taxes achieve the standard of being the least distortionary (or “neutral,” as the tax economist literature terms it). This is due to the fact that the nature of income taxation introduces a host of problems, including difficult-to-implement definitions of income and the presence of double taxation of streams of investment. To put it another way, taxing a dollar at the point it is taken out of the economy (what is consumed) is preferable to taxing it when that dollar is put into the economy (when is earned and then saved or invested).

How tax treatment changes over the life-cycle of a business is also important. As workers and employers generate wealth, they are greeted with higher marginal tax rates in Arizona in each bracket. This is by definition a non-neutral treatment of income and one that can have the effect of suppressing business growth as businesses in the state become more successful.

There is another reason to believe this principle may be more important than in years past: Because the origin of income may be slowly moving away from the location of the worker earning it, effectively defining in-state taxable income for both businesses and workers may be a long-term challenge.

Principle 2: Remain Competitive

States are competing with other states as well as entire nations for both institutional and individual talent - entrepreneurs, workers, citizens, and businesses. Therefore, maintaining a competitive tax policy - one that adheres to standards that avoid distorting or suppressing economic growth - is important. There are many things a state legislature cannot change about a state’s “business climate” - like the actual meteorological climate, for instance. Tax policy, however, is one thing they can have a direct control over.

The form that such tax competition takes can be significant. Tax preferences in which governments pick who gets the favors, or subsidies and tax credits that function in the same way, are not the correct answer. This is especially true in an economy where it becomes increasingly hard to predict (assuming it could be done accurately at all in the first place, which is a very debatable notion) the form the workforce and future business models will take. The politically-influenced and arbitrarily targeted strategy of tax favoritism has even less justification in a post-pandemic world.

Tax rates matter as well. Tax rates that are unusually high compared to competing states can deter those considering a move here. Additionally, it can have the effect of penalizing local businesses that are hoping to expand (more on why that is later). Therefore, the best strategy to remain competitive in tax policy is to focus on broad-based tax reforms that restrict or forbid ability of state and local government to meddle in the decision-making process of a family or business.

Principle 3: Maintain Stability

Stability in tax policy is also important. The most common form of stability in this area is “revenue stability.” This implies that tax revenues which are the least volatile can allow greater ability for state legislatures to plan ahead with greater confidence. Some of that is managed on the budgetary side of the ledger (through “rainy day” funds and expenditure growth limitations), but a large part of it can also be managed through the choice of revenue streams for a state. To that end, the most stable revenue source should be favored. Empirical research over decades has shown this to be taxes on consumption (like sales taxes or income taxes that have the attributes of consumption taxes). Income taxes - particularly corporate income taxes - tend to be sensitive to business cycles whereas sales taxes tend to be more stable.

The rates applied to income taxation also have an influence here. Higher rates, particularly when they apply to higher brackets, tend to be less stable. That’s because they can drives away people, deter others from moving to a state, and can also encourage excessive tax-planning maneuvers aimed at avoiding taxes instead of creating value for the economy. Business cycles, which are typically unavoidable in the course of a normal decade, can also lead to volatility in income tax systems that have high rates and steeply-graduated tax brackets because of  businesses and individuals with higher incomes falling into lower tax brackets during recessions. Finally, higher rates also have the effect of decreasing a states’ competitiveness relative to other states with lower tax rates.

Note that this doesn’t necessarily imply “revenue neutrality.” That is when the new tax system raises the same amount of money as the current one. A legitimate part of the discussion around tax reform should indeed address the question of whether the actual amount of tax collected is too high.

Policymakers should be conscious of the importance of what can be called “policy stability” as well. Changes that are seen as temporary will not have the impact desired because they will not lead to long-term investments. Most of the impact from temporary tax rate cuts will usually just move forward economic activity that would have occurred anyway, creating a short-term illusion economic growth, but one that is fleeting. Federal tax changes can also mean that a business can take advantage of one important tax provision one year but be made worse off the next year if that provision hasn’t been codified permanently in Arizona statute.

Tax Reform Proposals

No tax system is ever perfect and it’s also unlikely, due to the nature of political systems, that a textbook-perfect tax system would be enacted or survive for very long if it were. Instead, reforms that move the general contours of a tax system toward satisfying the relevant principals stated here should be preferred.

As a general guide, the type of income tax reforms that satisfy these principals to the greatest realistic degree possible are those that strive for the lowest tax rates possible over the flattest (most neutral) bracket structure possible with a tax base that is not biased against investment or sensitive to unpredictable changes in economic realities.

A number of personal income tax reform proposals could move the current Arizona personal income tax system in the right direction:

• “Flattening” and widening tax brackets. State reforms have moved in this direction recently. The changes enacted in Arizona in 2019 reduced the number of state tax brackets from five to four. Those brackets also became “wider” by allowing the earning of more income before the next highest rate applies. Movement further in this direction should entail another reduction of the number of brackets, with a goal of bringing it to one or two-brackets eventually.
• Lowering tax rates. The 2019 reforms also reduced the rate in the low-to-middle tax brackets. Not only would further reduction in the rates in all brackets make Arizona more competitive but it could unlock a substantial amount of investment and business creation, both from out of state businesses moving here as well as encouraging the growth of those native to Arizona. This is in large part because most businesses (and therefore responsible for a large share of private employment in the state) are small- and medium-sized businesses, and many of those businesses are incorporated in such a way that they pay their taxes through the personal income tax system. Lowering rates, either across-the-board (which is preferable to avoid distortions) or in most brackets would help the largest number of both workers and employers. An alternative approach would be rate cuts coupled with a reduction in the number of brackets thereby resulting in a net tax cut. This could provide the biggest economic benefit than just one of these policies enacted in isolation.
• Removing bias against investment. An important part of redefining the tax base to be more friendly to economic growth is removing layers of double taxation on investment and savings activity. Therefore, removing the tax barrier to investments by business (like the existing “instant expensing” provisions which allows businesses below a certain size to immediately subtract new equipment and business investments from their taxable income in the year those investments are made) and investments by individuals (through increasing tax exemptions for capital gains income) should be an important policy goal. Arizona has made strides in both of these areas over the past few years, but going further would be advisable. Making these features a permanent part of the state tax code is essential (particularly with regard to the instant expensing provision which has its roots in federal tax law and for the sake of stability should be embedded directly in state tax law instead to avoid possible federal revocation of this provision in the future.)

These reform proposals can increase the potential for new business creation in Arizona. They can address both the short-term reality of businesses clawing their way out of an economic hole and the long-term market reality that have been precipitated by the pandemic. Finally, they can help make the state an attractive destination for entrepreneurs and workers by lowering the penalty to job creation and investment.

Arizona can leverage its current position of opening the door to both new residents and new homegrown businesses alike. It’s a goal that the state has pursued more recently in the form of innovative licensing reforms. That goal should be integrated into the state’s approach to tax policy as well.