Arizona's income tax rates are capped at 4.5%, headed lower

July 12, 2021

Arizona’s newly passed budget reduces the top rate for high-income taxpayers from 8% to, eventually, a flat 2.5%, and counters the impact of the Prop. 208 surtax.

On June 30, Arizona Gov. Doug Ducey signed legislation, passed by House and Senate Republicans on party-line votes, that, according to a Governor’s Office statement, “paves the way for the largest tax cut in state history.”

The new law provides a maximum tax rate of 4.5% (the state’s current top tax bracket) and, by year three, replaces the state’s four income tax rates (ranging from 2.59% to 4.5%) with a flat tax rate of 2.5% for most taxpayers.

According to legislative budget analysts, the average Arizonan earning between $75,000 and $100,000 will save $231 a year in state income taxes, while taxpayers earning between $500,000 and $1 million a year will save more than $12,000.

Small Business Tax.

Specific to business owners, on July 9 Ducey signed SB 1783, which lets taxpayers exclude pass-through business income from their total individual income. Business owners who elect that option will instead pay a flat “alternate small business income tax” that will phase in as follows:

3.5% in 2021
3% in 2022
2.8% in 2023 and 2024
2.5% in 2025 and thereafter.

Additional Tax Savings.

The new law also reduces commercial property taxes by 10%; increases the homeowner’s rebate, with the state covering half of homeowners’ primary property taxes; and spares military veterans from paying state income taxes on their retirement benefits, which is estimated to save the average veteran $650 a year.

Response to Prop. 208 Surtax.

Ducey and Republican legislators pursued the tax reduction to, in part, counter a tax increase stemming from Proposition 208, which Arizona voters approved in November. That ballot measure calls for a 3.5% surtax on earnings above $250,000 for single filers and businesses, with revenues targeted for public education funding.

The Prop. 208 surtax, combined with Arizona’s existing 4.5% top income tax rate, produced a combined top rate of 8%. For many high-income taxpayers – businesses and individuals – that represented a 77% state income tax hike.

In commenting on the tax cut legislation, Ducey stated that the state’s budget includes increased investment in K-12 education, and that the tax cut signed on June 30 “does not impact or reduce any K-12 dollars, including those approved by voters in 2020.” The estimated $827 million a year in new school funding will come from the General Fund, which will impact other state programs.

However, the alternate small business income tax that the Governor signed on July 9 may cut as much as $292 million from the education funding called for in Prop. 208, and backers of that initiative have indicated that they will try to address the cut through another initiative on the 2022 general election ballot.

Calculated Gamble.

According to a Ducey aide quoted in the

Washington Post,

the tax cuts are estimated to result in revenue losses of about $1.7 billion over three years – 4% to 5% of state revenue – but Ducey and legislative Republicans are counting on those losses being offset at least in part by economic growth that (a) would have been forfeited if the Prop. 208 surtax had remained in effect and (b) will occur as a result of business formation and in-migration attributable to the state’s lower tax rate.

Supporters of the tax-cut legislation noted that, of Arizona’s neighboring states, only California, at 9.3%, has a higher state income tax rate. A

Post

editorial noted that high-income Californians “would save thousands of dollars in taxes a year by moving across the Colorado River, and they would likely pay much less for a house, too. In the post-pandemic age of working from home, that difference could turn what is already a migration flood into a tidal wave.”