Flat Income Tax Proposal for Arizona: Another Shift in Tax Burden From High- to Low- and Middle-Income Households

By Alberta H. Charney, Ph.D.
Research Director, Economic and Business Research Center

Introduction

A flat income tax bill was proposed during the 2011 Arizona legislative session and, although the measure failed, some version of a flat tax bill is expected to be back during the 2012 legislative session. A flat tax imposes the identical tax rate on all taxpayers, regardless of income and personal circumstances. This is in contrast to the existing increasing block rate structure that taxes higher income taxpayers at higher rates and lower income taxpayers at lower rates. This article assesses the impacts of the proposed 2011 flat tax bill. Although the flat tax bill anticipated to be presented in 2012 may be somewhat different, any flat tax bill if passed will cut income taxes for highest-income Arizonans and substantially shift tax burden to low-and middle-income households. Such a shift will most certainly dampen economic activity in Arizona through reduced demand.

Existing Structure

Arizona’s current income tax structure can best be described as a progressive block rate structure. After deductions and exemptions are subtracted, the remaining taxable income is taxed at higher rates for each incremental block of income. Single taxpayers are taxed at the following rates:

2.59% on the first $10,000 of taxable income
2.88% on the next $15,000 of taxable income
3.36% on the next $25,000 of taxable income
4.24% on the next $100,000 of taxable income
4.54% of taxable income over $150,000

For married couples filing jointly, the same rates apply, but the income ranges double ($20,000 to $300,000).

Arizona’s Tax Structure Has Been Getting Flatter

Arizona’s rate structure has been getting flatter for the past 20 years. Since 1990, there were seven income tax cuts that have both reduced total revenue and shifted relative tax burden from high-income individuals to low- and middle-income individuals. In 1990, the income blocks were as described above, but the rates were 3.8%, 4.4%, 5.25%, 6.5% and 7%.

Through seven different tax cuts, each of the rates was cut by a total of approximately 35%, resulting in the current rates shown above. Cutting each rate by the same percentage had the effect of reducing the rates for the highest brackets more than the bottom rates were reduced. The highest 1990 rate was reduced 35% from 7% to 4.54%, a reduction of 2.46 percentage points in the rate. The lowest 1990 rate was also reduced approximately 35% from 3.8% to 2.59%, a reduction in the tax rate of 1.21 percentage points. The rate cut for those in the highest bracket was more than double for those in the lowest bracket.

Each of the seven cuts since 1990 shift some of the tax burden from the highest-income groups to low- and middle-income groups for a given amount of taxes collected. The proposed flat tax reduces the rate to a flat 2.13% for all groups. In order to maintain an equal amount of revenue, this relatively low tax rate is accomplished by eliminating exemptions, many deductions, exclusions, etc., which results in a massive shift of the income tax burden from high- to low- and middle-income households.

Winners and Losers

The Arizona Department of Revenue computed the taxes that will be paid by each income group under the flat tax and compared them to taxes paid under the current tax structure (Table 1). The DOR calculations are available on the Joint Legislative Budget Committee’s website at http://www.azleg.gov/legtext/50leg/1r/fiscal/hb2636.doc.pdf. The impact is based on DOR’s estimated 2011 tax liability for residential filers. Additional computations were made by the author.

Based on these figures, 88% of Arizona taxpayers will pay more in taxes with the flat tax and 12% will receive tax cuts. Almost $400 million in tax burden ($395.7 million, the sum of the tax increase above the line) will be shifted from taxpayers with Federally Adjusted Gross Incomes (FAGI) above $100,000 to those with FAGI below $100,000. Taxpayers with FAGI above $100,000 will receive an average tax decrease of 27% while those with FAGI below $100,000 will see an average tax increase of 43%.

Taxpayers in the very lowest bracket (under $10,000 in FAGI) will pay almost $57 million more than their current liabilities, an increase of more than 9,000 percent!

Exemptions and Deductions Lost

The following is a list of exemptions and deductions that can no longer be subtracted from FAGI to get to Arizona’s taxable income:

• Personal exemptions and exemptions for dependents
• Exemptions for the blind and elderly
• Military pay exemption and $2500 military pension exemption
• Standard deduction
• Itemized deductions, including:
  • Charitable contributions
  • Mortgage interest deductions
  • Moving expenses deductions
  • Un-reimbursed medical expenses

Fairness in Taxation

A common argument for applying the same tax rate to all income brackets is that it is “unfair” to tax higher incomes at higher rates and lower incomes at lower rates. But fairness is something that should be evaluated on the basis of Arizona’s tax structure as a whole - not on the basis of a single tax.

Arizona relies very heavily on the sales tax, which is widely considered a “regressive” tax, meaning the share of income paid is lowest for highest income individuals and highest for low income individuals. In Fiscal Year 2010, before the addition of the temporary sales tax, sales taxes comprised 56% of the state’s general fund and income taxes represented only 36% of general fund receipts. A major reason why income tax rates are “progressive” is to offset the regressive nature of other state taxes, especially the sales tax.

Many of the changes in Arizona’s tax structure since 1990 have had the effect of shifting the relative burden of state tax collections from the highest income groups to low- and middle-income groups, specifically, the repeal of the estate tax in 2006, the increased reliance on sales taxes, the reduced reliance on income taxes, and the repeated flattening of the income tax.

Macroeconomic Effects of the Shift in Tax Burden

During the recession of 2001, Peter Orszag (former Head of the Office of Management and Budget) and Joseph Stiglitz (a Nobel Prize winning economist) released a policy paper entitled “Budget Cuts vs. Tax Increases at the State Level: Is One More Counter-Productive than the Other During a Recession?” Recognizing that both general tax increases and spending cuts can have detrimental effects on the state economy, they concluded that as long as the economy is suffering from insufficient aggregate demand, then “if anything, tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits...”

The converse is also true. Shifting tax burden from high-income households to low- and middle-income households will have negative consequences on the state’s economy by reducing aggregate demand. During weak economic conditions, reducing aggregate demand will have a negative impact on jobs as low- and middle-income households have to reduce spending in order to pay the increase in taxes. Low- and middle-income households already spend almost all of the money they earn; high income families can save a portion. When taxes are raised on lower income taxpayers, they must pay for the tax by cutting spending and the corresponding tax cut for high-income individuals is likely to result in offsetting spending increases. As a result, as tax burden is shifted from the highest to the lower income groups, aggregate demand (total spending) in the state decreases.

The Myth of Flat Taxes and State Growth

Having a flat tax does not guarantee a healthy state economy nor does it indemnify a state from severe economic downturns and recessions. Some of the worst performers during the 2004-2009 period (most recent BEA data) had flat taxes throughout the period, e.g., Michigan (-7.14% employment growth), Indiana (-2.05%), Illinois (0.26%), Tennessee (0.56%), Pennsylvania (1.66%), and Massachusetts (2.16%)..... compared to Arizona’s (5.85%) and the US as a whole (2.83%). The only state with a flat tax during this period that grew faster than Arizona was Colorado (6.67%).

Conclusion

The proposed flat tax will shift almost $400 million in tax burden from taxpayers making over $100,000 to taxpayers making less than that. The shifting of tax burden to low- and middle-income households will have a dampening effect on total demand and hence on economic activity in Arizona.

For additional information, please contact the Economic and Business Research Center.