Arizona Legislature

Joint Task Force on Income Tax Reform

Final Report December 20, 2013

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Joint Task Force on Income Tax Reform

Overview

Members

Senator Steve Yarbrough, Co-Chair

Representative J.D. Mesnard, Co-Chair

Senator Kelli Ward, Legislative Member

Senator Steve Farley, Legislative Member

Representative Debbie Lesko, Legislative Member

Representative Eric Meyer, Legislative Member

Mr. Kevin McCarthy, President, Arizona Tax Research Association

Mr. Farrell Quinlan, Arizona State Director, National Federation of Independent Business

Ms. Aimee Rigler, Executive Director, Small Business Alliance

Mr. Barry Broome, President and CEO, Greater Phoenix Economic Council

Mr. Stephen Slivinski, Senior Economist, Goldwater Institute

Ms. Peggy Ullman, CPA, Ullman and Company, P.C.

Mr. Jim Rounds, Economist, Senior Vice President, Elliott D. Pollack and Company

Establishment

The Task Force was established by a Senate President and Speaker of the House appointment on

August 15, 2013.

Committee Charge

To enhance Arizona’s business friendly profile and to make our tax system fairer for the average

taxpayer. The Task Force will explore ways of reforming Arizona’s existing personal income tax

system in order to create a simple, predictable, and transparent system for all Arizona taxpayers.

Requirements

Submit a report to the President of the Senate and the Speaker of the House of Representatives on or

before December 31, 2013.

Public Meetings

The Joint Task Force on Income Tax Reform held seven public meetings between August 21, 2013 and

December 12, 2013. Proceedings of these meetings were recorded for the public and original minutes,

attachments and audio are on file in the Office of the Chief Clerk and Senate Resource Center; video

archives are available at http://www.azleg.gov.

Joint Task Force on Income Tax Reform Meetings

August 21, 2013, Minutes – Attachment 2 November 7, 2013, Minutes – Attachment 6

September 4, 2013, Minutes – Attachment 3 November 21, 2013, Minutes – Attachment 7

September 19, 2013, Minutes – Attachment 4 December 12, 2013, Minutes – Attachment 8

October 17, 2013, Minutes – Attachment 5

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Report and Recommendations

The Joint Task Force on Income Tax Reform approved the following report, which includes

observations, findings and recommendations, after hearing numerous presentations from tax and

revenue experts and completing its deliberations during the legislative interim period of 2013.

Observations & Findings

The Task Force acknowledges that the Arizona Individual Income Tax (IIT) system is not “broken,”

however all systems can be improved. The Task Force set out to take stock of the current Arizona IIT

system and assess how it compares to IIT systems in other states as well as to federal tax policies.

Ultimately the Tax Force directed its focus on short term and long term changes that embody good tax

policy: simplicity, fairness, neutrality, competitiveness, and stability. The Task Force arrived at the

following Observations and Findings:

General Income Tax Info:

According to the Joint Legislative Budget Committee (JLBC), the State of Arizona generated

approximately $3.4B in IIT revenues in FY 13, accounting for approximately 35% of General Fund

(GF) revenues, making it the second largest revenue source to the GF.

IIT is collected from individuals, estates, trusts, and owners of pass-through entities which include

sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations. Changes

in IIT statutes affect small businesses as well as individuals.

A pure flat tax system requires everyone to pay the same tax rate on earned taxable income and

eliminates all deductions, exemptions, and tax credits (see Fig. 1). A single-rate system requires

everyone to pay the same rate on taxable income but retains certain deductions, exemptions, and

tax credits.

Arizona in Comparison:

Currently 7 states have no IIT, 7 states have a single-rate IIT, and 35 states, including Arizona,

have a graduated-rate IIT (see Fig. 5). No state currently has a pure flat tax system.

The current graduated tax rate system in Arizona ranges from 2.59% to 4.54%, which is lower than

average in comparison to other states. According to data provided by Stephen Slivinski, Chief

Economist of the Goldwater Institute, Arizona ranks 41st in the IIT burden rankings.

Other states are moving on IIT reform. North Carolina passed the Tax Simplification and

Reduction Act of 2013 which adopts a single-rate IIT system with a rate of 5.75%, conforms state

statute to federal law, repeals state exemptions, deductions, and credits, and expands the sales tax

base. Utah adopted legislation enacting a single-rate IIT system in 2007 and maintained

progressivity by including a phase out of tax deductions and credits as income increases. The Utah

legislation was in the context of a multi-year effort and broader tax reform which made changes to

sales tax, corporate and other business taxes.

Volatility:

IIT is the most volatile revenue source of a significant scale. Although corporate income tax is

more volatile, it accounts for a much lower percentage of GF revenue (approximately 8%) than IIT.

Volatility in IIT is driven by federal tax law changes, the nature of capital gains, and the response

of current rate schedules to economic activity, among other factors. Reliance on a more volatile

revenue source increases the risk of forecast errors and complicates long term financial planning

for the state.

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Based on information from Stephen Slivinski, Chief Economist of the Goldwater Institute,

graduated-rate systems may be more volatile than single-rate systems.

Simplicity and Predictability:

Currently, a number of calculations are required to determine a taxpayer’s tax liability and tax due.

A taxpayer begins with his gross income less federal subtractions to arrive at his Federal Adjusted

Gross Income (FAGI). The taxpayer then adjusts his FAGI to account for any Arizona additions,

subtractions, and exemptions to arrive at his Arizona Adjusted Gross Income. Next, the taxpayer

subtracts standard and itemized deductions and personal exemptions to arrive at his actual taxable

income. The taxpayer applies the correct tax rates from the graduated-rate schedule to his taxable

income and then subtracts any tax credits to finally arrive at the amount of tax due. The Arizona

IIT base and rates vary in comparison to the federal system, thus adding complexity to taxpayer IIT

filing.

Conforming to changes in federal tax code passed by Congress could streamline the process but

may also have a financial impact on the state, depending on the timing of the proposals and the

concurrent financial health of the GF. Adoption of provisions also requires the state to make

estimates on conformity provisions that may not materialize, and thus can create uncertainty

regarding the impact on the GF.

Data Analysis Issues:

The Arizona Department of Revenue (DOR) received more than 2.6 million IIT returns and

performed approximately 65,000 IIT audits in FY13. Over 95% of IIT audits were directly linked

to federal information received from the Internal Revenue Service (IRS).

DOR is limited in the amount of data it receives and generates. E-file and 2D bar code returns

provide more data than paper returns. DOR receives data from the IRS two years after a given tax

year; therefore DOR will not receive full data on tax year 2013 until the fall of 2015. Furthermore,

due to limited resources, the current DOR IIT model, which is used to simulate changes in federal

law and changes/proposed changes in state law, contains data from tax year 2006 grown to

represent tax year 2013. The model also represents a sample size of 60,000, which creates

additional challenges because of tax changes enacted between tax years 2006 and 2013, potentially

causing inaccurate projections. Additionally, projections can be skewed because of changes in

taxpayer behavior due to changes in the economy.

Miscellaneous:

The Task Force reviewed the Marketplace Fairness Act (MFA), federal legislation currently before

Congress that enables states to collect sales tax on remote sales. The MFA, if passed in its current

form, would require states to simplify their tax laws in compliance with guidelines under the law.

Arizona does not currently comply with MFA guidelines, most notably in the area of the state sales

tax base. The MFA requires a uniform tax base throughout the state and Arizona currently has

different tax bases at the city versus state level, as well as tiered rates used by cities. JLBC

presented data from the University of Tennessee study estimating the share of revenue from the

MFA to Arizona’s GF at $190 million, while another study projected total Arizona state and local

revenue gain to be only $98 million. JLBC emphasized that at this point it is difficult to predict

Arizona’s potential revenue gain from the MFA due to uncertainty in the final law provisions,

Arizona’s compliance under the MFA guidelines, non-compliance of taxpayers, and specifics

related to the data relied upon by the outside studies. JLBC indicated that they have agreed to

collaborate with the Executive to compile an appropriate state forecast of revenue changes should

the MFA be adopted.

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Any adjustment to the Arizona IIT system will have a financial impact. Fig. 1 demonstrates the

impact of a pure flat tax on the GF and assumes a flat tax rate of 2.13% and eliminates any

additions, subtractions, exemptions, deductions, and the family tax credit while retaining any

federally required subtractions and nonconformity adjustments. This model results in an increase in

tax liability for those earning less than $100,000 annually and a decrease in tax liability for those

earning more than this amount. The Task Force acknowledged that moving to the pure flat tax

system represented by Fig. 1 would result in a significant “winners and losers problem” where

some taxpayers experience substantial decreased tax liability while others experience increased tax

liability. To remain revenue neutral, the winner/loser problem may be overcome by GF monies,

which would either be lost or replaced with an alternative source of revenue, such as the MFA. Fig.

2 assumes a flat tax rate of 4.13% while retaining both personal and dependent exemptions, and

some deductions. The personal exemption for a tax filer as well as each dependent exemption is

based on the federal poverty level of $11,490. The majority of taxpayers would see a reduction in

their tax liability, with the exception of those with negative FAGI and those earning between

$100,000 and $1 million. Fig. 2, as compared to Figs. 3 and 4, reflect various reductions in GF

revenues (Note: Figs. 1 - 4 are for illustrative purposes only and are NOT representative of any

explicit or implied recommendation by the Task Force).

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Conclusions & Recommendations

The Task Force:

Determines that the principles of good tax policy include simplicity, fairness, neutrality,

competitiveness, and stability.

Believes that the pursuit of good tax policy is a continuous endeavor.

Acknowledges that good tax policy faces both financial and political constraints.

Suggests the state seek improvements to Arizona’s IIT system through a two pronged approach of

specific and comprehensive changes. Specific changes are those which the state can implement now to

improve our current IIT system. Comprehensive changes are those which may occur over the long-

term, as a dependent of Congressional action and/or as part of broader tax reform (that is, taking into

consideration other tax revenue areas) to improve and stabilize our overall tax structure.

Specific Legislative Income Tax Changes for 2014 Legislative Session

Permanently increase instant expensing allowance to $500,000. The expensing provision would

allow the cost of qualifying property to be treated as an expense rather than a capital

expenditure and would apply to qualifying business equipment as defined in IRC § 179. The

applicable investment ceiling limit would be $2,000,000. Thus, the expensing limit would be

reduced dollar for dollar by the cost of qualified property placed in service during the tax year

in excess of $2,000,000.

Permanently increase bonus depreciation allowance to 50% to match the current federal

allowance for future tax years for new equipment that is purchased and put into service the

same tax year the deduction is taken, which helps small businesses and therefore increases

economic competitiveness.

Index income tax brackets for inflation. Arizona Revised Statutes § 43-1011 prescribes taxable

income dollar amounts and rates for single and joint filers and does not account for inflation.

Increases in income due to inflationary causes may move a taxpayer to a higher tax bracket,

effectively causing a tax increase but without any real economic activity to show for. The tax

increase devalues the income for both small businesses and individual tax filers. Fig. 5

demonstrates the number of other states that currently index their tax brackets for inflation. An

adjusted tax bracket reflecting changes in the Metropolitan Phoenix Consumer Price Index

would increase fairness in the state IIT system by eliminating the annual inflationary tax

increase upon small businesses and individual tax filers created by the current tax code.

Reduce the IIT graduated-rate system from five to three income brackets, as illustrated by Fig.

6. However, the effective date must be delayed until one year after the current tax brackets

have been indexed for inflation. The delay will allow the inflation adjustment to compensate

for any minimal liability increase that may result from the reduction of the number of tax

brackets. This change will thereby increase the fairness and simplicity of Arizona’s IIT system.

Allow businesses to E-file income tax returns with DOR. All IIT tax returns may be filed

electronically with DOR, however corporations are not currently able to E-file. Although the

Task Force focused on IIT, E-filing across the board will promote fairness and simplicity

amongst all taxpayers while increasing DOR efficiency.

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Reduce audit period from four years to three years. Currently, DOR has four years from the

date a tax return is filed in which to audit and notify a taxpayer of tax adjustments. The task

force recommends modifying the current audit period to three years for all notices of taxes due

regarding IIT adjustments that are not based on federal information in the interest of fairness

and simplification. Although the Task Force acknowledges the benefit of requiring a three-year

audit period for all state audits, DOR does not receive federal taxpayer information until two

years after the year a return is filed. Since over 95% of income tax audits are performed based

on discrepancies between federal tax information and state income tax returns, the Task Force

recommends DOR adopt a three-year audit period for errors that are based on state-level data

only.

Provide DOR with resources to build an up-to-date, sophisticated IIT model. The current DOR

IIT model contains data from tax year 2006 grown out to tax year 2013. An up-to-date,

sophisticated model would provide greater information and guidance to the Legislature when

considering further tax reforms, thus increasing competitiveness and stability.

Repeal the following obsolete tax statutes, which are all transitional provisions of the 1978

Arizona Income Tax Act:

A.R.S. § 43-1021 (4) and § 43-1022 (8)

o Provide different treatment of pensions where the first payment was received

prior to December 31, 1978.

A.R.S. § 43-1021 (7) and § 43-1022 (11)

o Provide a different basis of property held for the production of income and

which is sold or otherwise disposed of during the taxable year, except

depreciable property used in a trade or business.

A.R.S. § 43-1022 (4)

o Provides a subtraction for certain amounts distributed from an IRA or retirement

plan of a self-employed individual to the extent that the total amount subtracted

in all tax years does not exceed the total of all plan contributions made by the

taxpayer prior to December 31, 1975.

Comprehensive Legislative Income Tax Changes for Future Consideration

The Task Force recommends that the current graduated-rate income tax model move towards a

single-rate model. Adopting a single-rate tax system increases simplicity, fairness, neutrality,

competitiveness, and the stability of Arizona’s IIT system. Other economically competitive

states are currently moving in this direction. A single-rate model reflects the principles of good

tax policy more so than the graduated-rate system, however the Task Force recognizes that

political and financial constraints currently make transitioning to a single-rate a challenge.

The Task Force recommends the Legislature pursue a successor task force in order to

comprehensively review all tax revenue sources and monitor upcoming Congressional action

relating to the MFA. Potential revenues generated from the MFA or other sources may reduce

the overall income tax rate or rates and offset the “winners and losers” constraint of tax reform

(compare Fig. 2 to Figs. 3 and 4). Additionally, any increases in tax collections due to tax

reform should be offset with commensurate tax decreases. The successor task force should also

continue discourse regarding comprehensive tax reform and a single-rate IIT system.

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Figure 1

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Figure 2

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Figure 3

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Figure 4

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Figure 5

11 states with multiple brackets fully index their brackets to inflation

o Idaho, Montana, North Dakota, Minnesota, Iowa, Wisconsin, Arkansas, South Carolina, Vermont, Maine, and Rhode

Island

1 state with multiple brackets indexes temporarily

o New York

2 states with multiple brackets partially index their brackets

o California and Oregon

20 states (plus D.C.) with multiple brackets do not index

o Arizona, New Mexico, Nebraska, Kansas, Oklahoma, Missouri, Louisiana, Mississippi, Alabama, Georgia, Ohio,

Kentucky, West Virginia, Virginia, North Carolina, Connecticut, New Jersey, Delaware, Maryland, and Hawaii

7 states have no income tax

o Alaska, Washington, Nevada, Wyoming, South Dakota, Texas, and Florida

7 states have a single-rate tax

o Utah, Colorado, Michigan, Illinois, Indiana, Pennsylvania, and Massachusetts

2 states have a single-rate tax on investment income only

o Tennessee and New Hampshire

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Figure 6

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Attachments

1. Charge of the Committee and Letters of Appointment

2. Agenda, Minutes, and Attachments for Meeting, August 21, 2013

3. Agenda, Minutes, and Attachments for Meeting, September 4, 2013

4. Agenda, Minutes, and Attachments for Meeting, September 19, 2013

5. Agenda, Minutes, and Attachments for Meeting, October 17, 2013

6. Agenda, Minutes, and Attachments for Meeting, November 7, 2013

7. Agenda, Minutes, and Attachments for Meeting, November 21, 2013

8. Agenda, Minutes, and Attachments for Meeting, December 12, 2013