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Research & Commentary: Ignoring Federal Tax Conformity Would Cause a Tax Hike for Arizonans

July 2, 2018

In this Research & Commentary, Matthew Glans discusses how Arizona's tax system is effected by the recent federal tax reforms and how taxpayers could see a tax increase without action on how the state conforms with the federal tax code.

In the wake of the Tax Cuts and Jobs Act (TCJA), Arizona, like many states, is considering reforming its tax code. Unless the Grand Canyon State modifies its income tax code, the changes to the federal code under TCJA could create an inadvertent tax increase for Arizonans. This issue emerged because of Arizona’s policy of conformity with federal tax guidelines. Arizona is one of 19 states that conforms its state taxes to the Internal Revenue Code (IRC) on a “static” basis.  Simply put, Arizona must rewrite its tax code each year to ensure it aligns with changes in the federal code.

In April, Arizona lawmakers updated its state code so that it once again complies with the IRC. The new legislation maintains Arizona’s existing IRC conformity date for post-2017 corporate and personal income tax purposes, but changed the date for transaction privilege and use tax purposes. Unfortunately, the law did not adopt the changes in the new federal tax law that will go into effect in 2018.

Why would Arizona lawmakers vote against reforming the state code so that it fully confirms to the federal tax law? One simple reason: Arizona would raise more revenue. Arizona could collect roughly $236 million in additional revenue during fiscal year 2019, the first full year impacted by the change in federal law, according to a report from the Department of Revenue. Revenue could increase even further, to $286 million, in fiscal 2020.

Instead of changing the tax code each year, Arizona lawmakers should consider a “rolling” conformity model. Under a “rolling” format, the state would adopt federal tax changes in real time, which is the standard practice in 20 states. Conforming Arizona’s tax code to the federal code on a “rolling” basis has several benefits. For instance, filing tax returns would be easier for citizens and less complicated for the state’s Department of Revenue to process, reducing administrative costs.

Arizona has taken several steps to make its tax code more competitive over the past three years. In 2018, Arizona instituted a multiyear corporate income tax rate reduction, which improved the state’s corporate income tax ranking from 19th to13th, as calculated by the Tax Foundation. Gov. Doug Ducey (R) also signed a bill this year that will increase the state’s personal exemption and index the exemption to inflation.

The Tax Foundation argues there are several methods states can use to implement tax reform in response to the new federal tax code. For example, states could phase in reforms over time or create tax triggers to ensure adequate revenue exists to cover necessary budget items. Arizona has already implemented a phase-in for corporate tax rate changes, with surplus revenue being used to enact tax cuts.

If the state does not want to embrace “rolling” conformity, Arizona could also use contingent enactment clauses to allow for future reforms. These clauses permit changes to occur predicated on specific events, such as federal tax reform. This would allow the state to keep static conformity while maintaining agility in case of federal tax changes.

Providing a tax environment that encourages relocation, investment, and economic growth is essential for keeping Arizona competitive with its neighbors. Arizona ranked 21st in the Tax Foundation’s 2018 State Business Tax Climate Index, a study that compares states across multiple areas of taxation that impact businesses. Arizona’s ranking is lower than many of its neighboring states, including Wyoming (1st), Nevada (5th), Utah (8th), Texas (13th), and Colorado (18th). If Arizona wants to attract businesses and maintain a thriving economy, lawmakers ought to do three simple things: 1) institute “rolling” conformity, 2) simplify the tax code, 3) and reduce rates on personal and corporate income.

The following documents examine tax conformity in greater detail.
 

Ten Principles of State Fiscal Policy
https://www.heartland.org/publications-resources/publications/ten-principles-of-state-fiscal-policy?source=policybot
The Heartland Institute provides policymakers and civic and business leaders a highly condensed, easy-to-read guide to state fiscal policy principles. The principles range from “Above all else: Keep taxes low” to “Protect state employees from politics.”

Federal Tax Reform: The Impact on States
https://taxfoundation.org/federal-tax-reform-the-impact-on-states/
Nicole Kaeding and Kyle Pomerleau of the Tax Foundation examine the effect of federal tax reform on the states and how they can use the changes to push for tax reforms of their own.

Federal Tax Reform May Cost Arizona Taxpayers $200 Million More
https://www.azcentral.com/story/money/business/consumers/2018/01/16/federal-tax-reform-could-mean-arizonans-pay-200-m-more-state-taxes/1029560001/
Russ Wiles of the Arizona Republic discusses the possible effects of the federal tax reforms and how it could result in a tax hike for Arizona taxpayers if tax conformity isn’t addressed.

Tax Reform Moves to the States: State Revenue Implications and Reform Opportunities Following Federal Tax Reform
https://taxfoundation.org/state-conformity-federal-tax-reform/#9
In this paper by the Tax Foundation, Jared Walczak discusses the options available to states looking to make federal tax changes. “In the wake of federal tax reform, states have a golden opportunity to move their own tax codes in a more simple, neutral, and pro-growth direction,” wrote Walczak.

Rich States, Poor States
https://www.alec.org/publication/rich-states-poor-states-11th-edition/
The eleventh edition of this publication from the American Legislative Exchange Council and authors Arthur Laffer, Stephen Moore, and Jonathan Williams offers both individual-state and comparative accounts of the negative effects of income taxes.

State Tax Conformity: Revenue Effects
https://taxfoundation.org/state-tax-conformity-revenue-effects/
On this website, the Tax Foundation has catalogued the projected revenue impact of federal tax reform on each state.

The Historical Lessons of Lower Tax Rates
http://www.heritage.org/research/reports/2003/08/the-historical-lessons-of-lower-tax-rates  
Examining the historical results of income tax cuts, Daniel Mitchell of the Heritage Foundation finds a distinct pattern throughout American history: When tax rates are reduced, the economy's growth rate improves and living standards increase.

The U.S. Tax System: Who Really Pays?
https://www.manhattan-institute.org/html/us-tax-system-who-really-pays-5748.html
Writing for the Manhattan Institute, Stephen Moore examines popular conceptions and misconceptions about the impact of tax rates on economic productivity and fairness, addressing these statements and debunking attendant myths. He provides useful information on how the rich are taxed and how much they contribute.

The Historical Lessons of Lower Tax Rates
http://www.heritage.org/research/reports/2003/08/the-historical-lessons-of-lower-tax-rates  
Examining the historical results of income tax cuts, Daniel Mitchell of the Heritage Foundation finds a distinct pattern throughout American history: When tax rates are reduced, the economy's growth rate improves and living standards increase.

Policy Tip Sheet: Corporate Income Taxes
http://heartland.org/policy-documents/policy-tip-sheet-corporate-income-taxes
Taylor Smith examines corporate income taxes and their effects on economic development. Smith suggests how legislators can limit or eliminate their corporate taxes.

Balancing State Budgets the Smart Way
http://taxfoundation.org/article/balancing-state-budgets-smart-way
Joseph Henchman of the Tax Foundation examines an array of options states can use to remedy both short-term and long-term fiscal woes and put their budgets back on sounder legal footing.

 

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website, The Heartland Institute’s website, and PolicyBot, Heartland’s free online research database.

The Heartland Institute can send an expert to your state to testify or brief your caucus; host an event in your state, or send you further information on a topic. Please don’t hesitate to contact us if we can be of assistance! If you have any questions or comments, contact Lindsey Stroud, Heartland’s government relations manager, at lstroud@heartland.org or 757/354-8170.

Author
Matthew Glans joined the staff of The Heartland Institute in November 2007 as legislative specialist for insurance and finance. In 2012, Glans was named senior policy analyst.
mglans@heartland.org @HeartlandGR