Bumpy Road For Flat Tax Proposal Supporters Call It Fair, But Opponents Say It Raises Taxes On The Poor

Arizona Capitol Times
April 1, 2011
Luige del Puerto

With Republicans firmly in control of the Capitol, the proposal to flatten the state’s individual income tax enjoyed a renaissance of a sort this year, albeit a brief one.

It received approval in the House and it survived a committee hearing in the Senate.

It was only a couple of steps removed from landing on Gov. Jan Brewer’s desk when its sponsor announced on March 29 he was pulling the plug — for this session, anyway — because there wasn’t time to resolve concerns that some Republican legislators had with the proposal.

Many policymakers and economists have lauded the idea of a flat individual income tax. They argue that, since everybody would pay the same rate, it is inherently fair.

In addition, by requiring a uniform rate, the poor, the rich and those in the middle will have some ownership in the political life of the community, they said.

And since it simplifies the tax code by flattening the marginal income tax rate, it would help shield state revenues from wild fluctuations in the economy. A flat income tax, along with competitive business taxes, good quality of living, a skilled work force and other factors that make an economy sound, can also arguably attract high-income earners, they added.

But the bill is proving to be too drastic of a change to accomplish this year, in large part because the state’s economy is still struggling to emerge from the recession and state government is broke.

Its main goal — to achieve a fairer tax code — is turning out to be its biggest liability.

The problem, simply put, is that the bill isn’t building a tax code from scratch. A complicated tax system is already in place, with varying marginal rates coupled with exemptions, deductions and tax credits.

Arizona’s tax code is the result of years of incremental modifications that recognize one fact: While some earn similar income amounts and therefore belong to the same tax brackets, individual circumstances vary.

By its very nature, a flat tax upends tradition, and that’s partly why it’s encountering fierce resistance in some sectors.

But in addition to political hurdles, HB2636 also faced practical challenges.

As drafted, it would increase the taxes of almost everyone in Arizona — except the top earners.

A fiscal analysis of the legislation prepared by the Joint Legislative Budget Committee said anyone who earns less than $100,000 would pay more taxes, while those who earn more than $100,000 would pay less.

Also, among the worst hit are the poorest.

As amended, the bill proposes a flat individual income tax rate of 2.13 percent, which would be fully phased in by 2015. It would also eliminate itemized deductions, including medical expenses and charitable contributions, and, in 2015, repeal the income tax credit for low-income families.

But critics argued that it would increase taxes at a time when families are struggling to cope with the economic crisis, while at the same time it would favor people who can afford to pay taxes.

Some Republicans don’t mind taxing those who currently don’t pay any taxes.

They have always argued that something is wrong with a society where some sectors are constantly pushing for more programs, and therefore for more spending, while the recipients of those public services pay little or no income taxes at all.

Inevitably, this leads to a situation where the most productive in society increasingly shoulder the burden of providing those services, arguably penalizing people for being successful.

But even Sen. Ron Gould, a conservative Republican from Lake Havasu City, said that while he supports a flat tax, he’s not sure this year’s bill is the right way to do that.

“If a majority of people end up paying more tax than they do now, then the percentage is not right,” Gould said. “I’m not going to vote for something that increases the taxes on the majority of the people.”

Here lies the practical difficulty of implementing a flat tax.

The reason for pegging the marginal income tax rate to 2.13 percent is to ensure the bill is revenue neutral, and it needs to be revenue neutral in order to avoid triggering a constitutional provision that requires a two-thirds vote for any bill that results in a net increase in state revenues.

If the bill resulted in a net increase in state revenue, it would be attacked as a tax increase, something Republicans have perennially vowed to block. But if it resulted in less revenue, it would be chipping away at state resources at a time when Arizona is facing historic budget shortfalls.

In addition, it would be immediately attacked for giving tax cuts to the rich at the expense of core government services like education and health care.

Either path is laden with practical and political landmines.

A fairer system?

But supporters said the idea, at the very least, is meritorious.

It is not novel. Other states have successfully implemented a flat tax.

First off, the legislation has no impact on the state’s general fund, said Rep. Steve Court, R-Mesa, the sponsor of HB2636.

The Mesa Republican also said that, for those tax brackets that would see a tax hike, the average increase is less than $200 a year, which he characterized as “not a huge hit.”

But by lowering and flattening the tax rate, it becomes a fairer system.

“It takes away government’s involvement in incentivizing how you spend your money,” he said. “It’d also put everybody at a level playing field.”

The bill’s backers believe that the less government is involved in how people spend their cash the better it is for society.

For them, the current system is inherently unfair since a progressive tax structure cannot treat everybody equitably. Add to that the various exemptions and deductions, and it becomes even more inequitable.

The difficulties for Court’s proposal come from the fact that so much of politics is about taxation.

Levying taxes is a tool of government, and those taxes are often sold to taxpayers as necessary to fund specific endeavors or programs.

Sen. Steve Yarbrough, R-Chandler, chairman of the Senate Finance Committee, which approved the measure, said this practice has become a part of America’s DNA.

Yarbrough said this is also one of the reasons why hardcore believers in a flat tax are pushing for it — to get politicians out of the business of fiddling with the tax code.

Meanwhile, some economists have advocated for either a true flat tax or the elimination of individual income taxes as a way to stimulate economic growth.

A graduated income tax structure stifles economic development, some say, since many small business owners file as individual taxpayers.

“These graduated rates actually decrease the incentive to do certain types of business transactions if it’s going to put them up into the next higher bracket,” said Stephen Slivinski, an economist with the Goldwater Institute.

“The same thing goes for workers: It penalizes them basically for being more successful the further up they get,” he said.

Slivinski, however, emphasized that any discussion of a major tax policy change shouldn’t take place in a vacuum.

Kevin McCarthy, president of the Arizona Tax Research Association, said it’s good for society if people have a skin in the game — even if they contributed in small amounts.

“By accountability, you want to have a system where there is a strong link between the people paying taxes and the people they are electing to make decisions,” McCarthy said.

“When you eliminate tax liability from large swaths of Arizonans, who are in the mix, are voting for elected officials and are asking for more government services, there is a breakdown in terms of that important link and that accountability,” he added.

With deductions and personal exemptions, those who earn less than $10,000 in Arizona pay very little or no income taxes at all under the current tax code.

Flat line for flat tax

A flat tax is one of those subjects that perennially come up as a topic of discussion at the Capitol, but after all these years it has also perennially remained as such — a topic of discussion.

Court’s proposal has actually gone further than previous attempts.

The last time the Legislature seriously considered a flat tax was in 2009, when lawmakers and Brewer were negotiating the governor’s proposal to raise sales taxes by 1 cent as a way to help balance the budget. That proposal ultimately ended nowhere, as its supporters said it was too massive of a subject to tackle in such a short period.

Court said he’s confident he could get his bill out of the Senate, but there has been no feedback from Brewer’s office and he didn’t want to risk a veto.

In addition, Court said he also wants to take time to address some of the points raised by the accounting community and those who prepare taxes.

Some asked the Legislature to slow down and study in more detail the bill’s implications — particularly the elimination of deductions — before passing it.

Court said he would work on the legislation in the interim and then try again next year.

He maintained it was questions raised by some in the accounting community that led him to decide to hold off this year, but the decision also followed a harsh wave of criticism.

Critics have said there’s nothing fair about a proposal that raises the taxes for a majority of Arizonans during an economic downturn.

“In these times of financial hardship for so many working families, this is so wrong,” said Sen. Paula Aboud, D-Tucson. “This is an attack on working families that are struggling.”

Dana Naimark of the Children’s Action Alliance described the bill as a “shift in taxes from the rich to the middle, masquerading as tax simplification.”

In a written statement, Naimark quoted an analysis from the Institute on Taxation and Economic Policy on an earlier version of the bill — which used a slightly different tax rate — as saying Arizona households earning less than $152,000 would see a an average increase of $169 while households earning between $152,000 and $354,000 would get an average of decrease of $918.

Dennis Hoffman, an economist with Arizona State University’s W.P. Carey School of Business, said there are advantages to a flat tax and certainly some merit to considering it.

He said the state’s progressive income tax is far more volatile than a flat tax. The progressivity of the tax code allows the volatility of capital gains and high-worth incomes to “whipsaw” the state’s revenue collections.

Put another way, the state gets more revenue from high-income earners and capital gains during an economic boom — but those revenues quickly evaporate during a bust.

Hoffman said there are also ways to mitigate the proposal’s disadvantages, which include the inevitable shift in the tax burden away from top earners to middle and lower income earners.

“It’s easily mitigated, and it’s unfortunate that the authors of the legislation did not take any steps to mitigate this,” Hoffman said, adding one way to do it would be to institute a low-income exemption.

That means exempting from taxation the lowest income earners and proposing a higher flat tax rate — maybe somewhere between 3.5 and 4 percent — compared to the bill’s 2.13 percent.

That would yield a lot of the benefits of a flat tax while shielding people who are least capable of paying taxes, effectively delivering them “regressivity relief,” Hoffman said.