Arkansas’s Sustainable Tax Reform: A Gift That Will Keep On Giving

Faced not only with immediate surpluses but with the expectation of sustained revenue growth in coming years, Arkansas policymakers have chosen to return some of the additional revenue to taxpayers in the form of individual and corporate income tax rate reductions, with additional rate cuts if future revenues permit.

Whenever a state has a short-term budget surplus—which many states do this year thanks, in part, to the one-time influx of federal COVID-19 relief funds—one of the worst things they can do is spend the windfall on a new long-term program. When short-term monies dry up, policymakers must look to the people for more money or abandon a program to which many have become accustomed. Drastically cutting state revenues through unsustainable tax reduction is effectively the same as enacting an unsustainable program—it is just spelled differently.

Arkansas’s fourth round of tax reforms is a case of tax reform done right. The state was in the enviable position of having a $946 million surplus from fiscal year 2021, a projected $263 million budget surplus in FY 2022, a $1.2 billion reserve, and full funding of essential obligations under the state’s Revenue Stabilization Act. Policymakers were right to think about how to best leverage those surpluses to maximize societal return, and to ensure that any tax relief adopted would be sustainable with projected longer-term revenue growth, not just short-term infusions.

Although Arkansas finished implementing its third individual income tax reform since 2015 at the beginning of the year, the state’s top individual income tax rate (5.9 percent) still ranked in the top half of all states that levy an income tax. Relative to the states next-door, Arkansas was an island. Each of its border states, except Louisiana, had a top individual income tax rate that was at least 0.5 percentage points lower and at most 5.9 percentage points lower than that of the Natural State. Missouri’s top rate was 5.4 percent; Mississippi and Oklahoma’s top rates were 5 percent; and Texas and Tennessee do not tax individual income.

Absent action from policymakers, the state’s position would have only worsened heading into 2022. Oklahoma’s top individual rate will decrease to 4.75 percent and its corporate tax rate will decrease to 4 percent. Louisiana’s top individual rate will be reduced from 6 percent to 4.25 percent. Additionally, Mississippi policymakers have signaled their intent to lower individual rates in the New Year. Arkansas policymakers were right to view their position with concern. They were also right to choose rate reductions that can be sustained due to the state’s own economic growth.

When Governor Asa Hutchinson (R) announced his plan on October 19 for a fourth tax reform, he prioritized three components: 1) consolidating the state’s low- and middle-income tax tables, 2) cutting the top marginal rate from 5.9 percent to 5.3 percent by January 1, 2023, and 3) increasing the low-income tax credit from $29 to $60 for everyone with a taxable income of less than $22,900. The plan was full of positive steps. But even though Arkansas ranked fifth relative to its neighbors’ corporate income taxes and was actively losing ground to Oklahoma, the governor’s announcement barely acknowledged the possibility of corporate income tax reductions.

With the completion of the legislature’s pre-Christmas special session, the good news for Arkansans is they are poised to enter the New Year even further ahead than under the governor’s October plan. Positive benefits would likely have accrued from standalone reductions to the top individual income tax rate. However, immediate individual income tax cuts supported by well-designed corporate income tax reform, revenue triggers, and inflation indexing will result in a more comprehensively neutral and pro-growth tax system than could have occurred by cutting individual rates alone.

The state’s two-front, revenue-based approach allows Arkansas to chart a responsible path to regional competitiveness while guarding against unforeseen economic downturns or inflation-related costs. If all the revenue triggers in the new law are enacted, Arkansas will no longer be an outlier in the region. Provided the state does not draw on its Catastrophic Reserve Fund between July 1, 2022 and January 1, 2024, the top individual rate would decrease to 5.1 percent at the start of tax year 2024. If no funds are transferred from the Catastrophic Reserve during calendar year 2024, the top rate would decrease further to 4.9 percent on January 1, 2025. That would position Arkansas as the median state relative to its neighbors with individual income taxes.

Similar potential exists for Arkansas’s corporate income tax. If all revenue triggers are met, the state’s top corporate rate will decrease from 5.7 percent (as of 2023) to 5.5 percent on January 1, 2024. It will then decline further to 5.3 percent on January 1, 2025. Arkansas’s top corporate rate would then be the average rate of all surrounding states that levy a tax on corporate income.

Policymakers in Little Rock were right to take a two-pronged approach that paired corporate income tax reform with a balanced reduction of top and lower individual rates. By splitting the FY 2021 surplus between corporate and individual tax cuts implemented between FY 2022 and FY 2024, they took positive action to reduce the burden of two of the state’s most distortionary taxes.

Of all Arkansas’s major sources of revenue, the corporate income tax consistently generates the smallest share (about 6.7 percent of general fund tax revenues in FY 2022). This hardly outweighs its distortionary impact on the economy. While all taxation introduces some inefficiency cost to society, corporate income taxation can be especially damaging due to its impact on wages, consumer prices, and adjacent tax bases (like sales and individual income).

Corporate income taxation reduces the amount of revenue owners have available to invest in future productivity, and it presents corporate decision-makers with trade-offs that affect employees and consumers. To remain profitable (or to avoid losses), a business owner may respond to taxation by investing less in capital or labor. She may choose to invest less in new machinery and equipment (capital), or she may adjust her labor force. If those options are not suitable, the alternative is to pass the tax along to consumers through higher prices. Either way, the burden of the corporate income tax is not constrained to business owners. Investing in corporate tax reform will go a long way to mitigating the distortionary effects of the tax.

In contrast to the corporate income tax, the individual income tax accounts for roughly half of Arkansas’s total revenue. While moderately less distortionary than the corporate income tax, it is far from neutral and is one of the most keenly felt taxes. Uncompetitive individual income taxes can hold back a state’s economy, because people make decisions on the margin. As tax rates increase and people keep less of their earnings, they can respond by working less, moving to a lower-tax state, or dropping out of the labor force entirely.

It is also important to remember that the income of pass-through entities (most small businesses) is subject to the individual income tax. Therefore, the individual income tax imposes many of the same trade-offs and investment decisions faced by corporations on sole proprietorships, S corporations, limited liability companies, and other partnerships. Of note, 99.3 percent of all Arkansas businesses in 2019 were small businesses; and these employed 47.9 percent of all Arkansas workers. Investing in individual income tax reform not only allows Arkansas workers to take home more of their earnings, but it eliminates financial impediments to small business growth in the state.

Arkansas policymakers were wise to invest their budget surplus in sustainable tax reform. Left alone, the state’s increasingly uncompetitive tax rates would likely have resulted in the state struggling to attract or retain residents. The latest iteration of pro-growth tax policies, including indexing the standard deduction to the consumer price index, will encourage in-migration and has the potential to generate income, sales, property, and excise tax revenue for years to come.

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