Income tax: Keep it or kill it?

Posted on October 07, 2006 | Type: In the News
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Consider the state income tax.

Two candidates for governor want to abolish it. The third wants to wait on any further cuts until two recent rounds of income-tax deductions play out.

So which approach is right for Arizona? Economists differ on the long-term consequences, but most agree that killing the income tax would make it difficult in the short run to keep state government programs at their current level, as the tax produces 40 percent of the state's revenue.

Add in a slowdown in state tax collections, due in part to a cooling housing market, and one thing is certain: State policymakers in the coming budget year won't have the $1 billion-plus of surplus money that they dealt with this spring. That surplus allowed them to hand out more than $500 million in tax breaks.

Still, the picture is hardly grim. A report from the Joint Legislative Budget Committee last week said that state tax collections in August were up 7 percent over the same time last year, with income-tax collections up 7.5 percent. But overall collections for the first two months of the fiscal year were down a tad from projections, lagging by $5.8 million. Budget officials said they need to see more data over a longer period before establishing a trend.

The state income tax tops out at 5.04 percent for the highest earners and is due to be cut 10 percent over the next two years.

Both Libertarian candidate Barry Hess and Republican nominee Len Munsil are proposing to have Arizona do something that only Alaska has accomplished: Kick out one of the hallowed legs on the three-legged stool of income, property and sales taxes that traditionally sustain governments.

Other states, such as Texas and Nevada, have no income tax, but they have operated that way since statehood, according to the National Conference of State Legislatures. Munsil wants to phase out the income tax over 10 years. Hess thinks it can be abolished within a year. Democratic Gov. Janet Napolitano advocates the wait-and-see approach.

Economists acknowledge that the cut-the-tax platform has enormous populist appeal. But it could have a downside.

A drastic cut in the income tax would leave a hole in the state budget, at least for a while, said Elliott Pollack, president of Elliott D. Pollack & Co., an economic and real estate consulting firm.

"What do you do in the interim?" he asked. "What do you do for all the goodies government pays for?"

Others say that hole would become a permanent crater. And unlike states without an income tax, such as oil-rich Alaska or casino-fueled Nevada, Arizona doesn't have an industry that could replace the lost 40 percent, said Tom Rex, associate director of the Center for Business Research at Arizona State University's W.P. Carey School of Business.

Proponents should acknowledge the negative effects of eliminating a key state tax, he said.

"They need to be honest and say what they're really doing is scaling back the size of government," he said.

Even the Goldwater Institute, a constant cheerleader for tax reduction, recognizes that it could be difficult to keep government programs running at their regular pace if the income tax was killed. Some adjustments would be necessary in the short term, economist Noah Clarke said.

"You could extend the sales tax to all services," he said. "Or you could raise it (the sales tax) a little."

But Clarke said there is little reason to panic, pointing out that such states as Florida, Nevada and Texas haven't seen their economies collapse for lack of an income tax.

Besides, Clarke said, whenever a government wants to attract a business, one of the first things it does is offer tax cuts, suggesting that taxes are an impediment to expansion.

"If you're eliminating the income tax, you're making everyone wealthier," he said.

As for a downturn in the economy making the cuts difficult, Clarke said that policymakers need to look at who would benefit.

"I can't think of a better gift to someone who loses a job, or is making less income because of a job change, than having to pay less in income taxes," he said.

Pollack said elimination of the income tax could achieve the economic stimulus its proponents trumpet, but it would take time.

But for the biggest economic benefit, policymakers may want to look at cuts in selected business taxes, say Pollack and Jim Rounds, a senior economist and vice president at Pollack's firm.

"I want you to notice that not every job in the state has gone to Texas and Nevada," Pollack said. "You don't have to eliminate the income tax to be attractive."

Cuts to business property taxes would be an incentive to attract companies to Arizona, bringing more jobs, Rounds said. That would be the prudent choice, he said, especially if the budget has a limited amount available for tax cuts.

Rex agrees and calls the perennial debates about eliminating the state income tax "tiresome."

The idea that a tax cut would spur economic growth makes some sense, if the tax is high to begin with. Arizona, with a top rate of 5.04 percent dropping to 4.54 percent over the next two years, does not fit in the stratosphere of state income-tax rates, he said.

Reach the reporter at maryjo.pitzl@arizonarepublic.com or at (602) 444-8963.

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