After weeks of deliberations, Arizona Gov. Doug Ducey (R) this week signed into law a budget for fiscal year (FY) 2022 that reduces the state’s individual income tax rates and consolidates brackets, a plan that will help restore Arizona’s reputation as a low-tax alternative to California.

The enacted law kept the basic framework of the original bill intact, but the legislature did make several changes to the bill before it passed both chambers. The most notable changes include a slight adjustment to the interim individual income tax rates, the use of revenue triggers, an increase in the percentage of state individual income tax revenue distributed to localities under the state’s urban revenue sharing program, and further reductions in the commercial property tax assessment ratio.

A separate bill, SB 1827, also enacted this week, creates a 4.5 percent cap on the top marginal rate when the general rates and the Proposition 208 surcharge are combined. (Adopted by voters last year, Prop. 208 imposes a tax surcharge on high earners.) Taken together, these reforms will restore the competitive edge to Arizona’s tax code by reducing individual income taxes for all individuals and non-corporate businesses while significantly improving the state’s tax structure.

However, another separate bill, SB 1783, also enacted this week, creates an entity-level tax election option for owners of pass-through businesses. While intended as a way to give businesses—many of which would otherwise be subject to the top individual income tax rate—the benefit of the low 2.5 percent rate that most individual taxpayers will pay under SB 1828, this law attempts to solve one nonneutrality (Prop. 208) with another, ultimately resulting in a system in which higher-income business owners can elect to be taxed at a lower rate than non-business owners making the same amount of income. (It bears noting, however, that businesses that elect to be taxed at the entity level would not be eligible to claim certain general deductions related to non-business activities.)

The individual income tax rate changes that will take effect over the next few years are shown in the table, with a detailed explanation to follow. The entity-level tax is also explained in further detail.

The first change adopted as part of SB 1827, which is effective retroactive to January 1, 2021, is the creation of a cap to prevent the combined top marginal tax rate from exceeding 4.5 percent when the general rates and the Prop. 208 surcharge are combined. This will significantly mitigate the negative economic impacts of the 3.5 percentage-point income tax surcharge that was narrowly adopted by voters in November 2020.

Since the surcharge is levied in addition to the general individual income tax rates, Prop. 208 effectively created a new top marginal rate of 8 percent, affecting taxpayers with marginal income exceeding $250,000 (single filers) or $500,000 (married filing jointly). By limiting the top combined rate to 4.5 percent, SB 1827 effectively reverts Arizona’s individual income tax rates for tax year 2021 to what they were before Proposition 208 was adopted. However, for taxpayers with taxable income exceeding $250,000/$500,000, much of the revenue from the 4.5 percent top rate will be allocated to education, as required by Prop. 208, while the remaining revenue will be allocated to the general fund.

Next, effective January 1, 2022, SB 1828 consolidates the state’s four general marginal individual income tax rates into two by eliminating the 4.5 percent and 4.17 percent general rates and reducing the two lower rates from 3.34 to 2.98 percent and from 2.59 to 2.55 percent, benefiting all individual income taxpayers. The Prop. 208 surcharge, however, together with the 4.5 percent cap, will result in a top rate of 4.5 percent applying to taxable income exceeding $250,000 (single filers) and $500,000 (married filing jointly).

While the rate reductions that take effect in January 2022 are not subject to revenue triggers, the subsequent rate reductions are. Tying future rate reductions to specific revenue targets is a prudent way to balance the economic reasons for tax reform with state and local governments’ need for revenue predictability.

After the tax year (TY) 2022 reductions take effect, once general fund revenues exceed $12,782,800,000, a further rate reduction will be triggered to take effect the following January, with the 2.98 percent rate further reduced to 2.75 percent and the 2.55 percent rate further reduced to 2.53 percent. These rates will remain in effect until any fiscal year in which general fund receipts are at least $12,976,300,000.

Once this subsequent $12,976,300,000 revenue threshold is met, the 2.75 percent rate will be eliminated and the remaining general tax rate reduced to 2.5 percent. If not for the Prop. 208 surcharge, Arizona would then have a flat rate of 2.5 percent. However, the combined effect of the Prop. 208 surcharge and the new 4.5 percent cap is a top marginal rate of 4.5 percent even after the final rate reduction to 2.5 percent is triggered.

In addition to these rate reductions, beginning in fiscal year 2024, SB 1828 increases the share of state individual income tax collections that will be distributed to incorporated cities and towns under the state’s urban revenue sharing program from 15 percent to 18 percent. This provision is designed to prevent localities from losing revenue under the plan, which would have occurred if the rate reductions were adopted without an increase in the percent allocated to localities.

Finally, the new law will reduce the property tax assessment ratio for most commercial property. House Bill 2900 as introduced reduced the assessment ratio from 18 percent in 2021 to 17.5 percent in 2022 and 17 percent in 2023, but the final law includes two additional reductions to 16.5 percent in 2024 and 16 percent in 2025 and years thereafter.

Taken together, these changes will reduce tax burdens for taxpayers across the income spectrum while restoring the competitive standing that Arizona policymakers had previously worked for decades to achieve.

As noted, however, SB 1783 was also signed by the governor this week. This law creates an entity-level tax election option for pass-through business owners, allowing them to pay income taxes under a separate system rather than under the general individual income tax rate schedule if they so choose. Owners of businesses that elect to be taxed at the entity level, such as sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations, would no longer be subject to the Prop. 208 surcharge. The law sets the entity-level rate at 3.5 percent for TY 2021, 3 percent for TY 2022, 2.8 percent for TYs 2023 and 2024, and 2.5 percent for TY 2025 and years thereafter.

While intended as a way to provide a 2.5 percent flat rate for small businesses on par with the rate that individuals with taxable income below the surcharge threshold will be subject to, creating a separate tax system for pass-through business owners departs from the principle of neutrality. Under SB 1783, business owners could enjoy lower income tax rates than their employees, as higher-income non-business owners will still pay the top rate of 4.5 percent. This entity-level tax could create an incentive for some higher-income employees to instead become independent contractors so they, too, can be shielded from the impacts of Prop. 208.

Prop. 208 is currently being challenged before the Arizona Supreme Court, and critics of the new tax reforms have threatened their own legal challenges.

Overall, SB 1828 and 1827 will make Arizona significantly more attractive for individuals and pass-through businesses than the state would be if taxpayers remained subject to the full brunt of the 8 percent top rate that Prop. 208 created. In a year in which many states are adopting income tax rate reductions, Arizona is taking important strides to reassert its own tax competitiveness.