Riding the Fiscal Roller Coaster: government revenue in Arizona: ninety-fifth Arizona Town Hall, November 1-4, 2009

              Government Revenue in Arizona
Background report prepared by the
L. William Seidman Research Institute,
W. P. Carey School of Business,
Arizona State University
Fiscal Roller Coaster:
Riding the
95th Arizona Town Hall
November 1-4, 2009 | Grand Canyon, Arizona
October 2009
We thank you for making the commitment to participate in the 95th Arizona Town Hall to be
held at the Grand Canyon on November 1-4, 2009. You will be discussing and developing
consensus with fellow Arizonans on Arizona’s revenue system.
An essential element to the success of these consensus-driven discussions is the background
report that is provided to all participants before the Town Hall convenes. As they have so
often done for past Arizona Town Halls, Arizona State University has prepared a detailed and
informative report that will provide a unique and unparalleled resource for your Town Hall
discussions.
Very special thanks go to Dennis Hoffman and Tom Rex who spearheaded this effort and
served as contributing authors, marshaled top talent to write individual chapters, and ensured
all deadlines were met. For sharing their wealth of knowledge and professional talents, our
thanks go to the many authors who contributed to the report.
The 95th Town Hall could not occur without the financial assistance of our generous
sponsors, which include Speaker Sponsor Greater Phoenix Leadership and Associate
Sponsors Mohave County, The Virginia G. Piper Charitable Trust, and Jennings Strouss.
When the 95th Town Hall ends, ASU’s background report will be combined with the
recommendations from the Town Hall into a final report. This final report will be widely
available to the public on the Town Hall’s website and will be widely distributed and promoted
throughout Arizona. The work of the Town Hall participants and the final report will help to
create solutions that will optimize Arizona’s revenue system.
Sincerely,
Bruce Dusenberry
Board Chair, Arizona Town Hall
Ninety-Fifth Arizona Town Hall
November 1-4, 2009
Riding the Fiscal Roller Coaster:
Government Revenue in Arizona
September 11, 2009
Background Report Prepared by Arizona State University’s
W. P. Carey School of Business
Arizona State University
Michael Crow, President
W. P. Carey School of Business
Robert Mittelstaedt, Dean
Editors
Dennis Hoffman Tom Rex
L. William Seidman Research Institute Center for Competitiveness
and Prosperity Research
Authors
Paul Bender
Molly Castelazo
Jeffrey Chapman
Alberta Charney
Kent Hill
Dennis Hoffman
Leezie Kim
Eva Madly
Georganna Meyer
Tom Rex
Ken Strobeck
Marshall Vest
Table of Contents
1: INTRODUCTION 1
2: AN ECONOMIC PERSPECTIVE ON THE ROLE OF GOVERNMENT AND
PUBLIC REVENUE
9
3: PRIMER ON STATE AND LOCAL GOVERNMENT REVENUE 21
4: THE RELATIONSHIP BETWEEN TAXES AND ECONOMIC GROWTH 31
5: CONSTITUTIONAL LIMITS ON THE POWER TO TAX IN ARIZONA 43
6: STATE GOVERNMENT REVENUE COLLECTION: PROCESS 49
7: STATE GOVERNMENT REVENUE: HISTORICAL RECORD 57
8: LOCAL GOVERNMENT REVENUE COLLECTION: PROCESS 67
9: LOCAL GOVERNMENT AND COMBINED STATE AND LOCAL GOVERNMENT
REVENUE: HISTORICAL RECORD
79
10: THE EFFECTS OF THE ECONOMIC CYCLE ON GOVERNMENT REVENUE 89
11: REVENUE SYSTEM GUIDING PRINCIPLES 97
12: CITIZENS FINANCE REVIEW COMMISSION 107
13: BUSINESS TAXES 117
14: REVENUE SYSTEMS IN OTHER STATES 127
15: ANALYSIS OF ARIZONA’S REVENUE SYSTEM BY SOURCE OF FUNDING 139
16: TWO ALTERNATIVES TO IMPROVE THE MANAGEMENT OF THE STATE
GOVERNMENT GENERAL FUND
153
17: BUDGET STABILIZATION FUND 163
18: OPINIONS OF INTERVIEWEES: PRIOR EFFORTS TO IMPLEMENT REVENUE
REFORM
171
19: OPINIONS OF INTERVIEWEES: STRATEGIES FOR IMPLEMENTING
COMPREHENSIVE REVENUE REFORM
185
Appendix 1: INTERVIEWEES FOR CHAPTERS 18 AND 19 199
Appendix 2: DATA AND DATA MEASURES USED IN THIS REPORT 200
Appendix 3: GLOSSARY 204
Appendix 4: ACRONYMS 211
List of Tables
2.1: Arizona State Government General Fund Expenditures, Fiscal Years 1979 and
2009
12
2.2: Combined State and Local Government Expenditures, Arizona and United
States, Fiscal Year 2006
15
2.3: Combined State and Local Government Expenditures, Per Capita and Per
$1,000 of Personal Income, Arizona and United States, Fiscal Year 2006
15
7.1: Estimated Dollar Value of Tax Changes, Arizona State Government General
Fund, Fiscal Years 1989 Through 2009
59
7.2: Ongoing Revenue by Source, Arizona State Government General Fund, Fiscal
Year 2009
63
9.1: General Revenue in Arizona by Source, Combined State and Local Government,
Fiscal Year 2006
81
9.2: Household Tax Burden, Combined State and Local Government, Phoenix,
Arizona, 2007
88
10.1: Volatility Index, 10 Most Volatile State Economies 90
11.1: A Qualitative Assessment of the Overall Revenue System as Currently
Structured in Arizona
103
11.2: A Qualitative Assessment of the General Sales Tax in Arizona 104
11.3: A Qualitative Assessment of the Property Tax in Arizona 105
11.4: A Qualitative Assessment of the Personal Income Tax in Arizona 106
12.1: Summary of Recommendations of the Citizens Finance Review Commission 109
13.1: Combined State and Local Government Business Taxes by Type of Tax,
Arizona and United States, Fiscal Year 2008
124
13.2: Combined State and Local Government Business Tax Burdens, Western States
and United States, Fiscal Year 2008
125
13.3: Combined State and Local Government Business Tax Burden by Type of Tax,
Measured as a Percentage of Private-Sector Gross Domestic Product, Arizona,
Fiscal Year 2008
125
14.1: Combined State and Local Government General Revenue by Source, Western
States and United States, Fiscal Year 2006
129
14.2: Arizona’s Rankings Among All States and Nine Western States, Combined
State and Local Government Revenue, Fiscal Year 2006
130
14.3: Combined State and Local Government Tax Collections as a Percentage of
Total Taxes, Western States and United States, Fiscal Year 2006
131
14.4: Comparison of Arizona and Utah, 2006 133
14.5: Shares by Source of Combined State and Local Government Own-Source
Revenue, Arizona and Utah, Fiscal Year 2006
134
14.6: Comparison of Individual Income Tax, Arizona and Utah, 2008 136
14.7: Comparison of Sales Tax, Arizona and Utah 137
19.1: Lessons Learned From Public Policy Successes and Failures 187
19.2: Barriers to Comprehensive Revenue Reform 193
List of Figures
1.1: Ongoing Revenues and Expenditures Per $1,000 of Personal Income, Arizona
State Government General Fund, Fiscal Years 1979 Through 2009
5
4.1: The Difference Between Arizona and the United States in the Annual Percent
Change in Inflation-Adjusted Earnings, 1970 Through 2008
40
4.2: Ongoing Revenues Per $1,000 of Personal Income, Arizona State Government
General Fund, Fiscal Years 1971 Through 2009
41
6.1: Revenues From the Three Major Taxes Unadjusted for Inflation and Population
Growth, Arizona State Government General Fund, Fiscal Years 1988 Through
2009
51
6.2: Estimated Dollar Value of Tax Changes, Arizona State Government General
Fund, Fiscal Years 1989 Through 2009
52
6.3: The Number of Available Individual and Corporate Income Tax Credits, Arizona,
Tax Years 1980 Through 2009
53
6.4: Individual and Corporate Income Tax Credits as a Share of Tax Liability,
Arizona, Tax Years 1990 Through 2006
55
6.5: Number of Auditors and Collectors at the Arizona Department of Revenue
Relative to the Arizona Population, Fiscal Years 1996 Through 2009
56
7.1: Revenue by Type Per $1,000 of Personal Income, Arizona State Government
General Fund, Fiscal Years 1971 Through 2009
61
7.2: Sources of Arizona State Government General Fund Revenue, Fiscal Years
1971 and 2009
62
9.1: Own-Source General Revenue in Arizona as a Percentage of the National
Average, Combined State and Local Government, Fiscal Years 1964 Through
2006
82
9.2: Revenue by Source as a Percentage of Total Own-Source Revenue, Combined
State and Local Government, Arizona, Change Between Fiscal Years 1993 and
2006
85
9.3: Combined State and Local Government Tax Burden in Arizona, 1977 Through
2008
87
10.1: Annual Real Percentage Change in Personal Income Based on Quarterly Data,
Arizona and United States, 1951 Through 2008
91
10.2: Annual Real Percentage Change in Arizona State Government General Fund
Revenue and Arizona Personal Income, Based on Quarterly Data From 1988
Through Early 2009
92
10.3: Estimated Annual Real Per Capita Percentage Change in Arizona State
Government Ongoing General Fund Revenue and Arizona Personal Income,
Fiscal Years 1989 Through 2009
92
10.4: Estimated Annual Real Per Capita Percentage Change in Major Sources of
Arizona State Government General Fund Revenue and Arizona Personal
Income, Fiscal Years 1989 Through 2009
93
10.5: Annual Real Percentage Changes in Taxable Income and Personal Income,
Arizona, 1985 Through 2008
94
10.6: Capital Gains as a Percentage of Personal Income, Arizona, 1988 Through
2007
95
13.1: Ratio of Business Taxes to Government Expenditures That Benefit Businesses,
Western States and United States, Fiscal Year 2006
122
14.1: Individual Income Tax Collections Per Capita and Per $1,000 of Personal
Income, Arizona and Utah, Fiscal Years 1993 Through 2006
135
14.2: General Sales Tax Collections, Arizona and Utah, Fiscal Years 1992 Through
2006
137
14.3: Property Tax Collections, Arizona and Utah, Fiscal Years 1992 Through 2006 138
16.1: State Government General Fund Ongoing Revenue as a Share of State Gross
Domestic Product, Arizona, 1971 Through 2011
155
16.2: State Government General Fund Ongoing Revenue Relative to Personal
Income and Adjusted Gross Income, Arizona, 1971 Through 2011
155
16.3: Actual and Projected State Government General Fund Revenues Compared to
Simulated, Arizona, 1985 Through 2015
157
16.4: Actual and Projected State Government General Fund Expenditures Less
Simulated Revenues, Arizona, 1985 Through 2015
157
16.5: State Government General Fund Ongoing Revenues From Major Sources,
Arizona, Fiscal Years 1992 Through 2011
159
16.6: Simulated State Government General Fund Revenues at 4.5% of State Gross
Domestic Product and Expenditures, Arizona, 1985 Through 2015
160
16.7: Simulated State Government General Fund Revenues at 4.5% of State Gross
Domestic Product Less Expenditures, Arizona, 1985 Through 2015
161
Note Regarding Data:
Two sources of data are used widely throughout this document, as discussed in Appendix 2.
Summary data on the state government general fund reported by the Arizona Joint
Legislative Budget Committee (JLBC) for fiscal year 2009, which ended on June 30, have
been incorporated into this report. However, some of the more detailed data for state
government for fiscal year 2009 had not yet been published by the JLBC when this report
was sent to the printer.
For state and local governments combined, the U.S. Census Bureau provides annual data
that can be used to compare states. In years ending in ‘2’ and ‘7’ these data are based on a
census of governments. In other years, the Census Bureau collects data from state
governments and a sample of local governments. The release of the fiscal year 2007 data
has been postponed by the Census Bureau, precluding the analysis of those data in this
report. Assuming the Census Bureau data are not further delayed, a summary of these data
will be produced as a separate document for release at or before the Arizona Town Hall
meets at the Grand Canyon.
The latest Census Bureau data shown in this report are for fiscal year 2006. While these
data are based on a sample of local governments, the time series of historical data does not
reveal obvious inconsistencies between the census data produced every five years and the
sample data in the intervening years. However, the Arizona Tax Research Association has
identified certain Arizona state government revenues that appear to have been omitted from
the 2006 data. Thus, Arizona governments probably collected more revenue than reported,
affecting the comparison over time as well as to other states.
The Census Bureau has a massive task compiling these data from thousands of
governments across the country. State and local governments do not use a consistent
accounting system. Some of the accounting systems are quite complex. The Census
Bureau converts these many accounting systems to one consistent system so that data can
be fairly compared across states. Further, the Census Bureau depends upon the accurate
reporting of data by state and local governments.
Thus, errors in the Census Bureau data are inevitable. Errors in the data reported for
Arizona are not unique. Indeed, the Tax Foundation, for instance, discovered a significant
error in the reporting of revenue data for Indiana. If all of the errors and inconsistencies
across the states and years were discovered and corrected, it is not clear if the relative
results for Arizona would be significantly different from those reported by the Census
Bureau. For example, other studies of the tax burden agree with the conclusion reached
from the Census Bureau data: the tax burden in Arizona is low compared to other states and
has declined over time.
Much of the analysis in this report is unaffected by any problems that may exist in the
Census Bureau data, since it is based upon the record of the revenue streams available to
support the state’s general fund spending initiatives from fiscal years 1971 through 2009.
These data come from actual general fund accounts as reported by the JLBC, not samples,
surveys, or census reports. These data clearly reveal that general fund revenues have not
kept pace with Arizona’s economic growth during the last 15 years.
Arizona State Government General Fund Ongoing Revenue
Per $1,000 of Personal Income, 1988 to 2009
1 Real Estate Crash
2 Deficit
	
	
	
3 Rainy-Day Fund Created
	
4 1990-91 Recession
	
5 Economic Recovery
	
6 Tax Cuts Begin
	
	
7 Rainy-Day Fund Modified
	
8 More Tax Cuts
	
	
9 Stock Market Boom
	
10 More Tax Cuts
	
	
11 Stock Market Crash
	
12 2001 Recession
	
	
13 Large Deficit
	
	
14 Economic Recovery
	
15 Real Estate Boom
	
	
16 Another Round of Tax Cuts
	
17 Real Estate Crash
	
	
18 Recession Begins in 2007
	
19 Revenue Plunges
	
	
20 Record-Setting Deficit
	
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
(Artistic Representation)
C h a p t e r 1 | 1
Chapter 1
INTRODUCTION
Dennis L. Hoffman
Arizona State University, L. William Seidman Research Institute
Government revenue—primarily taxes—always is a “hot” issue. This is especially so now,
given the budgetary problems faced by state government and most local governments in
Arizona during the past two years. While more severe than in the past, the budget shortfalls
are not new: imbalances between revenues and expenditures were a significant issue from
2001 through 2003, and in fact, during each of the previous economic recessions.
Public finance—what government is or should be doing and how to pay for those activities—
is an extremely broad topic. What government should be doing—a highly controversial
subject—is NOT addressed in this report, though the various economic reasons for the
existence of government are presented briefly in Chapter 2. That chapter also touches on
what government is doing by summarizing the expenditures of public monies in Arizona.
This background report focuses on Arizona’s revenue system—the means of paying for
government activities. Answering the question of what government should be doing is NOT a
necessary precursor to designing an optimal revenue system. The primary purpose of the
report is to inform Arizona Town Hall participants about the existing revenue system so they
can determine whether reform of the revenue system is advisable, and if so, to consider the
design of a better system—without determining how much revenue to collect.
Previous efforts to analyze the revenue system have been made over the past 20 years, but
few of the recommendations made by these study groups have been implemented. Thus, this
background report takes the unique additional step of attempting to determine why these
prior efforts were not successful. This assessment was made primarily by interviewing long-time
observers of Arizona’s political process. As revealed by the compendium of opinions of
individuals who have been deeply involved in reform efforts (from across the political
spectrum) in Chapters 18 and 19, passing any type of comprehensive revenue reform in the
near term may be extremely difficult. In order to successfully implement a well-functioning
revenue system, it may indeed be necessary to first address the question of what government
should do.
THEMES FROM THIS REPORT
A particular focus of this report is the state government general fund, which has experienced
the most severe imbalances between revenues and expenditures of any of the numerous state
and local government funds in Arizona. However, the state’s general fund cannot be
examined independently of the finances of the hundreds of local governments in Arizona, of
the other funds used by state government, or of the revenues received from the federal
government. Government revenue is a system. Like any system, examining the parts
2 | C h a p t e r 1
independently and implementing changes in a piecemeal fashion is likely to result in
unintended consequences and a suboptimal system.
In addition to considering government revenue as a system, other themes emerge from this
report. The first is apparent in the report’s title. Government revenue in Arizona is highly
cyclical, going up and down with the economic cycle. While cyclicality is not the only
revenue system issue, the budget deficits the state has encountered in each of the last several
economic recessions have received the most attention and have been the primary prompt to
examine the revenue system. The shape of the roller coaster on the cover, and repeated on the
chart that immediately precedes this chapter, represents revenue collected for the state’s
general fund adjusted for population growth, inflation, and economic growth. However, the
revenue data used for the data points on the left side of the chart were adjusted to remove the
effects of the tax increases passed in the late 1980s and very early 1990s.
Much of the revenue cyclicality is inherent to the state’s highly cyclical economy, but part is
due to the design of the revenue system (see Chapter 10). Changes to the system since the
early 1990s have increased the cyclicality of revenues. Yet demand for most government
services is not cyclical, and the demand for some services (such as unemployment insurance
claims) is countercyclical—rising during recessions as revenues fall.
Like most states, Arizona’s revenue system was designed decades ago, though a large
number of piecemeal changes to the system have since occurred. The sales tax in particular
has not been modified to keep pace with changes over time in consumer expenditures. Since
the revenue system has not changed as substantially as the evolution of the economy,
government revenues are not expanding at the pace of the economy.
Relative to other states, Arizona’s revenue system relies more heavily on taxes than on user
fees. Yet the state has a narrow tax base. In particular, the state’s general fund is highly
dependent on only two taxes that are especially cyclical: the individual and corporate income
tax and the general sales tax. Including local sales taxes as well as the statewide tax, the
general sales tax rate in Arizona is high.
The cyclical misalignment between public revenues and expenditures could be reduced, but
not eliminated, as discussed in Chapters 15 and 16. Thus, fiscal experts indicate that a
mechanism to pay for education, public safety, and other programs when revenues
temporarily fall during an economic downturn becomes a necessary component of a well-functioning
revenue system. The state’s rainy-day fund (the budget stabilization fund) is
mentioned in several chapters and is the topic of Chapter 17. As currently designed, the
rainy-day fund in each of the last two recessions has been depleted long before revenues have
recovered.
The cyclical nature of government revenues is not the sole reason for the state’s recent
budget difficulties. A structural deficit (discussed beginning on the next page) also exists—
revenue is insufficient on average over the economic cycle to pay for the state’s
expenditures. To repeat, determining the appropriate level of revenues and expenditures
(what government should be doing) is not the purpose of this report. Indeed, the optimal
C h a p t e r 1 | 3
structure of the revenue system is independent of the amount of revenue that needs to be
collected. But adoption of an ideal revenue system while leaving a structural imbalance in
place will not result in a well-functioning fiscal system. (A fiscal system includes not only the
revenue system but also expenditures and debt.)
Taxes, as the largest component of state and local government revenue, are discussed
throughout this report. The overall tax burden in Arizona is lower than in most states, and is
lower than it was in the past, as discussed in Chapter 9. This low overall burden is the result
of a very low tax burden for individuals and a moderate tax burden for businesses in general.
Small unincorporated businesses have a relatively low tax burden. However, the taxes paid
by large corporations are relatively high. The differential in tax burden between small and
large businesses results from two factors. First, business property taxes are moderate for
properties with a low valuation but quite high for large businesses, especially those with
substantial equipment (those subject to the business personal property tax). Second,
unincorporated businesses file under the individual income tax code, which results in a lesser
relative tax burden than for corporations filing under the corporate income tax code. Thus,
businesses—particularly large corporations—subsidize other taxpayers. The balance between
individual and business taxes is an important consideration in creating a well-functioning
revenue system (as discussed in Chapter 13).
The driving forces for revenue reform include the severe cyclicality of the existing system
(more volatile than in the past and compared to other states), the failure of the existing
system to generate revenues that grow at the pace of the economy, and the existing system’s
negative impacts on economic competitiveness due to relatively high business taxes. These
are relevant factors regardless of the total amount of revenue to be collected.
Improving the revenue system in each of these regards would raise the rating of the system
against the guiding principles (discussed in Chapter 11) of stability, responsiveness,
predictability, and competitiveness. Yet the existing system also could be improved on most
of the other revenue system guiding principles, including efficiency (the existing system has
a narrow tax base with high tax rates), neutrality and horizontal equity (the system has
multiple tax credits and exemptions), vertical equity (the current system is highly reliant on
regressive taxes), and simplicity (the property tax and sales tax codes in particular are
unusually complex).
Structural Deficit
Many states have a structural deficit, though Arizona appears to have one of
disproportionately large size. Structural deficits have two causes:
• Revenues chronically not growing in tandem with economic growth and the cost of
government. This results from the failure to modernize revenue systems, which
largely were created in the 1930s, to reflect changes in the economy in recent
decades.
• Permanent changes being made only to revenues or only to expenditures. During
periods of strong revenue growth that temporarily occur during economic expansions,
states have a tendency to permanently reduce taxes without reducing expenditures
4 | C h a p t e r 1
and/or to create permanent new spending initiatives without raising additional
revenue. When economic growth inevitably slows, revenues drop and the underlying
structural deficit becomes obvious.
Both factors contribute to Arizona’s structural deficit. In particular, revenues to the state’s
general fund have been greatly reduced since the early 1990s due to a series of tax law
changes that have reduced tax rates, eliminated entirely the contribution of some taxes to the
general fund, and increased the number of tax credits and tax exemptions. The tax changes
were passed when budget surpluses existed and were not equally matched by spending
reductions. In addition, spending requirements were added to the general fund, most notably
by shifting most of the expenditures for school construction into the general fund without
enhancing revenue to cover these additional expenditures.
The structural budget deficit of the Arizona state government general fund is not examined in
detail in any of the other chapters of this report because of the focus of the report on
revenues, rather than on the balance between revenues and expenditures. Yet, the structural
deficit along with the cyclical deficit is the cause of the imbalance in the general fund that
has so dominated the news since 2008 and factored into the choice of this Arizona Town Hall
topic.
Linking revenues and expenditures is a key guiding principle of a fiscal system (as discussed
briefly in Chapter 11). The existing structural imbalance between revenues and expenditures
has been cited as the main cause of low ratings of Arizona’s fiscal system (see Chapter 14).
As defined by these independent and out-of-state experts, a highly rated fiscal system cannot
be achieved in Arizona without resolving the structural deficit and reducing the magnitude of
the cyclicality of the revenue collections.
The “Fiscal 2000” report from 1989 cited a structural deficit as one of the state’s largest
problems.1
That deficit largely was the result of tax cuts implemented from 1979 through
1981 that were not accompanied by commensurate reductions in spending. A combination of
spending reductions and revenue increases in 1989 and 1990 largely resolved that structural
deficit.
Three factors created a new structural deficit in the state’s general fund beginning in the early
1990s:
• The failure of the existing revenue system to produce revenues that keep pace with
economic growth.
• New spending obligations from the general fund, such as school construction and the
expansion of Medicaid requirements, that were not accompanied by new or expanded
revenue sources.
• A long series of tax reductions that were not accompanied by a commensurate
amount of spending reductions.
The tax reductions have been the largest cause of the structural deficit. As presented in
Chapter 7, estimates of the impact of the tax reductions since 1993 cumulate to $1.4 billion in
nominal terms and $2.6 billion after adjusting for inflation and population growth. This
C h a p t e r 1 | 5
revenue decline is clearly seen in the revenue line in Figure 1.1, though the cyclicality of the
revenue collected distorts the exact impact of the tax reductions. As seen by the expenditure
line in the chart, spending per $1,000 of personal income has fallen over the same time
period, but not to the same extent as revenues.
Prior to the current economic cycle that began in fiscal year 2002, ongoing revenue to the
general fund (excluding any carry-forward balance from the prior year and transfers from
other funds) averaged close to $50 per $1,000 of personal income. Expenditures per $1,000
of personal income averaged more than $48. In the current 2002-09 cycle, the average
revenue figure has dropped 16%, while the expenditure average is down 9%. The
constitutional balanced-budget requirement has been met by transferring monies to the
general fund from other funds.
Though ongoing revenue per $1,000 of personal income averaged more than $41 in the 2002-
09 economic cycle, the figure plunged in fiscal year 2009 to less than $32. A huge difference
between revenues and expenditures is seen in Figure 1.1 for fiscal year 2009. Revenues were
$3 billion (30%) short of the initial appropriation and $2.5 billion less than the revised
appropriation. This follows a shortfall of $1.4 billion in fiscal year 2008 between revenues
and the revised appropriation.
Figure 1.1
Ongoing Revenues and Expenditures Per $1,000 of Personal Income,
Arizona State Government General Fund, Fiscal Years 1979 Through 2009
$30
$35
$40
$45
$50
$55
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Revenue Expenditures
Sources: Arizona Joint Legislative Budget Committee (revenues and expenditures) and U.S.
Department of Commerce, Bureau of Economic Analysis (personal income).
6 | C h a p t e r 1
The budget in 2008 was balanced primarily by transferring monies into the general fund from
the budget stabilization fund and a host of other state funds. In 2009, little was left in the
budget stabilization fund, but federal stimulus monies and further fund transfers were among
the means used to produce a balanced budget. It is difficult to determine just how much of
the deficit in these two years was due to the cyclical versus structural components, but it is
safe to conclude that both factors have contributed significantly to the recent imbalances in
the state government general fund.
PREVIEW OF THIS REPORT
The 18 chapters that follow this introductory chapter can be divided into four groups.
Chapters 2 through 4 provide an introduction to public finance. The existing situation in
Arizona—legal restrictions to the collection of revenue, the process of collecting revenue,
and empirical data regarding the amount of revenue collected—is the topic of chapters 5
through 10. Chapters 11 through 17 examine topics related to what an ideal revenue structure
in Arizona might look like. Finally, the last two chapters look at the process of making
changes to the existing revenue system.
Some topics are addressed in more than one chapter. This provides an indication both of the
cross-cutting nature of the topic and of its significance.
Part I: Introduction to Public Finance
Chapter 2 is the only chapter to address government expenditures. It provides the economic
rationale for the existence of government, and explains that taxes and user fees are the price
paid for public services, such as police protection.
Chapter 3 provides a primer on state and local government revenue systems from a national
perspective. Some key differences in Arizona’s revenue system relative to the national norm
are introduced in this chapter, including the complexity of Arizona’s property and sales
taxes. Some of these topics are explored in more detail in the chapters in Part II.
Chapter 4 introduces the relationships between taxes and economic growth. It builds on
Chapter 2 in linking public services and economic health. Conceptually and empirically, it
explains the lack of a significant relationship between tax increases and reductions in
Arizona and subsequent changes in economic growth.
Part II: The Existing Revenue System in Arizona
Chapter 5 summarizes sections of the Arizona Constitution that apply to the powers given
to, and the limits placed upon, state and local governments to raise taxes and other revenues.
The constitutional limitations on expenditures and debt indirectly act as limits on revenues.
Chapter 6 provides a brief background on the budget process and the revenue collection
process used by state government. Chapter 7 is an extension of chapter 6 that examines
empirically the amount of revenue collected by state government by source. It includes a
discussion of the changes to the tax code that have been made over the last 30 years,
particularly the tax cuts passed since the early 1990s.
C h a p t e r 1 | 7
Chapter 8 is the local government counterpart to Chapter 6. State law places a number of
restrictions on the operations of local government fiscal systems. Chapter 9 is the local
government counterpart to Chapter 7, but largely examines the combined state and local
government revenue system in Arizona in relation to the national norm. Tax burden studies
also are discussed.
Chapter 10 focuses on the cyclicality implied in the title of this Arizona Town Hall report. It
first looks at the unusual cyclicality of the Arizona economy and then addresses the high
cyclicality of the state’s revenue system. This cyclicality is contrasted to the noncyclical, and
in some cases countercyclical, demands on the public sector.
Part III: Designing a Well-Functioning Revenue System in Arizona
Chapter 11 reviews the national literature regarding the guiding principles behind a revenue
system. Briefly, it qualitatively evaluates the state’s revenue system.
Chapter 12 summarizes the recommendations of the Citizens Finance Review Commission,
which was the most recent effort (in 2003) at comprehensive revenue reform in the state.
Chapter 13 examines the rationale for taxing businesses. Across the nation, businesses pay
more taxes than the cost of the public services they consume. Business taxes in Arizona are
compared to those in other states.
Chapter 14 compares Arizona’s revenue system to that of other states, in part an extension
of the analysis in Chapter 9. It presents a more detailed analysis of how Arizona’s revenue
system compares to the highly ranked revenue system in neighboring Utah.
Chapter 15 incorporates information from the preceding chapters of this report and adds
detail for each of the larger sources of public-sector revenue in Arizona. Chapter 16
examines two alternatives that might be considered to improve the management of the state
government general fund.
Chapter 17 presents the rationale for a rainy-day fund. It examines the operation and
performance of Arizona’s budget stabilization fund.
Part IV: Implementing Changes to the Revenue System in Arizona
The last two chapters are largely based on interviews of 24 individuals familiar with the
legislative process in Arizona, though published materials also are examined. The focus of
these chapters is to identify the factors that have either contributed to, or detracted from, the
process of successfully implementing public policy initiatives, especially comprehensive
revenue reform.
Chapter 18 focuses on the history of such public policy efforts and draws conclusions as to
the factors that have prevented comprehensive revenue reform, and other significant efforts,
from succeeding. Chapter 19 addresses strategies that might be pursued to enhance the
likelihood of public policy initiatives being implemented. Both chapters talk about the
institutional barriers—term limits, supermajority requirement to raise revenue, Clean
8 | C h a p t e r 1
Elections, and the federal Voting Rights Act—that seem to be largely responsible for the lack
of significant public policy actions in Arizona since the 1990s.
Dennis L. Hoffman is a professor of economics at Arizona State University. He has published numerous
academic articles and a book on macroeconomics and econometrics. Professor Hoffman has received teaching
and research awards, including the Distinguished Faculty Research Award in 1992 and Arizona Professor of the
Year (by the Carnegie Foundation) in 1997. He has carried the title of Dean’s Council of 100 Distinguished
Scholar since 1996. In addition to his academic appointment, Dr. Hoffman is director of the L. William
Seidman Research Institute and faculty director of the Center for Competitiveness and Prosperity Research in
the W. P. Carey School of Business as well as director of ASU’s Office of the University Economist. Dr.
Hoffman's sponsored research efforts include the construction and maintenance of the tax revenue forecasting
model used by the governor’s Office of Strategic Planning and Budgeting since 1982. Dr. Hoffman headed
groups of economists who measured the economic impact of several fiscal initiatives for “Fiscal 2000” in 1989.
In 2003, he served as technical advisor to the Citizens Finance Review Commission. Dr. Hoffman has
conducted considerable contract research over the last several years for a host of business and public
organizations across Arizona.
1 Arizona Joint Select Committee on State Revenues and Expenditures, Final Report (November 1989),
http://azmemory.lib.az.us/cdm4/document.php?CISOROOT=/statepubs&CISOPTR=5969&REC=1.
C h a p t e r 2 | 9
Chapter 2
AN ECONOMIC PERSPECTIVE ON THE ROLE OF
GOVERNMENT AND PUBLIC REVENUE1
Jeffrey Chapman
Arizona State University, School of Public Affairs
KEY POINTS
• Government exists largely because of the limitations of the private sector: a perfectly
competitive private-sector market does not exist in all cases. In particular, the private
sector is not well suited to efficiently provide various “public goods,” such as police
protection, and infrastructure, such as transportation.
• In response to private-sector limitations, government may regulate certain activities, it
might ensure that the provision of desired goods and services occurs, or it may
provide the service itself.
• A second reason for the existence of the public sector is that the citizens of developed
nations have come to believe that the collective whole, administered through the
public sector, should provide a safety net for individuals and families.
• State government in Arizona provides public services through a general fund and a
number of other funds. The general fund is dominated by expenditures for education,
health and welfare, and public safety.
• Local governments—counties, cities and towns, school districts, and special
districts—provide a broader range of services.
• Public services are funded by taxes and user fees, which represent the price paid for
the service. However, the public commonly expresses a desire for both increased
funding for various public programs and tax cuts.
• Many public functions, particularly infrastructure provision and maintenance,
enhance economic development and quality of life.
• State government in particular will confront several significant cost pressures in the
coming years that have received little attention.
WHY IS GOVERNMENT NEEDED?
The private sector efficiently provides most goods and services, using the price as the
mechanism to balance supply and demand. Competition among companies ensures that
goods and services are provided efficiently and are priced equitably. Government intervenes
in the private-sector economy when these conditions are not met—that is, when a perfectly
competitive private-sector market does not exist or when markets produce more (such as
pollution) or less (for example, public safety) than is socially desirable. Economists describe
these private-sector limitations as “market failures.”
A second reason for the existence of the public sector is that the citizens of developed nations
have come to believe that the collective whole, administered through the public sector,
should provide a safety net for individuals and families. Historical abuses of disadvantaged
individuals and severe repercussions from circumstances out of the control of individuals,
10 | C h a p t e r 2
such as job losses and other hardships during the Great Depression, led to these social
welfare concerns.
Limitations of the Private Sector
The private sector is not well suited to efficiently provide various “public goods:”
• For some goods, one person’s consumption does not subtract from another’s ability to
consume. National defense is a classic example. No voluntary pricing mechanism
exists. Nor is there a mechanism that can be used to get citizens to reveal voluntarily
their true tastes for this service.
• There are other goods for which the price system does not work because consumers
will not voluntarily reveal their true preferences. For example, if government asks
residents to voluntarily pay for a park, they might believe that their neighbor will also
contribute, and so they name an amount considerably less than what the park is worth
to them. This attempt to “free ride” results in an inefficient provision of parks.
• The private sector generally cannot provide adequate infrastructure because of
immediate high capital costs and revenue that can be realized only in the future. Yet,
the benefits of infrastructure affect societal welfare. Schools and public hospitals
directly affect education and health levels. Roads and airport facilities directly help
economic development. Because of the expense and financing requirements of capital
infrastructure, government intervention is often necessary.
In some cases it is impractical or inefficient for private-sector companies to compete to
provide a service:
• Sellers and buyers that are large enough to affect prices attempt to underproduce and
realize higher prices for their output than the prices that would be determined by an
efficient, competitive market. Government may intervene to control prices—such as
for electricity—or may otherwise regulate such private-sector activities. In the case of
the provision of utilities, a monopoly originally was granted because of the
inefficiency of producing multiple water pipelines or electricity transmission lines.
• Municipalities either provide garbage collection themselves or contract with a single
private-sector company to provide this service because of the efficiency of having the
garbage truck stop at each house in succession rather than drive long distances
between customers.
The private sector also is not in a position to resolve differences of individuals. Sometimes
households engage in activities that impose costs on others that cannot be recouped. If a
consumer has a very noisy car that awakens others at night, there is no way that those
awakened can make the noise producer pay within a pure market context. There will be too
much noise pollution because its full costs are not counted; economists call this a “negative
externality.” The public sector intervenes by limiting such activities.
Other activities generate benefits for others that cannot be charged for. Economists call this a
“positive externality.” For example, if an individual repaints the outside of his house, his
neighbors may recognize an increase in their property value. However, the owner of the
newly repainted house may not be able to obtain compensation for the neighbors’ increased
benefits. This can lead to an underproduction of painted houses.
C h a p t e r 2 | 11
Other examples of market failures exist. In addition, society has determined that there are
instances in which the private-sector market should be precluded from working. For example,
laws have been passed that prevent vote selling because of the belief that the action is
unethical.
In response to these private-sector limitations, government may regulate certain activities, it
might ensure that the provision of desired goods and services occurs, or it may provide the
service through the public sector. Because these government activities require funding,
governments must use the mechanisms at its disposal to raise the necessary funds—that is, to
impose a system of nonvoluntary prices through taxes and user fees.
Social Welfare Concerns
The citizens of developed nations have demanded that society should provide a safety net for
individuals and families, administered through the public sector. All taxpayers contribute to
the funding for the safety net, even though they may never utilize its features. As
demonstrated in the recent severe recession, individuals and families that never before had
experienced a need for public assistance lost their jobs, health insurance, and homes.
Many factors affect household income, such as education, skill levels, health, age of wage
earners, and inheritance. Some of these variables are under the control of the household;
others are not. Some argue that one of the functions of government is to attempt to help those
who are not fortunate enough to be able to earn an adequate income. At the state and local
government level, this is done through the provision of some services, such as education or
health services, that help individuals reach their potential, and through direct aid, often in
conjunction with work requirements. Some argue that it is a matter of societal responsibility
to assist those who need special help, such as elderly residents and those with physical
handicaps.
Public education is a special example of the social welfare motivation for the existence of the
public sector. Most parents could not afford to pay the cost of schooling for their children at
the time the schooling is consumed. Parents usually are relatively young and do not earn as
much as they will later in life. However, their needs are greater than they will be later in life:
they experience many expenses related to their children, they need to build up their savings
account for a “rainy day,” and they need to purchase assets such as homes and automobiles.
Thus, the costs of educating their children are spread throughout their taxpaying lifetime.
Those who do not have children still contribute because of the societal benefits of an
educated populace, including lower crime rates, less need for public services, and higher
wages for all.
Public Services of State and Local Governments in Arizona
Because of the limitations of the private sector and because of the social welfare concerns,
government provides a variety of functions. More than half of the federal government’s
outlays are for Social Security, Medicare, Medicaid, and related programs. Another 20% is
for national defense. State and local government expenditures are largely for education,
health and welfare, public safety, and the provision of infrastructure.
12 | C h a p t e r 2
State Government
The state of Arizona provides a variety of services, finances some infrastructure, and shares
revenues with local governments. State government uses a general fund and a number of
specialized funds that receive monies from earmarked sources. The state budget is a complex
document, which in recent years has been continually in flux because of recession-caused
reductions in revenue and increases in demand for public services.
According to the Arizona Joint Legislative Budget Committee (JLBC), the total budget for
all funds in fiscal year 2009, which ran from July 1, 2008 through June 30, 2009, was
initially $28.1 billion.2 Significant reductions in the size of the budget were implemented
during the fiscal year. Of the original $28.1 billion, $9.9 billion was appropriated through the
general fund and another $3.2 billion was appropriated through other funds. Thus, the
Legislature appropriated only about 47% of the total funds budget. Most of the
nonappropriated monies originated from federal funds. Most of these funds are simply passed
through state government to local governments and are earmarked for specific purposes.
The general fund is the focus of most state fiscal analyses because it is the fund over which
the Legislature has the most discretion. Table 2.1 shows the general fund allocation for 1979
(the earliest year for which consistent expenditure data are available) and the revised 2009
budget by expenditure category.3
(These and subsequent references to years are for fiscal
years unless otherwise noted.) Substantial shifts in relative spending have occurred over time,
with large increases in the percentage of the budget going to health and welfare and to
protection and safety. Each of the other categories has experienced a decrease in share. In
2009, health and welfare and education combined accounted for 84% of general fund
expenditures; adding protection and safety brings the share to more than 95%.
Classified by state agency, six major state agencies accounted for about 91% of the state
spending in 2009: Department of Education (43%), universities/Board of Regents (10%),
Arizona Health Care Cost Containment System (AHCCCS, Arizona’s version of Medicaid,
15%), Department of Economic Security (8%), Department of Health Services (6%), and
Table 2.1
Arizona State Government General Fund Expenditures,
Fiscal Years 1979 and 2009
2009 (Revised)
Share in
1979
Change in
Share, 1979
to 2009
Dollars in
Millions
Share
Total $9,415.1 100.0% 100.0% 0.0%
Education 5,207.0 55.3 69.3 -14.0
Health and Welfare 2,714.5 28.8 15.9 12.9
Protection and Safety 1,068.5 11.3 6.3 5.0
General Government 329.5 3.5 4.9 -1.4
Natural Resources 54.2 0.6 1.4 -0.8
Inspection and Regulation 40.7 0.4 2.2 -1.8
Other 0.8 0.0 0.0 0.0
Source: Arizona Joint Legislative Budget Committee.
C h a p t e r 2 | 13
Department of Corrections (10%). Each of these large state agencies has subagencies and
departments embedded within them, each of which has some budget responsibility; 117
operating agencies and departments are listed in the formal budget document of former
Governor Napolitano, ranging from the State Board of Accountancy to the Department of
Weights and Measures.
Arizona’s initiative process has played an important role in state budgeting. In particular, the
state’s voters have mandated certain levels of expenditures for education and health services.
The federal government also mandates levels of funding for some programs, especially in the
health and welfare category, which has received a substantially increased share of the state
general fund’s expenditures over the last 30 years. The AHCCCS (Medicaid) program has
experienced especially large increases; state government did not have responsibility for this
program until 1983. While the federal government contributes to the funding, this is a classic
case of unfunded mandates passed on to state and local governments.
State government also funds infrastructure, including roads, energy, telecommunications, and
water. These expenditures are difficult to itemize as they are scattered throughout the budget
of the general fund and other funds. Based on U.S. Census Bureau data for fiscal year 2006,
about 10% of direct general expenditures by state government in Arizona were for capital
projects.4
State government shares a portion of the revenue it collects with local governments. These
transfers totaled about $1.346 billion in fiscal year 2008. The sharing of state revenue
consists of five parts:
• Urban revenue sharing: 15% of the net proceeds of the state income tax from two
years earlier are distributed to incorporated cities and towns based on population.
• State sales tax: 25% of the transaction privilege tax distribution base is distributed to
incorporated cities and towns based on population; 40.51% is paid to counties using a
complex formula.
• Highway user revenue fund: 19% of the net state collections of gasoline and diesel
fuel taxes as well as other transportation fees are distributed to counties; 72% of the
distribution is based on motor vehicle fuel sales by county with the remainder based
on population. Another 27.5% is distributed to incorporated cities and towns, with
half of the distribution based on population and the other half based on county motor
vehicle fuel sales, then population. Another 3% goes to incorporated cities with a
population of more than 300,000, based on population.
• Vehicle license tax: Of the revenue generated from alternative fuel vehicles, car rental
surcharges, and private ambulances, fire-fighting vehicles, and school buses, 20.45%
is distributed to county general funds and an equal percentage goes to incorporated
cities and towns, on the basis of population. Another 4.91% is given to counties for
transportation-related purposes. Monies collected from other vehicles are shared
similarly, but with different percentages: 24.6% to the general funds of both counties
and municipalities, and 5.7% to counties for transportation-related purposes.
• Local transportation assistance fund and county assistance fund: depending on the
amount of revenue generated by the state lottery, up to $23 million of lottery revenues
are distributed to the local transportation assistance fund on the basis of population. If
14 | C h a p t e r 2
all of this $23 million is distributed, then up to $7.65 million is placed in the county
assistance fund. Most (93.47%) of this money is shared equally among counties with
a population of at least 500,000; the balance is shared equally among the remaining
counties.
Local Governments
Local governments—counties, cities and towns, school districts, and special districts—are
service oriented. They provide education (kindergarten through community college),
transportation, public safety (including police, fire protection, and some corrections), and
environmental and housing services. In Arizona, local governments provide little health and
welfare services, with only 6% of their expenditures for this purpose compared to nearly half
of the state government expenditures (see Table 2.2).
Local governments (as well as the state) also are heavily involved in land-use planning and in
operating enterprises that provide utilities such as power, water, and gas. The particular
advantage of local governments compared to higher-level governments is that they are better
able to recognize the tastes and preferences of the residents.
What might be a function of state government in one state may be a local function in another
state. Thus, comparing state (or local) government finance figures across states can be
misleading. Moreover, state government data reported by the JLBC uses a different
accounting system than that used by the U.S. Census Bureau, which reports state and local
government finance data for all states.
Table 2.2 shows local government, state government, and combined state and local
government expenditures in Arizona in 2006. Using the Census Bureau’s accounting, local
governments made up nearly 60% of the combined total. As defined by the JLBC, the state’s
general fund accounted for barely more than one-fourth of total state and local government
spending.
Comparing the combined state and local government spending in Arizona to the national
total, Arizona’s percentages of the total budget spent on education and health and welfare
were slightly less than the national average. Arizona’s spending shares were higher than
average especially in the public safety and environment and housing categories.
However, as indicated in Table 2.3, Arizona’s government spending per capita is far below
(17%) the average in the United States. Only in public safety did Arizona’s expenditures
exceed the per capita U.S. average in 2006. In the two largest categories, Arizona’s per capita
spending was below the U.S. average by 20% for education and by 25% for health and
welfare. Based on the alternative measure of expenditures per $1,000 of personal income,
Arizona’s public expenditures also are below the national norm, though not by as much.
Arizona’s per capita personal income is substantially less than the national average.
TAXES AND USER FEES AS PRICES
An ongoing issue at any level of government is to relate the services provided to mechanisms
of paying for those services. In many cases, government must provide some minimum level
C h a p t e r 2 | 15
Table 2.2
Combined State and Local Government Expenditures,
Arizona and United States, Fiscal Year 2006
Arizona
Local Government
Arizona
State Government
Millions Share Millions Share
Total General Expenditures $21,070 100.0% $14,678 100.0%
Education 8,881 42.1 3,077 21.0
Health and Welfare 1,310 6.2 7,142 48.7
Transportation 1,502 7.1 1,372 9.3
Public Safety 2,990 14.2 1,161 7.9
Environment and Housing 2,736 13.0 595 4.1
Government Administration 1,588 7.5 579 3.9
Debt Service 903 4.3 405 2.8
Other 1,159 5.5 346 2.4
Combined State and Local Government
Arizona United States
Millions Share Millions Share
Total General Expenditures $35,747 100.0% $2,121,946 100.0%
Education 11,958 33.5 738,464 34.8
Health and Welfare 8,453 23.6 551,890 26.0
Transportation 2,873 8.0 159,462 7.5
Public Safety 4,152 11.6 189,555 8.9
Environment and Housing 3,331 9.3 164,130 7.7
Government Administration 2,168 6.1 111,308 5.2
Debt Service 1,308 3.7 85,660 4.1
Other 1,505 4.2 121,477 5.7
Source: U.S. Department of Commerce, Census Bureau.
Table 2.3
Combined State and Local Government Expenditures, Per Capita and Per
$1,000 of Personal Income, Arizona and United States, Fiscal Year 2006
Per Capita Per $1,000 of Personal Income
Arizona
United
States
Arizona
Ratio to
U.S.
Arizona
United
States
Arizona
Ratio to
U.S.
Total General
Expenditures
$5,900
$7,137
83%
$186.57
$199.86
93%
Education 1,974 2,484 80 62.41 69.55 90
Health and Welfare 1,404 1,875 75 44.39 52.51 85
Transportation 474 536 88 15.00 15.02 100
Public Safety 685 638 108 21.67 17.85 121
Environment and Housing 550 552 100 17.39 15.46 113
Government Administration 358 374 96 11.31 10.49 108
Debt Service 216 288 75 6.83 8.07 85
Other 240 390 62 7.58 10.91 69
Source: U.S. Department of Commerce, Census Bureau.
16 | C h a p t e r 2
of service because of the limitations of the private sector described earlier. Spending beyond
that minimal level depends upon the community’s demand for that service. However, the
necessary provision as well as any desired increment does not come free—the service must
be paid for by taxes or user fees. It is often quite difficult to determine which decision comes
first. Should the jurisdiction determine the level of service and then raise enough revenue to
fund that service level or should the jurisdiction determine how much revenue should be
raised and then determine how much of the service can be provided with those revenues?
Public opinion polls do not always provide useful insight to answer this question since
respondents often indicate that the levels of most services should increase while at the same
time indicating that state and local governments should cut taxes. For example, in a January
2009 survey, more respondents wanted to increase spending than decrease spending on
elementary and secondary education, mass transit, freeways, police, universities, and fire
protection. Only for prisons and corrections did a larger number want to spend less. In the
same survey, 93% of the respondents wanted to cut state taxes.5 But, there is no such thing as
a “free lunch.” Just as there are costs to increasing service levels, there are also costs to
cutting services in order to reduce taxes.
Two basic principles underlie a revenue system. First, if a service provides a benefit to a
resident, the resident should pay for that benefit. For example, if a household visits a state
park, they should anticipate paying a park entrance fee. Just as with any private good or
service, if the household believes that the benefits received from the park exceed the entrance
fee, they should be glad that they are getting a good deal. However, if they believe that the
benefits are less than the entrance fee, they should not visit the park. Note that benefit
charges have nothing to do with the household’s income—both rich and poor households pay
the same entrance fee in this example—just as private-sector goods and services are not
priced on the ability to pay. Property taxes, if thought of as an entrance charge to living in a
jurisdiction that provides a particular bundle of services, are sometimes conceptualized as
benefit taxes.
Ability to pay (a household’s capacity for paying a tax) is the second principle underlying a
tax system (determining how to charge for public goods and services). An example of this
type of tax is the state income tax—its rates increase slightly as a taxpayer’s income goes up.
The concept is that wealthier people can afford that last dollar in tax payments easier than
poor people can. When ability-to-pay taxes are utilized, it is sometimes necessary to remind
people that these taxes are going to finance a portion of government services, and it is
necessary to look at both services received as well as taxes paid.
Economists generally believe that residents should be taxed for the public services they
consume while businesses ought to be taxed for the public services they consume.6 However,
based on this principle, businesses are overtaxed throughout the nation. A study that
compared business taxes to government expenditures that benefit businesses found that in
2006 the tax-to-benefit ratio was 1.83 nationally, with the lowest state ratio at 1.42.7
Arizona’s figure was 1.64.
C h a p t e r 2 | 17
As discussed in Chapter 9, the overall tax burden in Arizona is low, with the personal tax
burden very low. In contrast, the business tax burden is moderate overall, but ranges from
low among the smallest businesses to high among many of the larger companies (see Chapter
13). State government taxes on individuals are so low that many individuals (especially those
with children in the public schools) are not covering their public costs, with the costs shifted
to businesses.
Financing the construction of infrastructure represents a separate challenge. Typically, such
expenditures are done through debt issuance, though “pay as you go” also is used,
particularly in Arizona. Pay as you go implies that no capital investment is made until
enough savings have been accumulated to pay for that investment, which may take several
years of earmarking money in a special fund. If these savings can be protected (and given the
continuing fund sweeps that occur in Arizona, this is demonstrably unlikely), the principal
advantage of pay-as-you-go finance is that it minimizes the overburdening of future
generations of Arizona residents since they will not have to pay debt service. (In 2006, about
4% of expenditures went to debt service.) However, pay as you go also means that current
residents are not getting the benefits of the inbuilt infrastructure, that the economic growth
that the infrastructure would stimulate is not occurring, and that once the infrastructure is
built, future residents will be enjoying the benefits without having had to pay for them.
Debt finance increases intergenerational equity because debt is typically paid back over a
period of 30 years, implying that future inhabitants will be paying a share of the project’s
cost as they enjoy the project’s benefits. In addition, inflation will have less effect on the
price of the project because of the quicker completion. Further, state and local debt is
subsidized through a variety of mechanisms, including the ability to issue the debt at tax-exempt
rates (which are below market). The current federal stimulus package offers a variety
of debt forms that subsidize debt issuance.
PUBLIC GOODS AND SERVICES AND ECONOMIC DEVELOPMENT
The extensive literature on the relationship between tax breaks and economic development
seems to indicate that statewide tax incentives have a statistically significant, but small,
effect on development. Other research seems to indicate that economic growth encouraged
by low taxes may be seen as increasing demands for public services, thereby placing upward
pressure on tax rates faced by the original taxpayers, and so may be counterproductive.8
Less research has been done on the effects of state and local government services on
development.9 Research suggests that government spending on some public services has a
positive effect on some measures of economic development in some cases.10
In particular,
transportation and public safety seem to be particularly important to economic growth. Some
research indicates that state and local governments can undertake some common-sense
activities to stimulate economic development. Some of these activities include maintaining
high-quality public infrastructure, having states help local governments create a high quality
of life, and carefully dealing with regulations and taxes that could stifle development.
Infrastructure, much of which is provided by the public sector, is of particular importance to
economic prosperity. In the early 1980s, arguments began to appear in the media that if
18 | C h a p t e r 2
governments had more effectively managed infrastructure, its deterioration would not have
occurred and economic productivity would be higher. These accusations encouraged a more
rigorous study of the relationship between infrastructure and economic growth. It is
sometimes hypothesized that public infrastructure can affect economic growth by increasing
labor productivity, increasing the durability of private capital, and helping in private capital
formation. In general, most of the studies have found that accumulation of infrastructure is
important for productivity gains.11 Rates of return to infrastructure investment seem to range
from 25–50%, although the returns differ by geographic area and time period. Some argue
that the maintenance of existing infrastructure may be as important as its actual provision.
Public spending can help cities develop in many ways. For example, helping neighborhood
schools improve, making the streets safe, creating a competitive cost climate for businesses
and residents, helping investment in downtown revitalization, investing in catalytic
development projects, and creating marketable sites for development have all been
suggested.12 Many economists strongly believe that direct spending reductions during a
recession will generate more adverse economic consequences in the short run than either tax
increases or transfer program reductions, because tax increases or transfer payment
reductions would reduce savings rather than consumption, lessening their impact on the
economy.13
It is reasonably clear that regions are fiercely competitive in their desire for economic
development. While much of the discussion has revolved around cutting taxes to establish a
better business climate, the availability of quality public infrastructure and services—largely
paid for by taxes—also improves the business climate.
FUTURE EXPENDITURE CONCERNS
Government, particularly at the state level, will confront many pressures over the next
several years. Since state and local governments must balance their budgets, these pressures
call for significant changes in the revenue system and/or in public expenditures. This chapter
concludes with three examples—infrastructure, health care, and retirement benefits—but
there are many more relating to education, court and voter mandates, and so forth.
A recent study that analyzed Arizona infrastructure needs over the next 25 years found that
the state faces revenue gaps of many billions of dollars for new capital investment in energy,
telecommunications, transportation, and water.14 While the federal stimulus plan has
included within it several ways of beginning to attack these gaps, the available funding is in
the magnitude of $700 million.15 Several new tax-credit bond programs are available for
capital construction.16
Nationally, Medicaid spending has doubled in the last 15 years. Two-thirds of the spending is
for the elderly and disabled. A one-percentage-point rise in the unemployment rate causes an
increase of 400,000 nonelderly adults in Medicaid and adds 600,000 children to the State
Children’s Health Insurance Program. The Government Accountability Office (GAO) in
January 2008 argued that Medicaid and health insurance for state and local government
employees and retirees (retirement is discussed below) is the primary driver of the fiscal
These bonds make it less expensive to the state to finance
infrastructure improvements, if the state is willing to enter the debt market.
C h a p t e r 2 | 19
challenges facing state and local governments. The GAO forecasts a deficit of 1% of gross
domestic product (GDP) for state and local governments by 2010 and a 4% deficit by 2050
unless the system is substantively changed.17
Although Arizona does not spend as much on Medicaid as many other states—in some states
it is now the largest single expenditure item—demand for the Arizona Health Care Cost
Containment System generally follows the national pattern, though the state’s population
growth causes the rate of increase to be higher. In addition to the trend growth, sharp
increases currently are occurring due to the economic recession. AHCCCS rolls grew by
about 46,500 in just two months (June and July of 2009) and over the year experienced a
growth rate of 16%. The estimated 2010 shortfall is $253 million.
A third example of the increasing expenditure pressures facing state and local governments is
the interrelated pension and other post-employment benefit situation. Health insurance is the
primary post-employment benefit other than the pension.
Most state and local government employees in Arizona belong to the Arizona Retirement
System, a defined benefit plan (university professors have this as an option).18
Under a
defined benefit plan, employee and employer contributions as well as the investment
earnings on these contributions fund the benefit payouts. A fully funded system will have
adequate accumulated assets to meet the benefits earned by the participants at the time of
retirement. In Arizona, various parts of the retirement system are funded at different ratios—
the retirement portion of the plan is 82.1% funded, health insurance premiums is 85.7%
funded, defined contribution retirement is at 102.2%, and the long-term disability program is
at 49.7% (all estimates for June 30, 2008). The unfunded actuarial accrued liability (based on
an overall funding ratio of 82.8% for the entire plan) is about $5.5 billion.
Contribution rates, which are evenly split between employer and employee, are 18.8% for the
current fiscal year. The contribution rates of the current year and the three previous years are
the highest during the last 30 years. These rates are expected to rise further in the next three
years, perhaps by as much as a full percentage point.
These increasing costs will put a large burden on state and local governments. Solutions to
the general pension problems might include moving to a defined contribution plan (which
does nothing for the existing unfunded liability), cutting benefits, increasing the age at which
retired employees receive full benefits, and ending other expensive retirement options.
Solutions for the other post-employment benefit problems are equally difficult: put a dollar
cap on annual benefits; reduce benefits for pre-Medicare retirees by increasing co-pays,
deductibles, or other costs; limit the period of pre-Medicare retiree benefits that plans pay; or
eliminate inflation increases for retirees who terminate prior to reaching Medicare age.19
Jeffrey Chapman is the Foundation Professor of Applied Public Finance in the School of Public Affairs at
Arizona State University. Professor Chapman is a graduate of the University of California, Berkeley, where he
earned both his M.A. and Ph.D. in Economics. He holds an A.B. in Economics, with honors, from Occidental
College, Los Angeles. Following experience as an assistant research economist with the Institute of
Government and Public Affairs for the University of California, Los Angeles, he joined the University of
20 | C h a p t e r 2
Southern California in 1973. In 1999, he became the director of the School of Public Affairs at Arizona State
University and was the interim dean of the College of Public Programs from 2004-05. Dr. Chapman is the editor
and author of four books and has contributed chapters to several others. Scholarly journals and periodicals that
have published his work include Public Administration Review, Journal of Urban Economics, Public Budgeting
and Finance, National Tax Journal, Land Economics, Public Finance, The University of Southern California
Law Review, Public Choice, Public Finance Quarterly, and Public Works Management and Policy. His current
research interests are land taxes, arcane methods of infrastructure finance, economic development, and fiscal
sustainability.
1 Isaiah McCoy and Junk Wook Seo contributed to this chapter as research assistants.
2 Arizona Joint Legislative Budget Committee, FY2009 Appropriations Report (August 2008),
http://www.azleg.gov/jlbc/09app/apprpttoc.pdf.
3 Arizona Joint Legislative Budget Committee, http://www.azleg.gov/jlbc/fiscal.htm.
4 U.S. Department of Commerce, Census Bureau, http://www.census.gov/govs/www/estimate.html.
5.Michael J. O’Neil, “What We Want Depends on Question,” The Arizona Republic (January 4, 2009): B12.
6 See, for example, Robert P. Inman, “Financing Cities,” in A Companion to Urban Economics, ed. Richard
Arnott and Daniel McMillen (Malden, MA: Blackwell Publishing, 2006): 311-331.
7 Andrew Phillips, Robert Cline, and Thomas Neubig, Total State and Local Business Taxes: 50 State Estimates
for Fiscal Year 2008 (Ernst & Young, January 2009),
http://www.ey.com/Publication/vwLUAssets/Total_state_and_local_business_taxes:_50_state_estimates_for_fi
scal_year_2008/$FILE/Total_state_and_local_business_tax_fiscal_year_2008.pdf.
8 See Shelby Gerking and William Morgan, “State Fiscal Structure and Economic Development Policy,”
Growth and Change 29, no. 2 (Spring 1998): 131-145, http://www3.interscience.wiley.com/cgi-bin/
fulltext/119106825/PDFSTART.
9 The effects of taxes on development have been long controversial, with results changing with improvement in
econometric techniques. For a survey of the literature, see Michael Wasylenko, “Taxation and Economic
Development: The State of the Economic Literature,” New England Economic Review (March/April 1997): 37-
52, http://www.bos.frb.org/economic/neer/neer1997/neer297c.pdf.
10 For a survey of the literature, see Ronald C. Fisher, “The Effects of State and Local Public Services on
Economic Development,” New England Economic Review (March/April 1997): 53-67,
http://www.bos.frb.org/economic/neer/neer1997/neer297d.pdf.
11 For a literature survey, see Stéphane Straub, Infrastructure and Development: A Critical Appraisal of the
Macro Level Literature (Washington D.C.: World Bank Policy Research Working Paper 4590, April 2008),
http://www-wds.
worldbank.org/external/default/WDSContentServer/IW3P/IB/2008/04/14/000158349_20080414115839/Re
ndered/PDF/wps4590.pdf.
12 Jenifer S. Vey, “Revitalizing America’s Older Industrial Cities: A State Agenda for Change,” Retooling for
Growth (Washington D.C.: Brookings Institution, 2008), 33-60.
13 Nicholas Johnson, quoting Joseph Stiglitz and Peter Orzag, Budget Cuts or Tax Increases at the State Level:
Which is Preferable During a Recession? (Washington D.C.: Center on Budget and Policy Priorities, January
12, 2009), http://www.cbpp.org/cms/index.cfm?fa=view&id=1032.
14 Arizona Investment Council, Infrastructure Needs and Funding Alternatives for Arizona: 2008-2032 (Tempe,
AZ: L. William Seidman Research Institute, W. P. Carey School of Business, Arizona State University, May
2008), http://www.arizonaic.org/images/stories/pdf/AIC_FINAL_report.pdf.
15 These are figures from the “Federal Funds Information for States,” State Policy Reports 27 (February 2009).
16 Government Finance Officers Association, Issue Brief: Taxable Tax-Credit Bonds Programs (Washington
D.C.: GFOA Federal Liaison Center, 2009).
17 David M. Walker, “Long-Term Fiscal Outlook” (testimony before the Committee on the Budget, U.S. Senate,
GAO-08-411T, Washington D.C.: Government Accountability Office, 2008),
http://www.gao.gov/new.items/d08411t.pdf.
18 All data come from the Arizona State Retirement System, Comprehensive Annual Financial Report for Fiscal
Year Ended June 30, 2008, https://www.azasrs.gov/web/Publications.do.
19 Girard Miller, “Medicare Trumps the ‘OPEB Fairy,’” Governing (May 21, 2009),
http://www.governing.com/column/medicare-trumps-opeb-fairy.
C h a p t e r 3 | 21
Chapter 3
PRIMER ON STATE AND LOCAL
GOVERNMENT REVENUE1
Leezie Kim
Citizens Finance Review Commission
KEY POINTS
• Nationally, the majority of state and local government revenue comes from the
property, sales, and income taxes, in relatively equal shares. The property tax in
essence taxes wealth, the income tax is levied on earnings, and the sales tax is applied
to consumption.
• More narrow taxes, such as on the purchase of alcoholic beverages and gasoline, and
user fees are other significant sources of state and local government revenue.
• The sales tax base in most states, including Arizona, is largely limited to nonfood
goods. With an increasing share of consumer expenditures going to untaxed services
and untaxed goods purchased through the Internet, the sales tax base is not providing
revenue that is expanding as fast as the general economy.
• The property tax tends to be the steadiest source of revenue of the major revenue
sources. The narrow tax base of the sales tax contributes to fluctuations in collections
over the course of an economic cycle. Personal income tax collections vary
considerably, largely due to the volatility in capital gains. Corporate income tax
collections are even more volatile.
• Since the three major taxes do not rise and fall by the same magnitudes over an
economic cycle, tax experts recommend using all three sources in order to provide
more stable revenues over time.
• The sales tax code in Arizona is complex due to multiple tax rates across jurisdictions
and a multitude of exemptions.
• Arizona’s property tax code is extraordinarily complex and favors homeowners at the
expense of other taxpayers.
THE BASICS OF STATE AND LOCAL GOVERNMENT REVENUE:
NATIONAL PERSPECTIVE
Nationally, more than 20% of the total revenue available to state and local governments in
fiscal year 2006 originated as a transfer from the federal government. State and local
governments have little discretion over the use of these federal funds, which must be spent
for specific purposes. Thus, the focus of most analyses of state and local government revenue
systems is “own-source” revenue, which is collected mostly from taxes and user fees
assessed by state or local governments.
Most states rely on a combination of three major taxes to provide the majority of nonfederal
government revenue: sales tax, property tax, and income tax (personal and corporate).
Commentators refer to these taxes as the “three-legged stool” of government revenue,
22 | C h a p t e r 3
implying the need for all three tax bases and a relatively equal reliance on all three to create
the most balanced tax structure. These three taxes are each broad based and apply to
somewhat different aspects of the economy: consumption, wealth, and earnings, respectively.
Each is somewhat differentially affected by the economic cycle.
Nationally, these three taxes accounted for 56% of own-source state and local government
revenues in fiscal year 2006.2
More narrowly applied taxes accounted for an additional 13%.
The most commonly levied of these other taxes are luxury (or “sin”) taxes (e.g., taxes applied
on alcoholic beverages, cigarettes, and gambling), gasoline taxes, mineral taxes (taxes
applied on the extraction of minerals), and the real estate transfer tax.
User fees (such as tuition at public universities, local government impact fees, and real estate
licensing fees) accounted for nearly one-fifth of state and local government revenue
nationally in fiscal year 2006. (The U.S. Census Bureau, the source of the statistics cited in
this section, uses the term “current charges” instead of “user fees.”) The balance of state and
local government revenue comes from interest earnings and a variety of other sources.
Property Tax
The property tax is applied to real property (land, buildings, and improvements to the land)
and personal property within the state’s jurisdiction. Furniture, equipment, and tools used for
commercial purposes are taxed as personal property. For reasons related to the legal rights of
sovereignty, the customs of federalism, and the impracticality of taxing oneself, states do not
apply property tax on real property within the jurisdiction owned by Native American tribes,
the federal government, or the state itself, respectively.
Most states apply the property tax on a selected basis on privately owned personal property
within the jurisdiction. The most common property tax on personal property incorporates
motor vehicle registration and license fees, which are based on the value of the vehicle.
However, this is classified as a vehicle license tax, not a property tax, in Arizona.
Mobile and manufactured homes also are considered to be personal property and are taxed.
(However, a mobile/manufactured home permanently affixed to land owned by the owner of
the home is considered to be real property.) For reasons related to the administrative
difficulty of performing periodic valuations of individual household personal property and
assets, states have departed from the practice of applying property taxes on most residential
personal property. States still generally apply a property tax on the personal property of
businesses, which primarily affects capital-intensive businesses, such as utilities and
manufacturing companies. High-technology manufacturers, which use high-value equipment,
tend to be particularly affected.
All states levy a property tax at local government levels. In Arizona, most local
governments—including school districts, counties, cities and towns, community colleges,
and special districts—receive funding from the property tax, with school districts receiving
by far the largest amount. Arizona state government, like many state governments, receives
little revenue from the property tax.
C h a p t e r 3 | 23
Property taxes are primarily collected at the local (i.e., county) level and then remitted to the
state. Collections take place annually or semiannually. The large amounts are noticeable and
contribute to making the property tax unpopular. With mortgage lenders collecting a portion
of annual property taxes on a monthly basis from some borrowers, homeowners with
continuing escrow accounts may not perceive the impact of the property tax in the same way
as individuals who write the payment check themselves. Renters also typically do not know
the magnitude of property taxes that they pay: the property tax is one of the factors that
determine the amount of rent charged.
Regular appraisals of the property being taxed are a necessary component to assessing a
property tax. Appraisals are based on complex formulas that vary from state to state. The
valuation formulas typically include a market component, and thus the property tax moves up
and down with fluctuations in fair market value. However, the valuations generally have
artificial caps on how much a valuation may change from year to year so property tax
valuations usually are not equal to the fair market value of the real property.
The property tax tends to be the steadiest of the major revenue sources, with collections
fluctuating the least from year to year. Moreover, the public-policy problems associated with
property tax, such as the effect of the tax on fixed-income elderly homeowners who may be
cash poor despite free and clear property ownership, can usually be alleviated through
relatively simple, targeted measures, such as income tax credits. In Arizona, a constitutional
provision allows the valuation of property owned by low-income senior citizens to be frozen.
Sales Tax
Forty-five states collect what is generally termed a sales tax. However, the legal burden of
the tax varies by state. Technically, some states, including Arizona, levy a “transaction
privilege tax” in which the seller is responsible for remitting the tax. Sales taxes are levied as
a percentage of the sales price of the good or service purchased, but the goods and services
taxed vary from state to state.
There are six generally and widely accepted exemptions to the sales tax base, that is, sale
transactions to which no sales tax applies:
• Exemption due to federal pre-emption or sovereignty. The concept of federal pre-emption
in tax collection is that a state does not have the legal power to tax the
federal government or an agent thereof. The concept of sovereignty in tax collection
is that one government entity does not have the jurisdiction to tax another sovereign
entity (such as another nation or a Native American tribe). A related concept limits
the breadth of a state’s jurisdiction, legally preventing a state from taxing an entity
that does not have sufficient nexus with the state. This is the legal concept that
prevents states from taxing purchases from Internet companies that have no physical
presence within the state.
• Exemption to avoid double taxation. The sales tax is borne only by the ultimate
purchaser of the taxed product. Wholesalers thus are exempt from paying sales tax. In
addition, purchasers of parts for the manufacture of machines for ultimate resale
generally do not pay sales tax on the purchase of component parts. If the sales tax
were applied at every level of purchase in the manufacturing chain, the ultimate
24 | C h a p t e r 3
purchaser would be paying taxes not just on the value of the machine purchased, but
also on the taxes applied at each level.
• Exemption for ease of administration. There are some transactions for which
collecting sales tax is administratively difficult. An example in Arizona is the
exemption on the collection of a sales tax in the resale of an individual’s car to
another, when the seller is not a “dealer” as defined by statute. In this rather limited
category of exemptions, policymakers have decided the cost of educating the public,
collecting the tax, and assessing it fairly is greater than the revenue collected.
• Exemption for nonprofit endeavors. Policymakers have long supported an exemption
from the sales tax for nonprofit organizations recognized as such under the law.
• Exemption for certain goods and services considered “basic needs.” Perhaps to
balance out the relatively regressive nature of the sales tax, policymakers have
excluded certain “basic needs” goods and services from sales taxation. The most
common exemptions of this type are for grocery food items and prescription drugs.
• Exemption to support an economic development policy or industry. While created to
boost economic development, such exemptions frequently are criticized as
subsidizing an industry and as picking winners and losers.
Sales tax exemptions frequently are criticized as being the product of political lobbying
rather than rational tax policy.
Sales tax revenue is less volatile than income tax collections, but still is subject to
considerable cyclical ups and downs. In many states, the sales tax has provided an increasing
share of government revenues due to increases in the sales tax rate, while rates have been
lowered for the other two major taxes. Some states, including Arizona, rely heavily on the
sales tax.
A growing refrain from tax policy analysts is that there is a long-term problem with heavy
reliance on sales tax revenue. In most states, the sales tax base was developed in the 1930s
and is limited to goods. In the 1930s, manufacturing dominated the United States economy
and the purchase of goods made up the majority of household expenses. Over time,
households are spending more and more money on services, which are generally not taxed.
Prior to 1960, less than 40% of the nation’s personal consumption expenditures were for
services (except during the depths of the Great Depression). By 2008, this share reached
60%. Relying on sales tax revenue as currently structured is “like riding a horse that is
rapidly dying,” according to James Hite, a professor teaching tax policy at Clemson
University.3
In addition, the growth of Internet sales of goods is eating away at the sales tax base. States
cannot tax a sale by a party that does not have adequate legal nexus with the taxing state.
Virtual or Internet companies that have no physical presence within a state but ship goods for
sale to a buyer within a state may be beyond the legal power of the local taxing authorities.
Brick-and-mortar businesses competing with such virtual or Internet companies complain
bitterly about the economic disadvantage placed upon them.
As a result of the shift in consumer expenditures to untaxed services and untaxed Internet
goods, sales tax collections are not rising as quickly as gains in the overall economy. In
C h a p t e r 3 | 25
Arizona, taxable retail sales as a share of personal income have steadily fallen over the last
25 years. At the cyclical peak, the share was 32% in the mid-1980s, 30% in the mid-1990s,
and 28% in the mid-2000s. At the cyclical trough, the share fell from 28% in the early 1990s
to 27% in the early 2000s to only 23% in 2008.
Personal Income Tax
The personal (or “individual”) income tax generally is assessed on income earned (including
wages from employment, distributions from partnerships, capital gains from passive stock
ownership, and interest earnings). Forty-three states levy a personal income tax, but two of
these states limit the tax to earnings from dividends and interest. In a few states, local
governments also can levy an income tax.
In most states, the net income on which the personal income tax is assessed begins with the
federal adjusted gross income, from which a state may add certain income that is exempt
under federal rules or take out income that the state considers exempt. (For example,
Arizona’s allowable deduction for medical expenses is more generous than the federal
equivalent.) Reductions in income tax may come in the form of “deductions,” which are
reductions on the net income on which income taxes are assessed, or the more generous
“credits,” which are dollar-for-dollar reductions on the net income tax liability owed.
Revenue from the personal income tax is more elastic than from the property or sales taxes,
fluctuating the most from year to year based on the health of the overall economy. Most of
the variation comes not from fluctuations in wages and salaries, but rather from investment
income. In particular, capital gains have been especially volatile over the last 15 years, a
result of sharp fluctuations in the stock market and in the housing market.
Unincorporated businesses—small in size but numerous—also file income taxes using the
personal income tax. The volatility in the income of small businesses also contributes to the
variability in tax collections from this source.
Corporate Income Tax
Only a few states do not levy a corporate income tax. Since the tax applies only to
corporations—a relatively small portion of all businesses—collections from this source are
significantly less than collections from the personal income tax. The corporate income tax
accounted for less than 5% of total state and local taxes collected nationally in fiscal year
2006. Collections were only about one-fifth the magnitude of personal income tax
collections. Corporate income tax revenue is highly volatile, fluctuating more than the
personal income tax during an economic cycle.
Understanding how corporate income tax revenue is assessed is difficult. Large accounting
firms have entire departments devoted to just corporate state and local government income
tax management. The tax is assessed on the annual net income of a corporation, but the
formula is complicated by the fact that many corporations are located in multiple states.
Describing the formula in a crude fashion for the sake of brevity, the multistate corporation’s
income is divided among the states it operates in based on a formula related to the percentage
of employees, real property, and sales that occur within the state. Each state, however, may
26 | C h a p t e r 3
calculate the formula differently, making it theoretically possible for a corporation to be
paying taxes to more than one state on the same income or for there to be some income on
which no income tax is assessed.
In recent years, a number of states, including Arizona, have changed their employee, real
property, and sales tax formula to more heavily weight the sales factor. Thus, the percentage
of total corporate income that is taxed by a state relies more and more on that percentage of
sales that occurs within the state. This benefits companies that export their goods out of the
state. A more heavily weighted sales factor formula benefits an export company like Intel
relative to a local retailer like Bashas’.
Another reason corporate income tax levels may be so small a portion of a state’s overall tax
revenue base is that corporations engage in creative restructuring to lower their tax liability.
Some restructure to move taxes to low-tax jurisdictions or structure as partnerships, which do
not pay the corporate income tax.
PECULIARITIES OF ARIZONA’S REVENUE SYSTEM
Arizona’s revenue system is unusual in some regards. A political characteristic of note is that
any state revenue increase requires a two-thirds majority vote by the Legislature, but revenue
reductions only require a simple majority. See Chapter 5 for details. Tax cuts have proven to
be easier to enact than tax increases and once enacted are for all practical purposes
permanent. This is one reason Arizona tax policy analysts prefer a tax rebate rather than a
permanent tax cut when there is a budget surplus.
Mix of Tax Sources
Combined, state and local governments in Arizona are much more dependent on the general
sales tax than the national average. Lesser shares of revenue come from the personal income
tax, user fees, property tax, selective sales taxes, and miscellaneous taxes (see Chapter 9).
The comparison is more exaggerated when looking only at state government (see Chapter 7).
Nationally, the property tax provided 21% of state and local government revenues in 2006,
with income taxes accounting for 19% and the general sales tax for 16%. In Arizona,
however, the sales tax accounted for 27% of the total. Despite this heavy reliance on the sales
tax, Arizona’s state and local government revenues were more balanced among the three
primary sources than in most states.
Complexity of the Property Tax
Arizona’s property tax system is highly complex.4
This discussion only touches on the
complexity. The first distinction is between the primary property tax, which is used to
finance maintenance and operations of local governments, and the secondary property tax,
which is used to pay off bond indebtedness.
The assessed value of a property is estimated annually by the county assessor. The following
information, obtained from the Arizona Joint Legislative Budget Committee and the Pima
County Assessor’s Office,5 illustrates the lengthy process for determining the 2010 full cash
value of a property and then levying the tax:
C h a p t e r 3 | 27
• Using sales from January 2006 through September 2008, the value as of January 1,
2009 had to be determined by December 15, 2008.
• By March 1, 2009, the 2010 notice of value was mailed to property owners.
• Property owners had 60 days to file an appeal to the county assessor.
• The county assessor had until August 15 to rule on all appeals and send notice to
property owners.
• Property owners had 25 days to appeal to the County Board of Supervisors or, for
property owners in Maricopa and Pima counties, the State Board of Equalization.
• Appeals from the second stage had to be ruled upon by October 15.
• Property owners had 60 days to file an appeal with the state tax court.
• In December 2009, the tax roll is certified.
• In August 2010, tax rates are adopted.
• In September 2010, tax bills are mailed. The payment for the first half of the year is
due on October 1, 2010; the payment for the second half is due by March 1, 2011.
Thus, the tax year lags the valuation year by one year and payments are due in the fiscal year
after the tax year.
In a typical period of rising property values, this lengthy process results in a long delay
before the property owner must pay based on the increase in value. This delay is particularly
noteworthy in the case where a home is built on a lot previously assessed as vacant land. In
the recent environment of falling real estate values, property owners must wait to realize the
impact on their tax bill of the reduced valuation.
In addition to the full cash value, which in essence is equal to the market value, a limited
property value, which cannot increase more than 10% per year, is determined. The tax
liability is calculated by multiplying the limited property value by an assessment ratio to get
to the “net assessed valuation.”
Nine legal classes of property are defined in Arizona, with the assessment ratios varying
across these classes. The highest ratio, which is in the process of declining from 25% in 2005
to 20% in 2011, is for commercial property. In contrast, the residential assessment ratio is
only 10%.
The net assessed valuation is multiplied by the tax rate to determine the tax liability. The tax
rate is a combination of multiple tax rates of several overlapping jurisdictions, such as
county, municipality, school district, and special district. Thus, the tax rate varies across the
state, and even within individual cities. There are more than 3,000 taxing authorities in the
state: 410 for the primary property tax and the balance for the secondary tax.
In addition, a variety of tax exemptions and tax limitations affect the actual amount of
property tax paid. A number of the limitations are specific only to residential properties. The
effect of limiting the residential property tax is to shift the tax burden onto other taxpayers,
particularly businesses.
The homeowner’s property tax rebate reduces the school district primary tax levy. The rebate
is the process of going from 35% in 2005 to 40% in 2010, with the cap on the amount of the
28 | C h a p t e r 3
rebate moving from $500 to $600. In addition, the total primary property tax levy cannot
exceed 1% of the value of the residential property. Further, the primary property tax can rise
only 2% per year.
In addition to the real property tax, commercial businesses pay a personal property tax, which
is assessed on an annual basis on the value of depreciating capital assets owned by the
company. Thus, more capital-intensive businesses pay more taxes.
Complexity of the Sales Tax
Arizona’s state sales (technically, transaction privilege) tax rate of 5.6% is 23rd highest of
the 50 states. Passed by the voters in 2000, 0.6% of the tax is earmarked for education and
does not enter the state’s general fund.
Due to cities and counties levying an additional sales tax, the total sales tax rate is higher and
varies across the state. Further, the goods and services taxed vary by jurisdiction. County tax
rates range from 0.25–1.125%. Cities levy a tax ranging from 1.5–4%. The typical total sales
tax rate in a municipality is from 7.8–9.7%, with three cities having totals in excess of 10%.
These are relatively high rates that have some policy analysts concerned that the tax rate is
distorting buyers’ behavior.
The total sales tax rate has increased over time in Arizona, following the national pattern.
One reason Arizona voters and policymakers favor the sales tax is that it is exportable to
nonresidents: seasonal residents and tourists also pay the tax. However, sales taxes are
considered more regressive than most taxes because lower-income consumers spend a greater
portion of their total income on taxed goods. To address this concern, grocery food items are
exempt from the 5.6% statewide rate—but some cities still tax food.
Perhaps in part because Arizona’s combined state, county, and municipal sales tax rate is
high and rising, the number of sales tax exemptions have expanded during the last 25 years.
According to the Morrison Institute for Public Policy, the number of exemptions rose from
22 in 1980 to 121 in 1999.6 An analysis by public and private accounting and tax analysts on
behalf of the Citizens Finance Review Commission identified 220 exemptions as of 2003.7
In
an exemption-by-exemption analysis, the research group recommended that only 79 of the
exemptions be retained, 113 be repealed, and further study be conducted on two. The
estimated revenue in 2003 from the repeal of the 113 exemptions exceeded $900 million.
Cyclical Revenues
Another characteristic of Arizona’s revenue system is that tax revenues are highly sensitive
to changes in the economy (see Chapter 10). This cyclical nature creates significant
problems. The basic issue with cyclical revenue is that the demand for government services
is noncyclical—unlike the demand for most private-sector goods and services. In fact,
demand for some public programs is countercyclical, going up when the economy is down.
Arizona policymakers addressed this cyclicality by instituting a budget stabilization fund in
1990 (see Chapter 17). However, the original budget stabilization fund statute was changed
by the Arizona Legislature in 1995, reducing the maximum amount of money placed in this
C h a p t e r 3 | 29
“rainy-day” fund from 15-to-5% of the general fund. The limit was subsequently raised,
reaching 7% in 2000. A fund capped at this percentage has proven to be greatly inadequate to
offset the budget deficits experienced during the two economic recessions that have occurred
since that time.
Leezie Kim was the executive director of the Citizens Finance Review Commission in 2003 and the general
counsel to the Governor of Arizona in 2008. Ms. Kim has a bachelor’s degree from Rice University and a law
degree from the University of Virginia. She recently left sunny Arizona to move to Washington, D.C. at the tail
end of a shockingly cold January 2009 to serve as the Deputy General Counsel at the U.S. Department of
Homeland Security under Secretary Janet Napolitano. Ms. Kim grew up in Scottsdale, Arizona, where her
parents still live, and most recently spends her weekends in the D.C. area looking for a decent street taco and a
good green corn tamale.
1 This chapter is an update to a portion of Chapter 7, “Aligning Arizona’s Tax Structure to Meet Our State’s
Rapid Growth,” in the 89th Arizona Town Hall background report, Arizona’s Rapid Growth and Development:
People and the Demand for Service (2006).
2 U.S. Department of Commerce, Census Bureau, http://www.census.gov/govs/www/estimate.html.
3 Katherine Barrett et al., “The Way We Tax: A 50-State Report,” Governing Magazine (February 2003),
http://www.governing.com/gpp/index.htm.
4 For an excellent summary of this complex property tax system, see Citizens Finance Review Commission,
Property Tax Research Committee, Effects of Eliminating the Distinction between Full Cash and Net Limited
Property Value on Property Tax (2003), http://www.azcfrc.az.gov under “Research Reports.”
5 Office of the Pima County Assessor, http://www.asr.pima.gov/pdf/2010Valutation_timeline.pdf, and Arizona
Joint Legislative Budget Committee, 2008 Tax Handbook, http://www.azleg.gov/jlbc/08taxbook/08taxbk.pdf.
6 Arizona State University, Morrison Institute for Public Policy, Five Shoes Waiting to Drop (October 2001),
43, www.asu.edu/copp/morrison/apc2001.htm.
7 Citizens Finance Review Commission, Transaction Privilege Tax Research Committee, Transaction Privilege
Tax: Suggested List of Exemptions for Elimination (2003), http://www.azcfrc.az.gov under “Research Reports.”
30 | C h a p t e r 3
C h a p t e r 4 | 31
Chapter 4
THE RELATIONSHIP BETWEEN TAXES
AND ECONOMIC GROWTH
Tom R. Rex
Arizona State University, Center for Competitiveness and Prosperity Research
KEY POINTS
• Developed economies, as in Arizona, must rely on innovation and technological
progress in order to maintain economic growth. Education and research and
development are keys, while cost factors, including tax burden, are of lesser
importance to economic development.
• Businesses that sell (export) their goods and services to customers outside the region
drive the regional economy. Economic base activities that are mobile, such as
manufacturing, are of special importance.
• State and local government taxes have only a small effect on economic growth. These
taxes are small relative to federal taxes and to other business expenses, and represent
the price paid for public services used by businesses and individuals.
• Arizona’s tax burden on individuals is very low relative to other states, but this has
little effect on the state’s export sectors that drive economic growth.
• Most of the tax cuts implemented since the early 1990s in Arizona have been to
personal taxes that already were low from a national perspective. Some business taxes
remain high.
• Tax reductions boost economic growth only when the tax burden is relatively high. In
order for a tax reduction to have a net positive effect on public-sector finance, a
region must have underutilized resources.
• The tax cuts and tax increases passed in Arizona over the last 30 years have not had
any perceptible effect on the state’s economic growth. The tax cuts have lowered
government revenues, contrary to claims of enhanced revenues made by some supply-side
adherents.
ECONOMIC GROWTH1
Economic growth and development occurs in stages. Once development begins, it proceeds
in similar ways across countries:
• In the early stage of development, labor flows from agriculture into industry and
services.
• In a later stage, labor flows from agriculture and industry into services.
• As countries further progress, they purchase modern capital such as machinery and
equipment from the advanced economies and adopt the advanced production
techniques appropriate for their level of development. Countries in this so-called
“catch-up” phase of development become competitive relative to the leading
countries.
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• When the catch-up phase comes to an end, the country has a developed economy and
enters the advanced phase of economic growth. Innovation through technological
progress then becomes the key to further growth.
Existing industries in developed economies are subjected to global competition from the next
wave of low-wage global competitors in their own catch-up phase. As “catch-up” countries
compete successfully at lower costs for the older established industries, firms in these
industries in the advanced economy are forced to exit the market. Unable to compete on
wages and other cost factors, leading economies must innovate in order to continue to grow
economically.
Economic Growth in the United States
The United States has a developed economy. As discussed in Chapter 2, the private sector is
not always well-suited to efficiently provide various public goods. Thus, in order for the
nation to successfully compete, the federal government must be an active participant.
The federal government in particular is a key player in supporting research. Because ideas
are the product, research and development (R&D) is not like other products. Knowledge
cannot easily be restricted. Its ownership is difficult to determine and even more difficult to
confine. As such, the development of R&D provides spillover benefits to other users of the
ideas, and hence, the broader economy. It follows that the developers of R&D cannot obtain
the full rate of return for the invention because of the spillover. Hence, the private-sector will
underproduce R&D from the perspective of society, and the government can be justified in
intervening. Intellectual property regulations and subsidies for basic research are common
methods of intervention.
R&D has an obvious direct effect on innovation, and hence productivity, and an indirect
effect of causing accumulation of new technologically efficient capital. The secondary effect
can be very large. Furthermore, advances in R&D create new knowledge that becomes
available to others at no cost, inducing still more innovations at lower cost than the original
discovery. R&D is especially crucial for the invention process of leading economies. In
contrast, emerging economies can simply adopt the leading technologies from the developer
of the technology.
The closer to the technological frontier, the greater is the impact from expenditures on
research universities. Higher education also improves economic performance because
education is required for many high-skilled jobs and for producing cutting-edge technology.
Education also gives workers the flexibility to adjust to technological innovation.
Policies and institutions that promote competition and facilitate entry of firms and industries
with new technologies and exit of companies and industries that utilize old and inefficient
technologies are instrumental to economic gains in an advanced economy. Markets that work
most effectively will allocate resources freely across competing uses to the ones that are most
likely to result in growth. By extension, protection of industries, firms, products, and jobs
reduces efficient turnover.
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Each of the states within the United States has a developed economy. The states compete not
only with each other but with countries around the world. Countries in the catch-up phase are
the competition for products using older technologies while other developed countries
compete for newer products.
For a local economy to be competitive, state and local governments must provide certain
services:
• Government has a role in providing economically efficient access to the market for
education. Without government intervention, the private sector will underproduce
educational services, human capital accumulation will be inefficiently low, and
growth in living standards will suffer. Moreover, to compete in a developed economy,
research universities must be present.
• Modern physical infrastructure must be present to compete economically. There is a
role for government involvement with respect to efficient transportation and
communication networks, including cost-effective access to private or public “rights
of way” in corridors, trenches, conduits, tower sites, etc.
• Just as the federal government should get out of the way of market forces, state and
local governments should not protect existing companies and industries.
Enough revenue must be collected from taxes and other sources to pay for the public
institutions and infrastructure that promote growth, without imposing excessive tax rates. In
the advanced stage of economic growth, cost factors, including tax burdens, become less
important than in the earlier stages of growth, while education and research and development
become more important.
The Measurement of Economic Growth
The rate of change of real (inflation-adjusted) gross domestic product (GDP) per employee
(or per capita if employment data are not available) is used by economists as the proper unit
of measurement when comparing economic growth over time or across regions. GDP per
employee is a measure of the productivity of the economy.
Gains in GDP per employee are tightly correlated with advances in real wages. Thus,
productivity gains drive improvements in living standards. Indeed, without productivity
gains, there are no improvements in living standards, on average. Over a long time period,
small differences in economic growth rates have a very large impact on standards of living.
Economic Base and Population-Serving Industries
Some sectors of the economy, such as manufacturing, are highly export oriented. Other
sectors, such as retail trade, predominantly sell their goods and services to local residents and
businesses. Those businesses that sell (export) their goods and services to customers from
outside the region form the economic base of any region, regardless of whether the region
has an underdeveloped or developed economy. It is the export activities that drive any
economy. Without such activities providing jobs, the population-serving activities would not
exist.
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Export activities take many forms. The classic examples are agriculture and mining, whose
locations are dependent on local attributes of the land. These sectors are not mobile.
In contrast, most manufactured goods are sold to customers from outside the region, and
most manufacturing activities can locate anywhere. Regions compete with the rest of the
world for manufacturing facilities. Similarly, companies in many other sectors sell at least a
portion of their goods and services to customers outside the region and can locate elsewhere.
The presence in a region of such mobile export businesses is due to the region’s business
climate. A long list of regional factors—including availability, quality and cost of the
workforce; quality of life; and tax policy—determine the business climate and influence
location decisions of manufacturers and other export businesses.
Tourism and retirement migration also are basic economic activities. They are like
agriculture and mining in that their presence is in part due to local natural attributes (such as
climate, mountains, and bodies of water). However, the aspects of quality of life that are
determined by human decisions and activities also influence the number of tourists and
retirement-aged migrants that any region receives.
Just as private-sector markets that work most effectively allocate resources freely across
competing uses to the ones that are most likely to result in growth, public-sector policies
need to distinguish between economic-base and population-serving industries to the extent
possible in order to maximize competitiveness and economic growth.
TAXES AND ECONOMIC GROWTH
Nearly any position on the relationship between state and local government taxes and
economic performance is supported in the published literature. However, the bulk of the
modern literature indicates that state and local government taxes have only a small effect on
economic growth. Many factors affect economic growth.
Despite the attention given to taxes, state and local government tax payments are a minor
expense for most businesses. All state and local government taxes and most federal
government taxes—Social Security and payroll taxes, unemployment insurance taxes, excise
taxes, import and tariff duties, business license and privilege taxes, and the environmental tax
but not the federal income tax—account for only a little more than 2% of the operating
income of the average business. Thus, state and local government taxes are less than 2% of
business operating income for most businesses—a lesser expense than the compensation of
company officers.
Further, taxes represent the price paid for government services consumed. Many state and
local government services—such as the education of children and the provision of police
protection—are of high value to individuals and businesses alike.
State and local government business taxes receive attention because many state and local
governments grant tax incentives, tax credits, and tax exemptions to businesses. A rational
profit-seeking business will avail itself of such opportunities. In site location decisions, such
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tax breaks are a deciding factor only if two or more locations are viewed essentially equally
on all other factors.
Thus, state and local government tax burdens must be far out of line with competitor regions
before much of an effect on the economy can be measured. For a state, a tax cut will have
little effect on the economy unless the tax burden is comparatively quite high (especially
versus competing states) and the tax reduction is very large. In general, tax policy is an
inefficient way to stimulate the economy. Investment in infrastructure and education has
been shown to have a greater effect on economic growth.
The Laffer Curve and Supply-Side Economics
Supply-side economics is based on the concept that tax reductions stimulate economic
growth, with the stimulus so great that government revenue rises despite the lower tax rates.
The “Laffer Curve” popularized this theory.
The economist Arthur Laffer brought the relationship between taxes and economic
performance into the popular literature in the 1970s. However, the analytical foundations of
his Laffer Curve were established centuries ago. Moreover, the curve is a mathematical
relationship (Rolle’s Theorem).
The concept is simple. A single tax rate produces the greatest government revenue: the
revenue-maximizing rate (RMR). Setting rates below the RMR leaves governments with less
than maximum revenue but setting rates higher than the RMR stifles the economy, resulting
in lower tax collections despite the higher rate. The relationship between tax rates and
revenue collected follows a curve. The exact shape of the curve can vary by specific
circumstances, but the end points always are the same: No tax results in no public revenue
while a 100% tax rate would cause all legal economic activity to cease. The difficulties in
real-world application of this relationship are to identify the tax rate that constitutes the
RMR, and to describe the exact shape of the curve.
The simple concept of the Laffer curve has been lost in some applications. Some proponents
of limited government erroneously argue that tax rates are always above the RMR and
reduced taxation is always better.
Laffer originally discussed the relationship between tax rates and tax revenue in the context
of national tax rates, particularly the federal income tax, which was quite high in the 1970s.
The concept also is valid at a regional level such as a state. However, state tax rates are low
relative to the federal income tax rate. Thus, a decrease in a state tax rate is less likely to have
a supply-side effect and any effect likely is small.
On the other hand, a state tax by definition is narrower than a national tax and thus is more
likely to have a RMR that is being exceeded in reality. This is because states compete for
export-oriented economic activity, much of which is mobile (not tied to a particular place as
in the case of a mine). Capital and labor move easily throughout the country.
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While tax rates may influence capital and labor mobility across the states and give rise to
Laffer-type effects, capital and labor move for a host of reasons. The amount and quality of
public infrastructure (such as airports, roads, and schools) available in a region—amenities
supported by state and local government tax revenue—are among the factors influencing
economic growth. So the RMR in a state or region will be the rate that allows sufficient
investment in public amenities that foster economic growth without imposing tax burdens
that stifle growth.
For a tax cut to result in a positive effect on economic growth and government revenue, the
existing tax rate must be higher than the RMR. For much of a positive effect to result, the tax
rate must be very high and be lowered to near the RMR. Such a situation is most likely in the
case of a narrow tax. In addition, a greater economic impact is likely from a reduction in a
business tax with a rate above the RMR than in a personal tax with a high tax rate since one
business decision (for example, in site selection) can affect many workers.
Value of Public Services
Over time, some supply-side enthusiasts have moved to a position that any tax cut is good for
the economy and enhances public revenue—which violates the Laffer Curve. The idea that
lower taxes always are better ignores the purpose of taxation.
Taxes are the price paid for a service that is publicly provided. Particularly at the state and
local level, many government services directly impact the lives of all: education of children,
water provision and sewer services, collection of trash, building and maintaining roads,
police and fire protection, the judicial system, the correctional system, etc. Many public
services, such as education (kindergarten through graduate school) and provision and
maintenance of physical infrastructure, are of key importance to export businesses,
particularly high-technology and other “new-economy” companies. For these types of
companies, the quality of public goods is more important than the level of taxes. Thus,
business climate benefits from investment in various public programs.
Empirical evidence exists that public infrastructure plays a role in increasing business
investment, job creation, and economic growth. Similarly, tax reductions financed by cutting
education, infrastructure spending, and other services valued by businesses likely will have a
negative effect on economic performance.
The idea that taxes remove money from the economy is false. Tax revenue is spent in much
the same way as private-sector revenue: paying employees, purchasing materials from the
private sector, etc. On average, a higher portion of public-sector spending is for wages and
salaries while private-sector firms spend a higher portion of their revenue on raw materials
and manufactured goods, much of which must be purchased from outside the region. Because
of this, public-sector expenditures stay within the state’s economy to a greater extent than
private-sector expenditures. In other words, the in-state multiplier effect is higher for public-sector
spending than for private-sector spending.
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TAXES AND ECONOMIC GROWTH IN ARIZONA
Like the nation, Arizona’s economy is in the highest stage of development and must develop
new technologies in order to sustain its growth. Cost factors, including taxes, are of lesser
importance to interstate economic competition than in the past. Arizona’s real GDP per
employee in 2007 was 5% less than the national average.2
While Arizona ranked seventh
among nine western states, it ranked 20th among all 51 “states” (including the District of
Columbia).
Conceptual Basis for the Relationship
A significant distinction exists between business taxes (discussed in Chapter 13) and personal
taxes from the perspective of economic development. The distinction is blurred somewhat for
very small businesses—sole proprietorships and partnerships—that file income taxes using
the individual income tax. A disproportionate share of these unincorporated businesses serve
the local population.
Compared to other states, Arizona’s tax burden is very low on individuals (see Chapter 9),
but this has little effect on the state’s export sectors that drive economic growth. The tax
burden on small businesses in Arizona is lower than in the average state, but the taxes paid
by large businesses, especially some of the most desired export businesses, are relatively
high.
A policy of state government tax reductions has been present in Arizona since the early
1990s. Most of the tax cuts, particularly during the 1990s, have been made to individual tax
rates that already were less than the national average and lower than the historical rates in
Arizona. Thus, based on the Laffer Curve, Arizona was not generally in a position to benefit
from this series of tax cuts, either in terms of enhanced government revenue or economic
performance. Further, little tax relief was granted to businesses, though the tax burden for
some businesses is higher than the national average.
For a net positive effect to accrue on government finance from a state government tax cut,
the state must have underutilized resources. For example, if a state with higher-than-optimal
tax rates also has high unemployment and high commercial and industrial vacancy rates, then
a reduction in taxes to near the optimal point might stimulate economic growth, putting more
residents to work and more highly utilizing existing facilities. Since labor to support the
faster economic growth would not have to be imported to the state, population growth would
not accelerate. Thus, the increase in government revenue would not be offset by the need to
increase public spending to support new residents.
Except during recessions, Arizona has had neither high unemployment rates nor high
commercial/industrial vacancy rates. The majority of jobs created in Arizona are filled by
labor imported into the state from other states and other countries. Thus, even assuming that
tax cuts in Arizona did have an effect on economic growth, the requirement of excess
capacity was not met in order for a net benefit to accrue. If lowered taxes had stimulated the
Arizona economy, then even more labor would have had to have been imported into the state,
both for the construction of the facilities needed to house these economic activities and for
the permanent employment created. Thus, while public revenue would have increased, the
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need for public spending also would have risen. Unless the incomes of the imported workers
were above the existing average (considerably so if the worker had or would have school-age
children), the taxes paid by new residents would not have covered the costs of providing
them with public services.
Most of the taxes cut in Arizona since the early 1990s (discussed in more detail in Chapter 7)
have been broad-based taxes applied to individuals. In particular, decreases in the individual
income tax have accounted for nearly 60% of the cumulative $1.6 billion nominal overall tax
decrease since 1992.3
However, even in the early 1990s, the individual income tax rate in
Arizona was less than the average of the states. Using the Laffer Curve, this suggests that the
individual income tax cuts in Arizona should have decreased, not increased, government
revenue. Conceptually, it is unlikely that these tax cuts had much of an effect on the state’s
economic performance.
The remaining 40% of the tax cuts since 1992 have been split between the sales tax, the
residential property tax, the vehicle license tax, and the corporate income tax. Like the
individual income tax, the residential property tax rate in Arizona already was relatively low,
so this cut is unlikely to have had any positive effect on government revenue or economic
performance.
In contrast, the general sales tax rate in Arizona is high, so the reductions in the sales tax
potentially had a positive effect. Most of the revenue decline occurred in the late 1990s and
was due to the reduction in the commercial lease rate and to the passage of sales tax
exemptions. Similarly, the corporate income tax rate was relatively high before tax cuts were
implemented in the early 2000s and again recently. Thus, while these tax rates might have
generated a Laffer Curve effect, the magnitude of any benefit would be small given the very
small scale of the tax cuts from the perspective of the size of all business expe