Seeking Economic Boost, Arizona Cuts Capital Gains Taxes

By: - May 11, 2012 12:00 am

Arizona lawmakers approved a major cut in income taxes on capital gains last week, just the latest chapter in the debate over whether income from salaries and income from investments should be treated the same for tax purposes. That debate has roiled Washington in recent months in the form of Democrats’ “Buffett rule” proposal and has been popping up in states as well.

The federal government has assessed lower tax rates for capital gains income for decades, under a tax structure that supporters say spurs investment and, in doing so, helps the economy. On the other hand, as of 2011, only eight states broadly give capital gains similar preferential treatment: Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont, and Wisconsin. Now, Arizona will be the ninth.

Originally, supporters in the legislature proposed eliminating taxes on capital gains entirely. Although the legislation that ultimately passed doesn’t go that far — instead it phases in a 25 percent cut — business groups are still celebrating.

New Mexico saw substantial gains after cutting capital gains taxes a decade ago, according to Garrick Taylor, vice president of communications at the Arizona Chamber of Commerce and Industry. “This is big deal for Arizona,” Taylor says. “This is something we have never done before and to move closer to the way the feds and our regional partners treat capital gains is an extremely positive step for the state.”

Still, the move has skeptics. Democrats in the legislative minority argued that the changes would make the state’s tax code more regressive because lower-income workers typically get a larger share of their income from salaries, not capital gains. “It’s another check that’s cut for the wealthy,” says Democratic Senator Paula Aboud, “that will not create one job.”

With that argument about distributional fairness in mind, Democrats in some states have actually proposed going in the opposite direction: Providing preferential tax treatment for income that doesn’t come from capital gains. In Washington state, which has no personal income tax, some Democrats proposed creating a 5 percent capital gains tax this year. In Maryland, some Democrats also wanted higher rates for capital gains income than other income. Neither of those measures advanced.

Meanwhile, in Congress, the debate over Democrats’ Buffett rule was really a debate over capital gains taxes: The reason Warren Buffett can play a lower tax rate than his secretary is that most of his income comes from capital gains. With the Buffett rule, Democrats tried to create a new 30 percent minimum rate on all of millionaires’ income — which effectively would have raised capital gains taxes — but Republicans blocked those efforts.

In Arizona, the question isn’t just what the tax cut will mean for the state’s economy or its taxpayers, but also its budget. The state enjoyed a budget surplus this year, but faces an uncertain outlook after a temporary sales tax increase expires next year. To critics such as Aboud, the tax cut will exacerbate those difficulties and make it harder for the state to restore cuts to services it’s made since the recession began. Supporters, however, believe the tax cuts can produce enough economic growth to make the changes a net benefit for the state budget.

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Josh Goodman

Josh Goodman helps lead research on fiscal management and place-based economic development programs as part of Pew’s state fiscal health project. Goodman has served as a primary author for Pew studies that examine how states should evaluate tax incentives and maintain budget discipline when implementing those incentives.