Don't work too hard this December. Not because it is a great time to spend with your family instead of with work (though that is true). Don't work too hard because it could cost you big time due to Arkansas' curious new tax rules. For some people, an extra dollar of income could be a costly mistake.
Don't get that extra job. Don't let your spouse work overtime. Don't try for that bonus. Why? Arkansas has a very strange income-tax structure. Earning additional dollars doesn't just increase your tax rate, it can change the tax rate for dollars you've already earned. For example, if you have earned just under $21,000 this year, be careful; that last dollar you earn could cost you almost $17 in taxes. Similarly, if you have earned right around $75,000, that extra $1 of income could cost you $60 in taxes.
Arkansas' tax structure is very unusual in this respect. Many states and the federal government have a progressive tax system. That means that higher earners pay more than low earners, and as you earn more, the tax rate increases. This is quite common.
Alas, Arkansas' complex tax policy has three different tax schedules (as well as separate low-income exemption tables). Earning more money could push you from one tax schedule to another. The higher tax schedules have higher rates not only for the additional dollars, but for previously earned dollars.
How did this happen? It is an unintended consequence of an otherwise worthy attempt in 2015 to cut taxes for the middle class. In order to specifically target the middle class but keep state revenue comparable, new tax brackets had to be introduced such that high-income earners (defined as above $75,000) didn't benefit from these income-tax cuts very much.
The different rate schedules create "tax cliffs" which are instances where a small increase in income dramatically increases tax liability.
For example, right at $75,000, a little more income would result in hundreds of more dollars in taxes. Something had to be done to offset this "tax cliff." Thus, the new tax law also included several adjustments to ease the high burden, not only at $75,000, but at each $1,000 increment up to $80,000. But as with many well-intended plans, this created five more tax cliffs! And for some tax cliffs, an additional $1 of income increase taxes by $100, implying a marginal tax rates of 10,000 percent.
Yes, you read that right.
Confused yet? Don't worry, even tax experts and some legislators who voted for this are confused too. Critics will say that this complexity doesn't matter because your tax preparation software can easily handle these changes. But this overlooks an important economic effect: how the law changes incentives, particularly for those right around key income "cliffs" in the tax code.
Aside from these new tax cliffs, Arkansas has many other problems in its tax system. Our taxes are more complex, less fair, and higher than many competitor states. But by reforming our tax system, we can remedy all three of these problems.
Normally when we think about tax reform, we think about lowering taxes. That's great. But tax reform can also mean reforms that improve the tax code even without lowering government tax revenue.
The Arkansas Center for Research in Economics recently released a comprehensive analysis of the Arkansas tax code in cooperation with the Tax Foundation in Washington, D.C. The analysis presents several ways to make the tax code simpler, fairer, and incentive-compatible to better compete with neighboring and regional states.
In addition to simplifying the complex three-bracket system, they recommend removing special-interest exemptions in the sales tax and corporate income tax. Those special exemptions lead to higher rates on everyone else, and more importantly, they are just unfair.
They also recommend lowering income-tax rates and broadening the tax base. Under their suggested reforms, the vast majority of Arkansans would see an income-tax cut, and taxes overall would be simpler, fairer, and more in line with principles accepted by economists across the political spectrum.
Taxes fund important public services, but some taxes hurt more than others. Wouldn't a simpler, fairer, more incentive-compatible tax system be better?
Dr. David Mitchell is an associate professor of economics at the University of Central Arkansas and the director of the Arkansas Center for Research in Economics (ACRE).
Editorial on 12/19/2016