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OPINION | NATHAN SMITH: Iron it out

Don’t add more wrinkles to tax code by NATHAN SMITH SPECIAL TO THE DEMOCRAT-GAZETTE | February 12, 2021 at 2:56 a.m.

The Legislature is in session, and as usual, tax code changes are being floated. Before we look at some, let's discuss a glaring flaw in the Arkansas state tax code, and how to fix it.

It's possible in Arkansas to end up poorer by earning more, because your state taxes alone rise by more than the extra money you earned. Some call that a "tax cliff." No other state tax code makes this blunder. Sen. Jonathan Dismang, R-Beebe, recently told Talk Business & Politics that he's working on a bill to smooth these tax cliffs.

Suppose you're a single person who's on track to earn $22,800 in net taxable income. Finish out the year like that, and you'll owe $535 in state income tax, leaving you with $22,265 in income after state taxes.

Now suppose your boss needs some extra help over the Christmas holiday. You step up and do a bit of overtime, earning an extra $100 in taxable income. Good for you!

Unfortunately, your state tax bill jumps to $720. Your income after state taxes is now $22,180. You have, at best, $85 less in disposable income. You probably owe extra federal taxes too. Hopefully you didn't already spend that overtime pay on Christmas presents!

The tax cliff is a speed bump on the road to the middle class. A person who had taxable income of around $20,000, and makes another $5,000, will see their taxes rise by $385. The state income tax rate they pay on the raise is 7.7%. That's higher than what six-figure earners pay. There are six more tax cliffs between $80,000 and $90,000. For example, someone who raises their taxable income from $82,000 to $87,000 will pay a whopping 16.4% of that raise in extra state income tax.

How did we get into this situation? As often happens, it came from good intentions. In 2015, lawmakers wanted to cut taxes for middle-class Arkansans, but they wanted to do it in a way that wouldn't be too costly to the state budget. So they carved up the tax code into three tax schedules. This process gave a tax cut to those in the middle of the income distribution, but without cutting taxes for high-income earners (though they would get a tax cut four years later).

Backing out of this three-tax-bracket situation will require forgoing a lot of tax revenue, but it is worth it in the long run. A simpler tax code, with no bad incentives, is better for both taxpayers and state government.

The situation is even more dire for the poorest Arkansans. Many of them use social safety net programs, which often have phaseouts as income rises. These phaseouts function like hidden taxes, reducing your disposable income. Taking these implicit taxes into account, a study titled "Marginal Net Taxation Of Americans' Labor Supply" by economists at the Federal Reserve Bank of Atlanta found that one in four low-wage workers in the U.S. faces a marginal effective tax rate of over 70%. That means that if these people earn $1,000, over $700 is lost in taxes and benefit cuts. For some Arkansans, the tax cliff would eat another $180.

To fix the tax cliff problem, let's get everyone back on the same tax schedule. A straightforward fix would result in a tax cut of about $180 per year for middle-class Arkansans, stepping up to just over $670 for high earners. Removing tax cliffs would result in a loss to state revenue, but policy changes could be crafted to offset or mitigate these losses.

Meanwhile, what other tax code changes are being proposed?

Sens. Jim Hendren, R-Gravette, and David Wallace, R-Leachville, have introduced state Earned Income Tax Credit proposals. That would help smooth the road out of poverty into the middle class. And Gov. Asa Hutchinson advocates a top tax rate of 4.9% for newcomers to Arkansas for the first five years. That might make the state more competitive in attracting talent.

But both changes would make the tax code more complicated and use revenue that could be used for other tax reforms, such as removing the tax cliffs or lowering tax rates for all, rather than a select few.

Let's iron out the tax code and work on getting rates lower. Don't add more wrinkles.

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Nathan Smith is a legislative research associate at the Arkansas Center for Research in Economics at the University of Central Arkansas. He holds a Ph.D. in economics and has worked in state government, most recently as state broadband manager. The views expressed here are his own and are not an official statement of UCA.

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