What Will the Arizona Individual Income Tax Rates Be for 2021 and Beyond?

Recent ballot initiatives, legislation, and lawsuits have created uncertainty about Arizona individual income tax rates. What the rates will be for 2021 and beyond remains unclear.

Tax Year 2021 Changes

Proposition 208 Subjects High-Income Earners to Tax Surcharge

Proposition 208, approved by voters in 2020, imposes a 3.5% income tax surcharge on top earners beginning in tax year 2021. Revenue from the surcharge provides direct funding to schools. Proposition 208 imposes the surcharge on taxable income over:

• $250,000 for single filers and married taxpayers filing separately; and
• $500,000 for joint filers and heads of households.

The surcharge effectively increases the top individual income tax rate from 4.5% to 8%.

Legislation Caps Tax Rate Applicable to Individuals Subject to the Surcharge

In response, the Arizona Legislature enacted S.B. 1827. The law caps the income tax rate for individuals subject to the surcharge 4.5%, effectively nullifying the Proposition 208 increased rate on high-income earners.

Supreme Court Rules Proposition 208 May Be Unconstitutional

Opponents of Proposition 208 filed a lawsuit challenging the constitutionality of the initiative. They questioned whether the initiative’s direct funding provision mandated expenditures in excess of constitutional spending limitations. Based on the limited record before it, the Arizona Supreme Court said it appeared likely Proposition 208 would produce far more revenue than the state could constitutionally spend. But, the Court remanded the case to the trial court to make that determination.

Changes for Tax Year 2022 and Beyond

Legislation Lowers Tax Rates, Phases in Flat Tax if Revenue Targets Are Met

The Arizona Legislature also enacted S.B. 1828, which reduces individual income tax rates beginning in tax year 2022. For 2022, the legislation consolidates the state’s four tax brackets into two, with tax rates of 2.55% and 2.98%. After 2022, the tax rates decrease to 2.53% and 2.75%, or a flat 2.5%, if the state meets certain revenue targets. These will replace the current tax brackets, which have rates ranging from 2.59% to 4.5%. The 3.5% surcharge (if upheld) and 4.5% cap on top earners are not affected by the tax rate changes.

Referendum Petition Seeks to Reverse Legislative Changes

A referendum petition seeks to overturn the tax rate cuts enacted in S.B. 1828. If the measure qualifies for the ballot, voters will decide the issue in November 2022.

Lawsuits Challenge Validity of Proposed Referendum

But, lawsuits seeking to block the proposed referendum have been filed. One complaint argues that the tax rate cut legislation is not referrable, because the Arizona Constitution prohibits referendums of legislation for the support and maintenance of state government. Another complaint alleges that many of the signatures filed for the referendum are invalid.

Other Significant Income Tax Legislation

Further complicating matters, Arizona also enacted the following major income tax changes in 2021:

• S.B. 1783, allowing individuals with Arizona small business income to elect to pay an alternative tax on that income beginning in tax year 2021; and
• H.B. 2838, creating an elective pass-through entity tax option beginning in tax year 2022.