Arizona Encountering a Major Revenue Problem with Tough Decisions in a Divided Capitol Looming

An end-around to placate the state’s highest earners and nullify a citizen initiative seemed like a clever move at the time. The chickens have since come home to roost however, and there may be some major repercussions.

Arizona is now staring down the barrel of a massive $1.7 billion deficit at the start of the legislative session. Since the budget is finalized at the end of the session, likely this summer, there will be plenty of time to narrow that gap, but it will be fraught with extremely difficult decisions and further showdowns between the Republican-led legislature and Democrat Governor Katie Hobbs.

So how did we get here? One thing that we can say definitively is that it was not because of a major increase in spending; the pro-public school faction will point to vouchers being a major contributor, but those were designed to come out of the existing education budget. Instead it was revenue that dropped like a rock. And why did revenue drop like a rock? Many attribute it to the flat tax enacted by then-Governor Doug Ducey to the state’s income earners.

As a reminder, in 2020 Arizona voters voted in favor of a ballot initiative that would have increased the marginal income tax rate on high earnings by 3.5%. While Proposition 208 did pass, it was later ruled unconstitutional, but in the meantime Governor Ducey pre-empted it by enacting a flat tax of 2.5% on all income. While it served as a tax cut for nearly all income earners at the time, many did project that it would lead to a significant drop in revenue.

The outcome, for lack of a better word, has been catastrophic: a 44% drop in revenue year over year as measured in May. Perhaps a parting gift for Hobbs, as the ramifications are only now being felt in force. Perhaps even more damning is that this includes a significant influx of people; Arizona had a 7% net influx of people in 2023, which should have led to an increase in tax revenues, all else held equal.

So what now? The state constitution makes it notoriously difficult to raise taxes, although hands may soon be forced. There is a rainy day fund, but that is not meant to account for a serious structural imbalance.

What is likely to happen this year will be an absolutely grueling battle, as hundreds of millions will need to be chopped from the budget to even approach a balance. How two sides that have been at each other’s throats begin to get to that point is anyone’s guess. It’s difficult to fathom how that gap will be bridged.

Suffice it to say, sine die won’t come early this year.