Alia Beard Rau

The Republic | azcentral.com

When it comes to state-government finances, Republican and Democratic lawmakers agree on one thing: They hate tax credits.

You would never know by watching them.

Over the past two decades, the Legislature has created dozens of income-tax credits, starving the state's general fund of more than $400 million a year that instead goes directly to taxpayers' favorite schools, charities and business ventures.

State leaders agree the piecemeal handouts are destroying Arizona's tax system — by overcomplicating it, some say, and by removing too much from the state coffers, others argue.

Still, lawmakers continue to pile on more credits.

It's a bad policy that feels good.

"It's a feel-good thing, but at some point you have to draw the line," said Sen. Steve Farley, D-Tucson, who has supported tax credits. "You cannot look at it separately from the big picture. We would all like to lower taxes. We would all like to pay no taxes. But then we have no way of paying for the public-education system that lifts people out of poverty and creates the trained workforce that we need."

This year alone, lawmakers have introduced more than 30 bills seeking tax credits and tax exemptions.

Meanwhile, no bills propose any sort of comprehensive tax overhaul that clearly sets the state on a path toward balancing taxation and revenue needs.

"The focus that needs to happen on tax-credit policy is at a crisis point in Arizona," said Dick Foreman, president and CEO of the nonpartisan, non-profit Arizona Business and Education Coalition. "We are headed to some very dark days in our general fund if we don't reverse the trend. It's absurd."

A $400 million hit

There are currently 38 tax credits on the books.

Last year, 1.7 million Arizonans claimed $287 million in individual income-tax credits, according to an analysis provided to The Arizona Republic by the state Department of Revenue.

About 39,000 Arizonans claimed enough credits to avoid paying any state taxes all.

The credits now cover everything from private school tuition and public-school extracurricular activities to renewable energy production and hiring national guard members. Individuals claimed $84 million in tax credits for private-school tuition organizations in 2014.

In 2013, the most recent year available, 466 businesses claimed $129 million in tax credits, including $87 million for research and development, according to the Department of Revenue. And companies have squirreled away more than $700 million in unclaimed credits, which they could cash in at any time.

Once a tax credit is created, it's almost never eliminated.

Establishing one requires a simple majority, but eliminating it is considered a tax increase and thus needs the support of two-thirds of the Legislature.

A committee reviews the credits every 10 years and makes recommendations. But suggestions that some credits be discontinued are often ignored, even when they aren't used or benefit only a handful of Arizonans.

Several of the tax credits have so few applicants the state can't legally release information about them because it would potentially identify the beneficiaries. Others, according to Arizona Department of Revenue data, haven't been used in years — such as the individual credits for hiring national guard members or for buying a pollution-control device.

"Who is going to run a bill to take away a tax credit for hiring a national guard member?" Farley asked. "The system is set up to keep the tax credits in place."

Yet as they've expanded, they've had an insidious impact on the broader budgeting process.

Senate President Andy Biggs, R-Gilbert, said credits don't show up in budget documents as a state expense, even though they cut into the general fund's bottom line. Most lawmakers have no idea how much a tax credit ends up costing the state even years after it's passed, Biggs admitted.

Gov. Doug Ducey is concerned about the piecemeal approach to tax credits, his spokesman Daniel Scarpinato said.

Last year, the governor signed into law bills expanding both the public-school tax credit and the charitable tax credit.

"People who can pay for lobbyists are able to get tax credits that regular Arizonans can't, that small businesses can't and that startups can't," Scarpinato said. "We need to make sure we are approaching these things in a way that is fair."

Farley agrees.

"We tend to focus on the micro here too much when we need to look more at the macro," he said. "You are making the entire finance system a piecemeal approach that ends up rewarding a lot of special interest and punishing the larger state interest, which is to get a sustainable source of revenue you can count on year to year to pay for the things like education and transportation and public safety."

A matter of 'mission creep'

State political, economic and business leaders in the late 1980s and again twice in the early 2000s collaborated to develop comprehensive tax plans for Arizona.

"There was general consensus that the income-tax system ought to be simple and broad-based," said Arizona Tax Research Association President Kevin McCarthy. "The goal was to get income taxes on one sheet of paper. It's ironic that it doesn't take long for that consensus to decay."

Their suggestions were largely ignored. And nearly all the tax credits have come since then, McCarthy said.

"And none of them have any connection to any policy," he said. "It's because a lawmaker will have an idea they want to put some bell or whistle on the system."

Biggs said it's time for broad-based tax reform. "We need to do property-tax reform. We need to do funding reforms for K-12 education, which is related to property-tax reform. Income taxes need to be reformed," he said.

Biggs said he has such a proposal but did not introduce it this session. He continues to allow tax credits to advance through the Senate and has voted for expanding credits this session.

House Speaker David Gowan, R-Sierra Vista, did not respond to an interview request made via his staff. He also continues to allow tax credits to advance through his chamber, and has voted for several so far this session.

This year, Republicans and Democrats have both introduced bills to expand tax credits. They include an $80 credit for taking gun-safety classes, and a credit to help teachers who buy school supplies for their classrooms.

The school tax credits, in particular, have drawn criticism.

Children's Action Alliance President and CEO Dana Wolfe Naimark, said school tax credits funnel money to higher-income campuses at the expense of lower-income schools.

"When we come down here session after session and talk about classrooms being overcrowded, classrooms having outdated textbooks and no technology, the answer we get is, 'Sorry, there is no money,' " she said. "That's just not a true answer. The money is being diverted. If this money wasn't going to the tax credits, it would be in the state's general fund."

Out of desperation, she said, lawmakers then propose more tax credits to help make up the shortfall.

"It just makes the problem worse," she said. "You just keep shrinking the general fund."

Farley said some credits begin with good intentions, but then are tweaked and expanded.

"Public-school tax credits are a classic example of mission creep," he said. "It started as something designed to fund arts and music and sports programs, all of which were being cut by schools. We've already expanded it several times. This year, we see three more bills expanding it."

Shawn Novak, a tax policy expert with Arizona State University's School of Public Affairs, said Arizona's tax system is considered among the most regressive in the nation. For example, data shows that higher income schools and individuals benefit more from many of the tax credits than lower income schools and individuals.

"In an era of increasing income inequality, it's a real problem," he said. "Do you really want to have a tax system that is maybe contributing to inequality?"

Credits hit a critical level

The amount of general-fund money being diverted to tax credits has reached a critical level.

It totals more than what Proposition 123 is projected to bring to schools each year if voters approve the initiative in the May 17 special election. It nearly equals what the state has in its rainy-day fund, and what it spends on child welfare.

Tax reform to address that situation, however, would require leadership from the Legislature and governor.

Ducey hasn't publicly discussed any detailed vision for tax reform other than to say he wants to move toward eliminating income taxes. That would, by default, end tax credits because they're deducted from income taxes.

While he established a committee to look at overhauling the state's school-funding formula, Ducey has not yet forged a similar path on the tax formula.

Ducey has promised to deliver a tax cut every year he is in office, but has not revealed his proposal this year. He has indicated it will be "incremental."

"Certainly the governor has made it clear he wants to lower taxes for Arizonans," said Scarpinato, the governor's spokesman. "He's also talked about reforming the tax code, making it fairer, making it better. It's a discussion the governor wants to have."

Scarpinato said the process would be collaborative, involving input from taxpayers, the business community and education leaders. He emphasized that for Ducey, any tax reform discussion would focus on cutting taxes.

When it comes to taxes, there appears to be little common ground other than a desire to change the current system.

McCarthy said he would advocate for the simplest formula possible. "The ideal should be broad-based, low rates," he said. "The flat-tax argument."

Farley, along with most Democrats at the Legislature, oppose additional corporate tax cuts as well as eliminating the income tax. And raising the sales tax is a non-starter for them.

"We need to determine what we need to thrive in the 21st century, and we need to figure out a reasonable, equitable and fair way of paying for it," he said. "Enough tax cuts. We've got to have enough investment in our schools, our transportation, our public safety, everything we need to be able to operate as a society."

But he said he believes Democrats and Republicans can work together to overhaul the tax system.

"We need to have people in this Legislature with the political courage to commit to carrying it out," he said. "It takes a willingness for people across the aisle to hold hands and jump off a cliff and talk about issues of revenue and issues of investment and how we can make this happen. It requires some very gutsy leadership that I haven't seen yet."

It will also require the public demanding change to spur leaders to action, he said.

Foreman, the Arizona Business and Education Coalition CEO, said a push from the community and business groups has already begun, and he hopes it will grow.

"We've made the tax code incredibly complex. There are winners and losers, and the schools are getting the worst of it," he said. "I think we should all be winners, and the way to do that is through transparency, simplicity and evening out the rate."

But while the business community is very influential at the Legislature when it comes to tax policy, Novak, the ASU tax policy expert, said state leaders will need to go out of their way to make sure the public has a voice on a topic that can sometimes be confusing.

"What you really need to hope for is elected officials who really do want to come up with the right policy and who understand it can be a one-sided game where the business lobby has all of the advantage," he said. "Officials will have to seek out and make time for the underrepresented, which with taxes is the masses."

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Tax credit proposals

More than half a dozen bills this year propose to add or expand credits, and come from both Democrats and Republicans:

A new tax credit for donations to low-income schools.

A new credit to cover the cost of gun-safety training needed for a concealed weapons permit; legislative analysts estimate it could cost the general fund $1.9 million a year.

A new tax credit for early childhood education programs.

A new credit for teachers who buy classroom supplies; analysts estimate it could cost the state about $8 million a year.

Expand the existing public K-12 school tax credit to apply to classroom supplies.

Expand the existing public K-12 school tax credit to cover additional sports programs.

Increase the credit limit on charity donations to $400, from $200; analysts estimate it could cost $2.8 million a year.

What you need to know about Arizona's tax credits