Fiscal cliff could stall Arizona’s entrepreneurial leadership

Published in Inside Tucson Business

As the fiscal cliff discussion takes Washington, D.C., by storm, a number of state governors paid a visit to the White House to bring their perspectives on the complicated negotiations. The one apparent theme of the visit was a plea for a solution to the fiscal cliff debacle. This is for a good reason. Failure to find a solution will, in all probability, mean another painful recession for the nation and the states will get the short end of the stick.

For Arizona, memories of the “great recession,” which lasted almost 2½ years and ended in December 2009, are still fresh. The state suffered immensely.

Arizona gross domestic product fell by 8.2 percent in 2009 and at the height of recession the state’s unemployment rate reached almost 10 percent. State tax revenues, which mainly rely on income and sales taxes, fell by nearly one-third during the recession. Arizona lawmakers took appropriate actions to confront the problem head on. Major jobs packages that included business tax reductions and job incentives were signed into legislation in 2010 and 2012.

Arizona has begun to slowly recover, but unemployment is still a problem (8.1 percent in October 2012). However, recent state tax changes have put the state on the right path. Job creation has started and the 2011 Kauffman Index of Entrepreneurial Activity put Arizona at the head of the pack. Arizona had the highest entrepreneurial activity rate in the nation, 520 per 100,000 adults were creating businesses each month compared to an overall number of 320 per 100,000 adults for the nation as a whole. Any bad news from Washington, D.C., such as the possible increase in the federal capital gains tax rate, will be a direct impediment to Arizona’s economic recovery.

Investors already face high combined federal and state tax rates on capital gains. An analysis released by the American Council for Capital Formation based on a survey conducted by Ernst & Young shows investors currently face state-level capital gains taxes in 41 states with an average top individual capital gains tax rate on corporate equities of 5.7 percent in 2012.

Combined with the federal rate, these taxes substantially increase the separation between what an investment yields and what an individual actually receives (the “tax wedge”). The higher the tax wedge, the fewer investments that will be worth an investor’s time and risk, resulting ultimately in fewer investments being undertaken and longer holding periods as investors delay selling assets.

Both of those outcomes will ultimately further pressure tax receipts.

While Arizona’s capital gains tax rate is below the U.S. average, an Arizona resident currently pays a top combined effective federal and state rate of 18 percent.

Assuming the Bush-era tax cuts, including those on capital gains, are extended through the end of 2013, that rate will increase to 21.8 percent due to the new mandatory 3.8 percent Medicare surcharge on savings and investment which takes effect next year as part of the new health care law.

Then there is the most sobering scenario — if Congress doesn’t act and allows the Bush-era tax cuts to expire, the federal capital gains taxes will return to 20 percent. Under that scenario, Arizona residents would see a dramatic jump to a 27.7 percent combined rate (including the Medicare surcharge).

Legislation was signed into law on May 11, 2012 included a 25 percent reduction in the state capital gains tax rate (phased in over three years beginning July 1, 2014). This was the right thing to do to spur entrepreneurial activity in Arizona.

However, if the nation goes over the fiscal cliff, the state’s effort might prove fruitless, especially in terms of investment and job creation. The increase in federal rates will more than offset the reduction in Arizona’s capital gains tax rate.

In recent years, each $1 billion increase in investment in the U.S. is associated with an additional 23,200 jobs. Conversely, decreasing the amount individuals and firms will invest due to federal and state capital gains taxes form a direct impediment to entrepreneurship and economic growth.

Research by Allen Sinai, an internationally highly regarded economist, has already predicted a decrease in jobs simply from moving from the current 15 percent tax rate on long-term capital gains to 20 percent. Real economic growth falls byan average of 0.05 percentage points and jobs will decline by an average of 231,000 per year.

For Arizona to keep its entrepreneurial stride, lawmakers must foster a favorable tax and business climate to allow risk taking and investment. The state has taken important steps to do just that. However, it is hard to keep your head above when the federal deadlock threatens to pull it back under.

A speedy and responsible resolution to the crisis in Washington will allow states like Arizona to breathe a sigh of relief.

Dr. Pinar Çebi Wilber is a senior economist for the American Council for Capital Formation (www.accf.org), a Washington, D.C., nonprofit, nonpartisan organization promoting pro-capital formation policies and cost-effective regulatory policies.