FILE - Scottsdale, Arizona

Scottsdale, Ariz., viewed from above.

(The Center Square) - On Friday, Gov. Doug Ducey signed legislation to create a new tax bracket for small businesses, excluding them from a potential 77% tax increase. 

Senate Bill 1783 creates a new tax class for small business owners who would otherwise file as a pass-through entity. This will allow them to forego the 3.5% income tax surcharge established by Proposition 208. 

Under the plan, “small business income” is defined as interest, dividends, profits and certain capital gains. A flat tax on small business income will phase in over time, starting at 3.5% in 2021 and decreasing to 2.5% in 2025. 

Sponsored by Sen. J.D. Mesnard, R-Chandler, the bill passed the Senate on June 28 along partisan lines. 

“Small businesses should be able to grow and reinvest in themselves without being forced to pay astronomical taxes,” he said. “Rather, government should get out of the way so that they can thrive.”

Ducey said in a release that the change sends a strong message to businesses that Arizona will not take more of their hard-earned money.

“This tax cut will keep Arizona competitive for small businesses already operating here and new businesses flocking here every day. After a year as tough as the last, we should not be raising taxes on our small businesses — we should be cutting their taxes,” Ducey said. “Arizona has now passed the largest tax cut in state history and will have the lowest flat tax in the country.”

Ducey signed the Fiscal Year 2022 budget on June 30, including provisions to transition from the state’s four-tier income tax to a flat tax of 2.5%, a lower rate than the lowest current tier. It also capped the state’s top income tax percentage that could be paid to 4.5%, meaning high-earners and businesses whose income triggers Prop. 208’s 3.5% surcharge would pay only an additional 1%. 

According to Ducey’s office, the historic tax cut saves money for every Arizona taxpayer, eliminates income taxes on veterans’ military pensions, and increases the optional charitable contribution deduction over time to 100%.

Critics of the tax cut say it benefits Arizona’s high-earners at the expense of the public education system. In debate, Democratic lawmakers said it defies the will of the voters. Activists are circulating petitions to repeal the law.

“It should be our goal as public servants to make filing taxes easier for Arizonans,” Rep. Ben Toma, R-Peoria, said on behalf of SB 1783. “This session has been a massive win for Arizona taxpayers.”

The business community praised the move, saying it sends a strong message to current and future job creators about the state's tax climate.

"This policy is one that could appeal to a variety of small businesses depending on their own individual plans and long-term goals," said Chad Heinrich, director of the National Federation of Independent Business Arizona chapter. "It’s a unique and innovative approach to taxing the income of small businesses and we’re glad to see Arizona leading the way with this option."

In a joint op-ed for Phoenix business journal, Ducey, Senate President Karen Fann, and Speaker of the House Rusty Bowers wrote that their tax reform plan would be successful because “we’ve made responsible, targeted investments over the past six years.”

They said that their decisions to invest in education and infrastructure and turn Arizona’s $1 billion budget deficit into a $1 billion surplus benefitted Arizonans of all incomes. The Arizona GOP leaders wrote that as a result, Arizona tied for first in the nation for personal income growth last year and is on track to add over 300,000 jobs by next spring.