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Arizona Income Tax Change: A Boon to Investment and Job Growth

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Arizona income tax legislation signed in April by Governor Doug Ducey is sure to make the state more enticing to small business owners. Senate Bill 1188 allows individuals and business owners to count up to $500,000 of long-term capital investments as an expense in the year of purchase, rather than just that year’s depreciation expense. Until now, only $25,000 of investments could be expensed.

How Expensing Long-Term Investments Works

When a long-term asset is purchased for business use, only a portion of the entire cost of such equipment counts as an expense for tax purposes during a given year. After all, this asset (whether it is a piece of equipment or property) may be used for decades into the future. For instance, if a lumber yard acquires a $500,000 sawmill that will likely last 10 years, $50,000 of that cost will be counted as an expense for each of the next 10 years. This $50,000 annual depreciation expense is deducted from business revenue to determine the net income.

Long-term expensing is important, because the annual income tax of a business is based on that year’s net income. Consider the example of the lumber yard again, assuming an effective federal and state income tax rate of 30 percent. Allowing $500,000 of the purchase to count as an expense in the first year lowers the income tax by $150,000. On the other hand, with the purchase price spread over 10 years, only $50,000 of the sawmill could count as an expense the first year, lowering taxes by just $15,000. This is a whopping $135,000 in taxes based on when a business owner can count a purchase as an expense.

Permitting upfront expensing is especially important for new and small businesses. Many new businesses make little, if any, profit during their first few years. In addition, cash flow during the start-up period is a big concern. Many aspiring entrepreneurs are forced to put plans on hold because their businesses’ limited cash flow might make it difficult to earn a living during the first few years of an otherwise viable enterprise.

Incentivizing Investment and Entrepreneurship

Expensing $500,000 could make all the difference in the aforementioned situation. For a company that shows no net income during the first year rather than close to $450,000, an extra $135,000 in cash could be used to pay staff or grow a business rather than feed state and federal government revenues.

Sure, on this surface this may result in lower tax revenue during the first year of the change. But simply looking at the initial $31 million cut in Arizona income tax revenues misses the bigger point. In future years, the income tax collected on identical levels of revenue will likely be higher because equipment depreciation deduction expenses will be lower. Remember, up to $500,000 of long-term capital investments can be deducted in the year of purchase rather than spread out over possible decades. The state will regain much of this lost revenue in future years. More importantly, this change spurs business investment and thus future growth by encouraging production equipment purchases. Furthermore, entrepreneurs may be incentivized to start their own companies, knowing that the first few years might not be so lean as previously feared.

Allowing investors to immediately deduct $500,000 in purchases as an expense incentivizes both investment and entrepreneurship. The initial lower tax revenue is a small price to pay for the long-term dividends of increased business growth and jobs creation.

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Joel Griffith is an attorney, writer, and financial professional based in Washington, DC. Presently, he is a research associate in the Chief Economist's Office at The Heritage Foundation. Joel graduated from the Chapman University School of Law where he was Treasurer of the Investment Law Society at Chapman and vice-president of the Chapman chapter of the California Republican Lawyers Association. In Throughout the 2012 election season, he worked for a presidential campaign as MI state field director, OH state operations director, and parliamentarian/assistant delegate strategist in WA . Joel also serves as DC Chair of the Young Jewish Conservatives.