State Equalization Tax Rate
This 2022 session, the Arizona Legislature significantly increased funding for K-12 education. However, the Legislature also permanently repealed the State Equalization Tax Rate (SETR), back-filling $330.5 million from the General Fund. SETR is a state property tax collected by counties and proportionally distributed to K-12 school districts in less wealthy areas with lower property values.
Eliminating SETR is yet another tax cut for the wealthy few that perpetuates Arizona’s reliance on the highly regressive sales tax. And like the temporary suspension of SETR in 2006, the repeal threatens future K-12 education funding – only this time it will require two-thirds of the Legislature to undo this change.
What makes a tax “progressive” or “regressive”?
These terms have to do with who pays more of a given tax, as a share of their income and wealth.
A progressive tax is one in which those with higher incomes and wealth pay a greater share in taxes (relative to their income).
A regressive tax is one in which those with lower incomes and wealth pay a greater share in taxes (relative to their income).
What role did SETR play in the school finance?
Each K-12 school district has a specific funding amount that they are either guaranteed to receive or limited to spend known as the equalization base. This equalization base is based on the number of students attending the schools within the district to ensure an equal amount is spent on each student. The equalization base is roughly 60% of total school district funding. To fund a school district’s equalization base, counties collect the Qualifying Tax Rate (QTR) – a local property tax – as the first source of revenue.
However, the funds generated from the QTR are not always sufficient to meet the district’s equalization base amount. This happens when a school district is in an area with lower-valued properties. In this case, the state steps in to fill the gap by providing equalization assistance.
SETR, collected at the county level, would have been the first source of this assistance. Should a school district still need more funds after receiving SETR funding, the state would provide additional assistance from three state funds: Proposition 301 Sales Tax, State Land Trust, and the General Fund. In the distribution of equalization assistance, the General Fund is the payer of last resort. Repealing SETR shifted the $330.5 million it was estimated to provide from property taxes in FY2023 to the General Fund.
How did the repeal of SETR change the equalization assistance funding formula for FY2023?
Equalization Assistance ($6.4 billion) = SETR(330 million) + State Funds (Prop. 301 Sales Tax($150 million) + State Land Trust ($330 million) + General Fund ($5.6 billion))
Equalization Assistance ($6.4 billion) =
SETR(330 million)+ State Funds (Prop. 301 Sales Tax($150 million) + State Land Trust ($330 million) + General Fund ($5.9 billion))
Source: John Legislative Budget Committee, K-12 Funding Since 2014 (All Funding)
How do property taxes (like SETR) work in Arizona?
Most property taxes in Arizona are collected by counties and local governments to fund the maintenance and operation of K-12 schools, community colleges, counties, cities, and towns. Roughly 49 percent of property taxes collected fund K-12 schools.
To determine how much a property is taxed, it must first be assessed or valued by either the state or county. When assessed, properties are given a full cash value (FCV) and a limited property value (LPV). To calculate property taxes owed, the LPV is multiplied by an assessment ratio (ranging from 1 percent to 17.5 percent in Tax Year 2022) depending on the property class assignment to get the total assessed value. There are nine property classes in Arizona with most property categorized under Class 1 (commercial) or 3 (primary residential). Next, any exemptions to taxation are deducted to get the net assessed value (NAV). And finally, the NAV is multiplied by a tax rate such as SETR and divided by 100 to arrive at the property tax amount due.
SETR is a property tax with a rate of $0.4263 (or 0.4263 percent of NAV) in Tax Year (TY) 2021. All non-exempt property in Arizona would be taxed at the same SETR rate – effectively making it a “flat tax”. However, as the next section further explains, SETR is a less regressive tax than other flat taxes.
What is a "flat tax"?
A flat tax (like Arizona’s sales tax and SETR, for example) is one in which everyone pays the same tax rate, regardless of income or wealth. The sales tax is a more regressive flat tax than SETR because it applies to spent income and exempts saved income (wealth) – this means those with lower incomes pay a greater share since they cannot save much of their income.
Why is SETR a less regressive property tax?
Taxes become less regressive when those with higher incomes and wealth, such as individuals or corporations who own commercial properties, pay a greater percentage of the funds collected. Of the nine property classes, commercial and primary residential contribute roughly 74 percent of the funds collected from SETR. JLBC estimates $322.7 million would have been collected from SETR in 2022 with $98.3 million from commercial and $141.9 million from primary residential. However, commercial properties pay a greater share of their valuations in tax.
As previously mentioned, each property class is assigned an assessment ratio between 1 percent to 17.5 percent that is multiplied by the LPV to determine the taxable value of a property. Commercial properties had an assessment ratio of 18 percent the last time SETR was collected in TY2021. This is much higher than the 10 percent applied to primary residential properties. Thus, a commercial property with a $250,000 LPV would have $45,000 of it taxed compared to just $25,000 for a primary residential property of the equal LPV. As the graphic below shows, the TY2021 SETR amount paid by this example commercial property would be $191.84 whereas the primary residential property would pay $106.58, assuming zero exemptions.
Based on the current median home market value, we estimate the median LPV to be $75,000 and these homeowners owing $31.97 in SETR. Because the assessment ratio is the same for all primary residential properties, the SETR amount is proportional to the property's NAV. Arizonans who rent their homes would also pay SETR as a cost passed down from their landlord in their rent. SETR cost for renters would be about the same as the median amount for primary residential property owners if they rent a single-family house or a fraction of the SETR amount due for a multi-family property.
There is also a 1% cap or property tax limit for primary residential properties, meaning that total primary property tax cannot be more than 1 percent of the LPV for owner-occupied primary residential properties. No such primary property tax limit exists for commercial properties, which increases the amount of tax paid in relative terms.
Primary property taxesfund basic maintenance and operation of school district and local governments whereas secondary property taxes pay for special taxing districts and voter-approved budget overrides and bond obligations.
What does the permanent repeal of SETR mean for the future of K-12 education funding?
The shift of SETR from property taxes to the General Fund does not bode well for the future of K-12 education funding. Despite the significant amount appropriated to K-12 education in this year’s budget, the repeal of SETR could lead to less money for schools in the future.
What happened to K-12 funding the last time SETR was temporarily suspended?
In 2006, the Arizona Legislature suspended SETR for three years. This suspension: (1) reduced money for schools and (2) made them more dependent on a shrinking and more regressive General Fund, a large part of which is generated from sales taxes – a highly unstable funding source especially during recessions. Revenue from sales taxes is considered regressive because people with lower incomes spend more of their income while those with higher incomes can afford to save.
During the Great Recession (which coincided with SETR suspension), General Fund tax revenues dropped by one-third from their 2007 $9.2 billion amount. This drop was mainly due to significant reductions in both income and sales taxes. Absent SETR property tax funds, K-12 education suffered drastic cuts to balance the General Fund deficit.
To raise revenue, voters approved raising the sales tax by 1 percent from FYs 2011-2013 through Proposition 100 in a 2010 special election. Proposition 100 raised the portion of sales tax revenues to record levels of 51 to 54 percent of the General Fund. The additional $900 million generated from Proposition 100 was still not enough to address the budget deficit, and so former Governor Brewer vetoed a bill to permanently repeal SETR in 2009, allowing for its return. The Great Recession revealed how SETR could serve as a stabilizing revenue source in times of economic downturn. Many economists suggest that US may be on the brink of another recession. But now SETR has been fully repealed, it cannot be reinstated without a two-thirds majority of the Legislature.
Could the repeal of SETR trigger K-12 budget freezes?
Perhaps even more alarming for the future of K-12 education funding is how SETR’s repeal may contribute to budget freezing triggers enacted by Proposition 123. This means schools could receive even less money – especially in the event of a recession.
As the first section explained, one of the funds used to provide equalization assistance the State Land Trust. Previously 2.5 percent of this trust fund goes to fund state-aid for schools. Voters passed Proposition 123 in 2016, increasing this percentage to 6.9 percent for 10 years and raising General Fund contributions to K-12 education by $50 million for the first five years and $75 million for the remaining five years. It also includes triggers that allow the Legislature to (1) not make inflation adjustments required in law and (2) reduce K-12 education funding by an amount equal to the otherwise required inflation adjustment if K-12 appropriations exceed 49 percent of General Fund appropriations. The inflation adjustment reduction amount doubles if K-12 appropriations surpass 50 percent.
The percentage of K-12 education funding from the General Fund has remained above 43 percent since 2018. There are two variables that impact the percentage of K-12 funding from the General Fund – reductions in General Fund revenue and fund shifts to or from the General Fund.
SETR’s repeal equates to a $330.5 million K-12 education fund shift to the General Fund. Recent legislation to gradually reduce the commercial class assessment ratio to 15 percent by 2027 also shifted $34.4 million to the General Fund – an amount set to increase each year. Another cost shift will be the 4.4 percent increase to K-12 education funding from the State Land Trust in 2025 (estimated to be $256.6 million for FY 2023). Some state agencies like the Arizona Health Care Cost Containment System (AHCCCS) have also shifted some of their General Fund dollars to other funding sources. SETR's shift combined with other General Fund shifts will place K-12 education funding closer to the 49 and 50 percent Proposition 123 triggers.
Lastly, a decrease in General Fund revenues would also increase the percentage of K-12 funding. Economic downturns such as the Great Recession reduce General Fund revenues that, in turn raise the K-12 education portion of General Fund appropriations. State tax cuts also decrease General Fund revenues and place K-12 education funding closer to Proposition 123 triggers. Arizona recently imposed a $2 billion revenue loss from the 2.5% income flat tax.
Proposition 123 also includes another trigger that would threaten K-12 education funding in the event of revenue loss, especially in a recession. If both sales tax revenue and employment grow less than 1 percent, an inflation increase is not required for K-12 education the following year. If this figure is between 1 and 2 percent, the Legislature could decide to suspend otherwise mandatory inflation adjustments. Should a recession happen, it could wreak havoc on General Fund revenues and by extension K-12 education funding – only this time the state legislature would need to vote by two-thirds to raise revenue to offset these losses, which is unlikely.