Federal tax conformity fight kicks off Arizona legislative session

Arizona's legislative session began last week with a battle over how to conform with federal tax law changes and concerns over public school funding and water.

Republicans, who control the legislature, rushed passage on Thursday of legislation to apply most of the tax changes in H.R. 1, the massive "One Big Beautiful Bill" signed by President Donald Trump on July 4, to Arizona's tax code to provide an estimated $1.1 billion in tax cuts over the next three years.

On Friday, Democratic Gov. Katie Hobbs, who supports a "middle-class tax cuts" package, vetoed the bill, blasting Republicans for lacking a plan to pay for their plan.

"It blows a huge hole in our budget and it is completely irresponsible," she told reporters, adding that her "balanced" fiscal 2027 spending plan covers her proposed $200 million tax cut.

The Republicans' bill would reduce general fund income tax revenue by an estimated $441.3 million in fiscal 2026, $337.2 million in fiscal 2027, $363.1 million in fiscal 2028, and $296.6 million in fiscal 2029, according to a Joint Legislative Budget Committee fiscal note. In a Jan. 8 report, the group estimated the governor's plan to conform with certain individual income tax provisions in H.R. 1 would result in a fiscal 2026 revenue loss of $252 million.

Republican lawmakers contended the state can afford their bill.

"Our revenue numbers look encouraging, our reserves remain intact, and recent spending reductions allow us to responsibly align with the Trump tax cuts," Senate Appropriations Chairman David Farnsworth said in a statement Wednesday.

S&P Global Ratings flagged potential financial pressure from federal tax and policy changes when it revised its outlook for Arizona's AA issuer rating back to stable in September after 14 months at positive.

"The outlook revision reflects our view of the state's evolving budget environment and the need to maintain strong budget management practices as it navigates potential economic uncertainty and effects from federal policy changes to maintain its strong finances," the rating agency said.

Arizona, which does not issue general obligation debt, has an Aa1 issuer rating and stable outlook from Moody's.

Proponents of the Republican plan said quick passage of conformity legislation is needed to provide certainty to income tax filers and to avoid amended returns.

"Gov. Hobbs' veto of our tax relief act is a failure of leadership that will create unnecessary confusion and disruption for millions of Arizona taxpayers," Republican House Speaker Steve Montenegro said in a statement.

While many states automatically conform with Internal Revenue Code, Arizona and some others require legislative action.

"Even though conformity updates are frequently taken up early, few states are getting to it quite yet, especially since IRC conformity has broader implications this year due to H.R. 1," Jared Walczak, a senior fellow at the Tax Foundation, said in an email.

The vetoed Republican bill included a provision to have Arizona participate in H.R. 1's federal education tax credit, which is available to individuals who donate to Scholarship Granting Organizations that distribute funding for school tuition and other expenses.

In a report last week, Moody's Ratings said private schools are likely to benefit the most.

"The tax credit program marks a substantial expansion of federal support for school choice and will intensify competition to traditional K-12 school districts for students and state funding," the report said.

In her Jan. 12 State of the State address, Hobbs renewed her call to bring greater accountability to the state's universal private school voucher program after previous attempts were blocked in the legislature.

"While other government entitlements have strict requirements and oversight, the (empowerment scholarship account) program continues to operate unchecked, squandering taxpayer dollars with no accountability," she said in her speech. "It seems like every day, we learn about new shopping sprees happening at the expense of taxpayers?diamond jewelry, high-end clothing and furniture?who knows what taxpayers will be footing the bill for tomorrow?"

The program's cost reached $985.14 million on an annualized basis in the first quarter of fiscal 2026 with nearly two-thirds of the 93,993 participating students receiving awards between $7,000 and $8,000, the state's education department reported.

The state in 2022 enacted the program under then-Gov. Doug Ducey, a Republican, who called it the nation's most expansive school choice law, allowing state money to flow to parents to help pay for private school tuition, online curriculum, and educational supplies.

As its price tag blew past "highly speculative" 2022 legislative projections, S&P raised concerns last year that escalating costs could crowd out Arizona's other discretionary spending and introduce uncertainty into its education funding framework.

The governor also asked lawmakers to refrain from inserting constitutional protections for the ESA program into a ballot measure to renew Proposition 123, which expired June 30.

The proposition, which was passed by voters in 2016, increased the amount of money K-12 public schools receive annually from the State Land Trust Permanent Fund.

Chuck Essigs, government relations director for the Arizona Association of School Business Officials, said while the legislature replaced the lost funding in the fiscal 2026 budget, Republican lawmakers could make another attempt to constitutionally protect ESAs this session.

Ahead of the governor's address, Republican Senate President Warren Petersen said the elimination of school choice is not going to happen.

"Republicans will continue to prioritize dollars in the classroom, higher teacher pay, and strong parental choice across all education options," he said.

School-related legislation this session includes a bill requiring districts to hire an independent municipal advisor registered with the U.S. Securities and Exchange Commission before calling for a bond election.

SB 1080 would allow districts to enter into public-private partnership agreements for the sale or lease of school buildings or land for the private development of affordable housing for public sector workers.

Public schools are waiting for a Maricopa County Superior Court judge to release a final judgment for an August ruling that found Arizona's system for funding school facilities is unconstitutional.

The lawsuit spotlighted districts' unequal access to local property taxes and bonds. Republican legislative leaders have said they will appeal the ruling.

Hobbs also addressed water in her drought-prone state, calling for data centers to "pay their fair share for the water they use" and for the elimination of a data center tax exemption, which she labeled "a $38 million corporate handout."

Tucson officials in August ended annexation efforts and negotiations for a $3.6 billion data center development in the wake of public concerns over its water and electricity use. The project is reportedly moving ahead in Pima County.

Hobbs said her budget proposal includes $30 million for a Colorado River Protection Fund "to supercharge our conservation efforts and continue building a sustainable and growing economy."

House Bill 2116 would appropriate $1 million from the general fund for the state's Colorado River Litigation Fund.

The seven upper and lower basin states, including Arizona, have yet to reach an agreement on post-2026 water use.