A clever gutting of Prop. 208 at Legislature
On tax policy, state Sen. J.D. Mesnard is as skilled and well-versed a legislator as has been seen in many a decade.
And darn if he isn’t moving through the Legislature a bill that would largely gut Proposition 208’s high income tax rate without running afoul of the state Constitution’s Voter Protection Act.
Proposition 208 imposed a surcharge on incomes over $250,000 for individuals and $500,000 for joint returns. The surcharge would put Arizona’s maximum rate at 8%, one of the highest in the country.
During the campaign, there was a debate about the effect Proposition 208 would have on small businesses. There were distortions on both sides, although consequentially more so by proponents.
Most small businesses are what are known as pass-through entities. Their profits aren’t taxed at the corporate level. Instead, they are attributed to the
owners, who pay taxes on the profits on their individual tax returns.
These taxes are owed regardless of whether the profits are actually distributed. And often they aren’t. Instead, they are retained for cash flow or investment purposes.
Now, not many small businesses have profits that hit the threshold for Proposition 208’s surcharge. So, at issue is a small number of highly successful small businesses.
Such businesses, however, are a dynamic force in a regional economy. In Arizona, the corporate tax rate is just 4.9%. So, Proposition 208 taxed the profits of these dynamic, highly successful small businesses at a much higher rate than the profits of big corporations.
Proposition 208 imposed the surcharge on income subject to tax according to a specific chapter of the tax laws dealing with individual income. Mesnard’s bill (Senate Bill 1783) cleverly creates a new chapter for small business income, such as these pass-through profits. It establishes a flat rate of 4.5% on such income, which is the pre-208 highest individual tax rate.
The bill gives taxpayers an option of paying taxes on small business income under the individual chapter or the new chapter. So, no one will have to pay more. But small business profits could be shielded from Proposition 208’s surcharge.
This will have a substantial effect on what Proposition 208 will yield for K-12 education. The Legislature’s budget staff estimated that the surcharge would bring in $827 million in the first year. It estimates that SB 1783 would reduce that to around $300 million.
The Voter Protection Act forbids the Legislature from amending something voters passed, except upon a vote of three-fourths of both chambers and only to further the purpose of the measure.
SB 1783 clearly doesn’t further the purpose of Prop. 208. The legislation would largely gut it.
So, the question is whether the bill amends it. That will be a hard argument for Proposition 208 proponents to make in court.
Proposition 208 was structured to apply a surcharge to income taxes paid under a particular chapter of the tax laws. To sustain a Voter Protection Act violation, Proposition 208 proponents would have to argue that its passage froze that tax base in place in perpetuity. No such claims were made during the campaign, and the knock-on consequences would be monumental. Among others, the Legislature would no longer be able to conform Arizona’s individual income tax laws to federal changes, making state filings progressively more complicated.
During the campaign, Proposition 208 proponents flatly denied that it would have any effect on small business. At a minimum, Mesnard’s bill, which has passed the Senate, exposes that deceit. Nearly two-thirds of the proposition’s projected revenue comes from taxing small business profits at a higher rate than big business profits.
Now, this is not my preferred Proposition 208 response. I would prefer a proposal that would raise as much or more for K-12 education, but from tax sources that don’t have the same negative economic effect as one of the highest income tax rates in the country.
But if going big isn’t in the cards, Mesnard’s bill should be enacted.
Proposition 208 proponents didn’t play straight with voters about the effect on small businesses. SB 1783 would ensure that the proposition doesn’t impact small businesses, as proponents claimed that it wouldn’t.
In that sense, perhaps the bill could be said to further at least the proclaimed purpose of the initiative after all.