Goldwater Steps in to Defend Small Business Owners

August 25, 2021
By Timothy Sandefur

The Goldwater Institute yesterday filed papers on behalf of the Arizona Free Enterprise Club to defend the constitutionality of the state’s new tax reform for small businesses.

In a lawsuit filed earlier this month by the pro-tax group Invest in Arizona—a case that involves many of the same players as the Proposition 208 lawsuit decided last week by the Arizona Supreme Court—the initiative’s backers argue that Senate Bill 1783, which gives tax relief to small business owners in the state, essentially amends Prop. 208, which is not allowed under the Arizona Constitution. That far-fetched theory ignores basic legal principles and, as we argue in our motion, would mean that lawmakers could never reduce taxes or create any new tax deductions ever. Voters never intended such a thing when they voted on Prop. 208.

Here’s how this new lawsuit works: Prop. 208 imposed a crushing new tax on income earners in Arizona—and it fails to differentiate between the income of an individual and the income of an individual’s small business. That’s a problem, because most small businesses are S-corporations or “pass-through” businesses, meaning that the business’s earnings are reported on the individual income tax returns of the owner. That works fine for federal law, but Prop. 208 turns it into a weapon against the state’s chief employers by imposing a massive new tax on that income, while calling it an “individual” income tax. So the Arizona Legislature decided to create a new tax rule specifically for small businesses, so that business owners can decide whether to be taxed under this new system, instead of under existing state law.

Prop. 208’s backers don’t like that, because despite the fact that they insisted during the campaign that the tax would not target small businesses, that is exactly what it does. So now they’ve reversed course, and are claiming in this new lawsuit that the Legislature’s creation of a new, separate tax system for small business conflicts with Prop. 208, since that tax was meant to target small businesses after all. They claim that the new small business tax is effectively an amendment to Prop. 208—and that would be illegal if true, since Arizona’s Constitution forbids the legislature from amending ballot initiatives. 

Their reasoning goes this way: When Prop. 208 was adopted, there was only one type of income tax in Title 43 of the Arizona laws, and the new small business tax creates a second one. Therefore, the new system “excludes large categories of individual income from the ‘taxable income’” that Prop. 208 taxes. Therefore, they argue, the new small business tax changes how Prop. 208 works, which violates the provision of the Arizona Constitution (called the Voter Protection Act) that basically forbids the Legislature from tinkering with ballot initiatives once adopted.

But here’s the problem: All tax deductions, credits, and exemptions work the same way. Under SB 1783, a business owner’s business income is subtracted from her personal income before it is counted as “taxable income” (and the business income is taxed separately). But every tax deduction or exemption does the same thing: It is subtracted from a person’s income before the tax is imposed. That means that if Invest in Arizona is successful in this lawsuit, not only would the new small business tax be struck down, but the Legislature would be forever barred from reducing taxes.

That’s obviously not what voters intended. In fact, Prop. 208 itself says that the Legislature remains free to “change, replace, or eliminate” existing tax brackets. And it left the Legislature free to create new sections of the tax code because it said the Prop. 208 tax would apply only to some provisions of the tax code. If voters had meant to prohibit the Legislature from changing how the tax system works in Arizona, they could easily have done so, by saying just that in Prop. 208. They didn’t.

The Goldwater Institute and the Free Enterprise Club—two of Arizona’s leading defenders of the rights of business owners and job creators—have now asked to intervene in the case to defend the constitutionality of the SB 1783 small business tax system. In the meantime, a Phoenix area judge will also be weighing the constitutionality of Prop. 208, after last week’s Supreme Court decision in our lawsuit that made clear the initiative is (as one of the justices put it) “almost certainly doom[ed].” If Prop. 208 is ultimately struck down, this new case will also be dismissed. But in the meantime, Goldwater and the Free Enterprise Club are proud to champion the rights of Arizona’s job creators.

Timothy Sandefur is the Vice President for Litigation at the Goldwater Institute.