Arizona Lawmakers Exempt Small Business From Prop 208 Surcharge

Arizona Republicans have endorsed a plan to shield small businesses from a new tax to better fund public schools.

The Senate voted along party lines Monday to pass Senate Bill 1783, which would create a new tax class for small business owners who would otherwise file as a pass-through entity. This would allow them to forego the 3.5% income tax surcharge established by Proposition 208.

Sponsored by Sen. J.D. Mesnard, R-Chandler, it passed along partisan lines.

If a business owner elects to enter the new class, they will set their tax rate at 4.5%, exempting them from the Prop. 208 surcharge. It also drops the rate by half of a percentage point every year until 2025, when the rate hits 2.5%.

Prop. 208, approved in the 2020 General Election, added a 3.5% income tax surcharge on those in the top-earning bracket in Arizona who were previously paying a 4.5% rate to fund education. The surcharge required single filers with incomes exceeding $250,000 to pay 8% of their total income. Prop. 208 opponents believed the surcharge would cause Arizona small businesses to no longer be competitive.

Because the surcharge only applied to tax categories that existed when the measure was approved, creating a new tax bracket for small business owners exempted them from additional taxing.

Legislative analysts estimate the new tax category would cut the revenue raised by Prop. 208 by a maximum of $378 million a year, over a third of its projected take. Democrats argue that the bill benefits the wealthy at the expense of education.

“I question if this is even constitutional,” said Sen. Kristen Engel, D-Tucson. “We wouldn’t even need Proposition 208 if the Legislature properly funded schools.”

Sen. Christine Marsh, D-Paradise Valley, called the bill a “disservice to kids,” saying it only benefitted “high income individuals who want to exclude profits from their businesses, trusts, and estates.”

Sen. David Livingston, R-Peoria, argued that more businesses than Democrats accounted for would lose their earnings from the Prop. 208 surcharge.

“We are investing over $6 billion general funds into K-12 this year, an all-time record in Arizona,” he said.

When including the $5 billion Arizona received in federal funds, Livingston said schools would have “almost double the amount of money” of last year. He said those funds should be used to increase teachers’ pay.

Sen. Mesnard said the bill is about making sure Arizona remains competitive when compared to other states and “making sure we don’t drive small businesses away, especially at a time when they are struggling because of the pandemic.”

He said the majority of the money raised from Prop. 208 will still go to schools, saying the bill both funds education and supports both small businesses.

The passage of this bill follows the passage of the largest income tax cut in Arizona history by less than a week.

The 2021 budget included provisions to transition from the state’s four-tier income tax to a flat tax of 2.5%, a lower rate than the lowest current tier. It also capped the state’s top income tax percentage that could be paid to 4.5%, meaning high-earners and businesses whose income triggers Prop. 208’s 3.5% surcharge would pay only an additional 1%.

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This article was published on June 30, 2021 and is reproduced with permission from The Center Square.