On Aug. 19, 2021, the Arizona Supreme Court held that Proposition 208 (Prop. 208), a voter initiative imposing a 3.5% income tax rate surcharge on high-wage earners, was facially unconstitutional because the measure evaded Arizona’s restriction on local school spending.1 The Court also determined that the remainder of the law imposing the tax surcharge could not be severed from the unconstitutional provision. Declining to enjoin the law, however, the Court remanded the case to the trial court to determine whether the revenue raised by Prop. 208 would exceed the state constitution’s expenditure limitation on local revenue. Finally, the Court ruled that Prop. 208 was not subject to the state’s two-thirds supermajority requirement because it was enacted through the ballot initiative process.
In November 2020, Arizona voters approved Proposition 208, a ballot initiative that implemented a new income tax surcharge to provide direct educational funding to schools.2 Prop. 208 contains three central provisions: (i) a taxing provision (Taxing Provision); (ii) a provision allocating revenues to several different funds for educational purposes (Allocating Provision); and (iii) a provision exempting the measure from the constitutional definition of local revenues (Local Revenues Provision). The Taxing Provision imposes a 3.5% income tax rate surcharge on individual taxpayers with more than $250,000 in annual taxable income, or joint filers with more than $500,000 in taxable income, beginning with the 2021 tax year, which would have resulted in a top marginal tax rate of 8%.3 The Allocation Provision outlines the distribution of revenue raised by the tax surcharge.4 In particular, the provision creates a “student support and safety fund” and mandates that the fund distribute nearly all revenue to school districts and charter schools through “grants.” Finally, the Local Revenues provision states that funding received by school districts are not considered local revenues for purposes of the Education Expenditure Clause of the Arizona Constitution.5
On the day Prop. 208 was certified, the petitioners, including Republican state lawmakers and several business groups, filed a lawsuit in state court to enjoin the measure and requested a preliminary injunction pending a trial. After the cases were consolidated, the trial court declined to grant the preliminary injunction. The petitioners appealed the decision to the state appellate court, and then petitioned to transfer the case to the Arizona Supreme Court.
On appeal, the petitioners asked the Court to reverse the trial court’s denial of a preliminary injunction. The petitioners argued that Prop. 208 was facially unconstitutional because: (i) the use of tax revenues for mandatory direct funding to school districts violates the Education Expenditure Clause; and (ii) the measure was enacted without a supermajority vote of both houses of the legislature as required by the Tax Enactment Clause of the state constitution.
Prop. 208 violates state educational expenditure limitation
The Court first considered the question of whether Prop. 208 violates the Education Expenditure Clause of the Arizona Constitution by attempting to exempt tax revenues from the state’s expenditure limitation. The Court considered whether the Local Revenues Provision was facially unconstitutional, and if so, whether it could be severed from the measure’s other provisions.
Local Revenues Provision facially unconstitutional
The Education Expenditure Clause provides that each Arizona school district is subject to an aggregate expenditure limitation with respect to local revenue spending, which includes tax disbursements by the state and from local or county taxes.6 Understanding that Prop. 208’s direct funding to school district is included in the definition of “local revenues,” proponents of the measure argued that the revenues qualify as “grants” that are exempt from the educational expenditure limitation.7 Interpreting both constitutional and statutory provisions, the Court determined that the Local Revenues Provision did not fall within the constitutional definition of a grant, and that the grant exception language “received directly or indirectly from any private agency or organization, or any individual” limits the word ‘grants’ to private, non-governmental voluntary contributions. As such, the Court determined that Prop. 208 revenues are not grants within the meaning of the Grant Exception, meaning they are categorized as local revenues. The Court thus declared the provision facially unconstitutional because it incorrectly characterized revenues to circumvent the state’s local spending cap. Accordingly, the Court also found the Allocation Provision unconstitutional to the extent allocated revenues exceed expenditure limits.
Unconstitutional provisions not severable from remainder of Prop. 208
The Court next determined whether the unconstitutional provisions of Prop. 208 were severable from the remainder of the measure. The Court analyzed this question under its precedent in Randolph v. Groscost, which established that an unconstitutional provision in a voter initiative is severable if “the valid portion, considered separately, can operate independently and is enforceable and workable.”8 Under this analysis, the Court determined that severance of the unconstitutional provisions left Prop. 208 without the statutory authority to spend most of the funds raised by the 3.5% income tax rate surcharge.
Under the first prong of the test established in Randolph, the Court reasoned that the implementation of the remaining provisions without the unconstitutional provision would result in “hundreds of millions of tax dollars” being collected, but unable to be spent to the extent they exceed the expenditure limit. The Court determined that such a result makes the remaining provisions unworkable and thus not severable from the unconstitutional provisions. As such, the Court concluded, severing the allocation provisions of the measure “materially impacts the initiative’s operation such that the remainder of Prop. 208 cannot stand on its own.”
Applying the second prong of the Randolph test, the Court determined that Prop. 208 could not survive because the remaining statutory provisions resulted in tax revenues being impounded with no prospect of being spent or refunded, rendering an absurd result. In other words, “[c]ollecting taxes that cannot be spent does little or nothing to provide increased support for school districts.” The Court rejected arguments by proponents of Prop. 208 that the state legislature could prospectively pass legislation in the future to remedy the unconstitutional provisions of the measure, finding that the Court’s role is to “analyze the legal landscape as it exists, not as the legislature might see fit to change it in the future.”
Court declines to grant preliminary injunction
Returning to its ruling that Prop. 208’s direct payments to school districts are unconstitutional “to the extent they exceed the constitutional expenditure limitations,” the Court next concluded that the record was insufficient to determine whether such payments did in fact exceed the state’s constitutional expenditure limitation. Noting it was likely that the payments would exceed the limitation, the Court nevertheless remanded the case to the trial court to determine whether the Prop. 208 revenues would actually exceed the limitation. “If the trial court finds that the tax revenues allocated will not exceed the expenditure limit,” the Court stated, “then there is no present constitutional violation and Prop. 208 stands.” However, the Court instructed the trial court to find the law unconstitutional and enjoin its operation upon a finding that the law results in the accumulation of revenue that cannot be spent without violating the expenditure limit.
Prop. 208 not subject to supermajority vote requirement
Finally, the Court determined whether Prop. 208 is subject to the Tax Enactment Clause of the Arizona Constitution, which requires a supermajority vote for newly enacted tax provisions.9 The petitioners argued that Prop. 208 is invalid because the Tax Enactment Clause prevents voters from raising taxes through a ballot initiative, or if not, that the clause requires a two-thirds supermajority vote in order to pass. However, the Court rejected these arguments, finding that that the Tax Enactment Clause applies to “acts” that require a vote of the legislature, and does not apply to voter initiatives. Interpreting the relevant constitutional provision, the Court found that the use of the word “act” meant that the provision was intended to apply to the legislative process, not the initiative process. Similarly, the Court found that the Tax Enactment Clause was drafted to restrict the legislature’s power, not that of the people. Finding that the term “act” applies to legislative acts only, the Court concluded that Prop. 208 was lawfully enacted when it was enacted by simple majority vote.
Concurring and dissenting opinion
One justice filed a concurring and dissenting opinion that agreed with the majority’s decision to deny the preliminary injunction but disagreed with the majority’s severability analysis and the framework for deciding whether Prop. 208 is unconstitutional. Specifically, the dissent concluded that the unconstitutional provisions could be severed from the rest of the measure without affecting the workability of the remaining provisions, even if there would later be separate challenges to the measure. In particular, the dissent reasoned that the plain language of the provisions at issue do not conflict with the Educational Expenditure Clause because they do not require school districts to spend the funds raised or require them to exceed the expenditure limitations.
The dissent continued that there are potential circumstances under which direct expenditures to school districts could comply with the Educational Expenditure Clause, pointing out that the state legislature and/or school district electors have the constitutional ability to permit excess expenditures. Instead, the dissent pointed out, the majority declared the provisions unconstitutional in their entirety, making no allowances for under-the-cap expenditures or constitutionally authorized exceptions. In the dissent’s view, the majority provisions were not facially unconstitutional because the petitioners did not make a showing that they would be unconstitutional in all their applications.
In declaring Prop. 208 facially unconstitutional, the Court’s decision spells likely defeat for Prop. 208, even though the case is remanded to the trial court to determine whether revenues raised by the measure will exceed the state’s expenditure limitation on local revenues. Based on its instructions to the trial court, the Court makes clear that Prop. 208 must be found unconstitutional and be enjoined upon a finding that the allocated tax revenues cannot be spent without exceeding the state’s expenditure cap. The Court pointed to financial projections indicating that Prop. 208 is projected to raise approximately $827 million in revenue, leaving an approximately $144 million gap between school expenditures and an aggregate expenditure limitation of $6.3 million for all school districts. Based on these facts, the Court indicated that Prop. 208 would likely produce far more revenue than it can constitutionally spend if the expenditure limit remains at current levels.
The controversy engendered by Prop. 208 since enactment in November 2020 at the ballot box has been significant. While proponents placed the measure on the ballot for the purpose of increasing school funding and teacher salaries, the initiative was strongly opposed by Republican lawmakers and other business groups, arguing that the income tax surcharge would nearly double the state’s top income tax rate, ultimately making Arizona a less attractive place to do business. In response to the enactment of Prop. 208, state lawmakers passed a 2021 budget package making significant reforms to Arizona’s individual income tax rates and brackets. In particular, the budget legislation established a cap to prevent the top marginal individual income tax rate from exceeding 4.5% when the general tax rates and the Prop. 208 surcharge are combined.10 Additionally, the legislation eventually consolidates the state’s four existing individual income tax brackets into one, also reducing the corresponding rates over time.11
Finally, the controversy surrounding Prop. 208 has even reached to a separately enacted law that creates an alternative tax structure for certain Arizona small businesses, allowing business owners to avoid the Prop. 208 income tax rate surcharge.12 Retroactive to Jan. 1, 2021, the legislation imposes an alternative 3.5% income tax on electing small businesses based on “Arizona small business taxable income,” which includes interest and ordinary dividends, certain capital gains and losses, and other income categories that would otherwise be considered individual taxable income.13 Most notably, the law exempts the owners of electing small businesses from Prop. 208’s 3.5% income tax rate surcharge in the event the measure stands. The law also gradually reduces the alternative 3.5% income tax rate over a four-year period, ultimately to 2.5% for the 2025 tax year and thereafter.14 Although currently subject to a referendum effort and legal challenge,15 the small business income tax law would significantly reduce the amount of revenue generated by Prop. 208 should the measure ultimately survive.
2 ARIZ. REV. STAT. § 43-1013. Voters approved the measure by a 51.7% majority vote.
3 ARIZ. REV. STAT. § 43-1013(A). Prior to the 2021 tax year, Arizona personal income tax was imposed according to four individual income tax brackets with tax rates ranging from 2.59% to 4.5%.
4 ARIZ. REV. STAT. § 15-1281(B), (D).
5 ARIZ. REV. STAT. § 15-1285.
6 ARIZ. CONST. art. 9, § 21(2).
7 Under the “Grant Exception” of the Educational Expenditure Clause, amounts or property received as grants, gifts, aid or contributions received directly or indirectly from any private agency, organization or individual are exempt from the definition of “local revenues.” Ariz. Const. art. 9, § 21(4)(c)(v).
8 195 Ariz. 423 (1999).
9 The Tax Enactment Clause requires that laws providing for a “net increase in state revenues” are effective “on the affirmative vote of two-thirds of the members of each house of the legislature.” ARIZ. CONST. art. 9, § 22.
10 For taxpayers with taxable income exceeding the Prop. 208 threshold, income taxed at the capped 4.5% rate would be sent to different sources. Approximately 78% of the tax collected at this rate would be sent to the education fund as required by Prop. 208, while the remaining 22% of the tax would be sent to the state’s general fund. S.B. 1827, Laws 2021.
11 S.B. 1828, Laws 2021.
12 S.B. 1783, Laws 2021.
13 Arizona’s small business income tax law is separate from recently enacted legislation that created an entity-level tax election option for pass-through entities. This election allows owners of such businesses to effectively reduce the income on which it would be subject to federal income tax through pass-through entity tax payments, rather than payments under the general individual income tax rate schedule which are currently subject to the $10,000 cap on the federal individual income tax deduction for state and local taxes available for most taxpayers that itemize deductions. H.B. 2838, Laws 2021, adding ARIZ. REV. STAT. § 43-1014.
14 ARIZ. REV. STAT. § 43-1711.
15 Invest in Arizona et al. v. Arizona Department of Revenue et al., No. CV2021-012451, Arizona Superior Court for Maricopa County, filed Aug. 5, 2021.
Jamie C. Yesnowitz
Jamie Yesnowitz, principal serving as the State and Local Tax (SALT) leader within Grant Thornton's Washington National Tax Office, is a national technical resource for Grant Thornton's SALT practice. He has 22 years of broad-based SALT consulting experience at the national and practice office levels in large public accounting firms.
Washington DC, Washington DC
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