Lawless Taxation

Lawless Taxation

Heard the one about the five-year retroactive tax increase?

California imposed a huge retroactive income tax increase last year, but some 2,500 small business owners are learning that once is never enough for Sacramento. The state now wants to hit them with a retroactive levy going back to 2008, to the tune of $120 million or more.

California has since 1993 let investors cut their capital-gains tax in half if they invest in qualified state businesses. But late last year the state Court of Appeal ruled that the tax break violates the U.S. Constitution's Commerce Clause by discriminating against out-of-state firms.

Instead of simply ending the tax incentive going forward, the state Franchise Tax Board has ordered investors who used the tax break to pay five years of back taxes. As a special insult, these taxpayers may have to pay interest and penalties on the "unpaid taxes" they were never required to pay in the first place. So the politicians promise tax favors for investment, but when the courts invalidate the favors the politicians punish the folks who did what the politicians asked them to do.

Normally in such cases, the taxing authority holds taxpayers harmless through what is called "transition relief." But Sacramento has an insatiable appetite for revenue, even after voters approved Governor Jerry Brown's income tax rate hike to 13.3%. That November initiative wasn't even placed on the ballot until July 2012, but it applied to income starting January 1, 2012. The Franchise Tax Board is merely doing what the politicians want.

A grassroots business coalition is urging the state legislature to drop the retroactive tax on grounds of simple justice, and even some liberals agree. "These taxpayers can't somehow go back five years in time and change their investments," says Democratic Senator Ted Lieu, who is sponsoring a bill to eliminate the retroactive tax. "California is not a banana republic." In imposing lawless taxation, oh yes it is.

A version of this article appeared August 30, 2013, on page A12 in the U.S. edition of The Wall Street Journal, with the headline: Lawless Taxation.