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Making a Square Peg Fit a Round Hole

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By Lowell L. Kalapa

Taking some idea from another jurisdiction is something akin to making a square peg fit into a round hole especially when there is no similarity in the parameters governing each situation.
Such is the case in trying to adopt the federal earned income tax credit for state purposes. Apparently advocates for establishing a similar credit for state income tax purposes that will provide tax relieve to low- income individuals in Hawaii argue that it helps to offset the state’s 4% general excise tax. But perhaps a little background is necessary to understand why this is a square peg.
The federal earned income tax credit (EIC) provides an incentive to low-income households to remain in the workforce. The credit is targeted at households with children but the credit is also available, at a lower amount, to low-income households without children. The credit is based on a number of tests for earned income, investment income, number of qualifying children, dependency, etc. Given the complexity of the credit, the IRS will optionally calculate the amount of the credit for taxpayers. The IRS reports an error rate of greater than 25% for this credit.
Advocates argue that the complexity problem would not apply to a state credit, as the state credit would merely be a percentage of the federal amount. While that may be true, it should be remembered that the federal credit was to offset the burden of social security payroll taxes that might have otherwise been paid to low-income wage earners but were instead paid to the federal government by the employer. Enacted in 1975 at the federal level primarily as a means of tax relief, the credit was expanded three times during the 1980’s and 1990’s by the federal government to boost income from work and lessen poverty in families with children.
In other words, it became a tool by which the federal government undertook social policy beginning with the first expansion of the credit in 1986. It is interesting to note the date of the first expansion because that was also the year that the federal Code was dramatically restructured, eliminating a number of tax benefits, rates were dramatically reduced, and along with the standard deduction and personal exemption, the rates were indexed.
Thus, what started out as a mechanism to fund payroll taxes that might otherwise have been paid to low and moderate-income workers the federal government has turned into a subsidy for these families. While federal policy makers have the luxury of expending millions of dollars to accomplish a social goal through the tax system, state lawmakers do not have the same level of resources.
If the intent of state lawmakers is to alleviate the burden on low and moderate-income workers in Hawaii who claimed the federal EIC, their efforts should focus on the state income tax burden as it affects these families. Hawaii has one of the lowest thresholds of the some 42 states that levy a state income tax. An income tax threshold is the income level at which families begin to pay the state income tax. Despite the reduction in personal income tax rates in 1998 and adoption of a low-income tax credit, Hawaii’s working poor ranks with the fourth lowest threshold before they begin paying taxes.
Hawaii has a structural problem in the state income tax rates and brackets as well as the floor after which lower-income persons begin to pay state income taxes. An increase in the standard deduction would be a far better approach to this problem than an earned income tax credit at the state level. By increasing the standard deduction the withholding tables would have to be adjusted to recognize the larger threshold before taxes are taken out of the worker=s paycheck.
This means more take home pay throughout the year as opposed to waiting for the end of the year and then processing the earned income tax credit. Given the complexity of applying for the earned income tax credit, the standard deduction insures that those who are least able to navigate their way through the maze of rules and regulations governing the federal EIC will be able to see the benefits of a larger standard deduction immediately in their paychecks. Both key lawmakers and the administration tried to push this reform, but to no avail because of the price tag.
It is doubtful that the state can afford both an increase in the standard deduction and the adoption of a state earned income tax credit.
Next week we will look at a more efficient way of addressing the regressivity of the general excise tax.

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