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Yes, Continue To Conform But Not With A Percentage

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By Lowell L. Kalapa

Last week we took a look at why Hawaii should not do away with the net income tax just because state lawmakers adopt the changes to the federal Code almost a year later.

That prompted one reader to write and ask why then should Hawaii not adopt taking a percentage of the federal liability as the amount of the state income tax. 

This approach would do away altogether with having to fill out a state income tax form. In other words, state taxpayers would just multiply their federal income tax liability by a set percentage and send in that amount as their Hawaii state income tax. The idea of using a percentage of the federal income tax liability is not new. In fact some thirty years ago, there were three states that based their state tax liability on a percentage of federal tax liability. Of the three states – Alaska, Nebraska and Vermont – none of them currently use the federal tax liability as the basis for computing the state tax bill for their residents. Why?

As Hawaii and many other states learned, Congress constantly fiddles with the federal Code. And while Hawaii and many other income tax states conform to the federal Code, it is only with respect to the definition of what is taxed and what is exempt, in other words how income is defined for tax purposes. Those three states which used the federal tax liability to determine the amount of state tax owed learned a very painful lesson when Congress started to mess around with the federal income tax rates and brackets.

Beginning with the Tax Reform Act of 1986, and for several more times in the nearly 20 years that followed, Congress tinkered with the rates and brackets, reducing the number of brackets from more than two dozen to three and then increasing the number to four and then six. Rates were also altered not only for all income but in recent years to encourage investment in the economy by applying reduced rates to income received as dividends or capital gains.

If a state decides to take a percentage of the federal liability, the application of different rates and the width of the brackets would be inherent in the amount of the taxpayer’s federal liability and therefore would be recognized for the state income tax liability.

If the state adopted the law to have the state’s income tax figured as a percentage of net federal income tax liability, then the state would also be picking up all of the tax credits offered by the federal Code. This would further exacerbate state tax policy, as the state tax law would be adopting many of the social and economic mechanisms inherent in the federal tax Code.

So while it is efficient to follow the federal definitions of what is taxable and non-taxable income, adopting federal rates and brackets, or for that matter even federal tax credits, has the effect of surrendering control over how much the state asks its residents to pay in income taxes. Adopting federal rates and brackets by merely taking a percentage of the tax liability produced by those rates and brackets surrenders the policy oversight that we expect state lawmakers to exercise.

What evidence do we have that this is a surrender of policy oversight and control? Hawaii, like many other states, decided more than two decades ago that Hawaii taxpayers shouldn’t have to contend with two different tax laws when it came to figuring out how much we were going to tax the estates of the deceased. Until 1984, Hawaii levied a tax on the recipients of a deceased person’s estate, calculating the tax based on the relationship of the beneficiary to the deceased. The federal law, on the other hand, focused on the decedent’s estate regardless of who received the legacy of the estate.

But lawmakers were told that the federal law allowed a credit for what was assumed would be an amount taken by a state’s death tax and in fact this mechanism was called a “state death tax credit.” And like lawmakers in many other states, Hawaii lawmakers adopted this amount as what would be paid to the state of Hawaii as the tax on the decedent’s estate. Very little work is needed to figure out the amount owed the state because the federal law specified the amount of credit that could be claimed for the state tax.

But along came Congress in 2001 and phased-out the credit over a period of four years. The result is that Hawaii no longer imposes a tax on estates. This is all a result of state lawmakers surrendering their policy oversight to a number in the federal law which Congress wiped out with the stroke of the pen.

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