Another issue that the current Tax Review Commission wants to take a look at is possibly doing away with the income tax both on the personal and corporate level. The rationale behind pursuing this issue is that: (1) the state income tax is primarily based on the federal law, and (2) Hawaii always has to wait for the legislature to adopt the changes made by last year’s Congress even though they are effective retroactive to the date set by the federal Code.
One of the beauties of the net income tax is that it adds progressivity to the state’s tax structure. Progressivity is that phenomenon where the amount of tax paid rises with the taxpayer’s ability to pay. That is, those with relatively smaller incomes pay a lesser percentage of their income than those with substantially more available income. It is the opposite phenomenon of a regressive tax where the tax paid is a larger percentage of small income taxpayers’ incomes than those with substantially more income.
That’s because the rate structure of the income tax can be designed to extract a larger percentage of the income as it rises. For example, a single taxpayer making less than $2,000 in taxable income pays 1.4% of that income in taxes while the single person with more than $40,000 in taxable income pays 8.25% of his or her income for each dollar over that income threshold.
On the other hand, a regressive tax, like the general excise tax or a sales tax, will take a much larger percentage of the lower income taxpayer’s budget than that of a taxpayer at the high end of the income scale. That’s because those at the low-income end of the scale will spend almost, if not all, of their income on taxable purchases where as a high income person will spend only a part of his or her larger income on taxable purchases. In the case of the latter family, some of that income will be saved or invested or spent on non-taxable purchases such as travel.
The income tax has also been an efficient way to target tax relief for those who cannot afford Hawaii’s heavy burden of taxes. Because the income tax reports all income received by the taxpayer, the structure allows those with lower incomes to receive relief from regressive taxes like the general excise tax. Some counties also use the income tax to provide relief to property owners who may be property rich but cash poor and are not able to pay their real property tax bills.
Since taxpayers have to contend with the federal income tax anyway, it just makes a lot more sense to retain the state income tax, especially if Hawaii continues to closely conform with the federal law. Sure, the changes to the federal law made by Congress in the previous year are not adopted until the ensuing legislature. But when those changes are adopted is controlled solely by the state legislature. They don’t have to wait until the end of the legislative session, which is usually after the filing deadline for the income tax, to adopt the federal changes.
The changes to the federal law are usually known by the first day of the new year and when the legislature goes into session on the third Wednesday in January, the measure adopting the federal changes could be ready for passage. So, if there is anyone to blame for the tardiness in adopting the changes to the federal law, it is our lawmakers. On the other hand, not everything is perfect with the state income tax. As has been recommended by every single Tax Review Commission since the first was convened, the standard deduction needs to be adjusted. While adjustment of the standard deduction is more critical, the personal exemption also has not been adjusted in more than 20 years. The excuse for lawmakers in the past has been there just aren’t enough revenues or money to offset the loss created by an increase in the standard deduction or personal exemption.
That’s what they said the last time we had a surplus, but lived to regret it when lawmakers needed something to “kickstart” the economy in the late 1990’s. Now that another surplus is being projected, lawmakers should be asked to update the income tax by adjusting the standard deduction and/or the personal exemption. And while they are at it, they should review the rates and structure of the brackets with an eye toward making the tax more progressive and competitive with other income tax states.
While the net income tax may not be perfect, the structure is not at fault. Lawmakers could improve it by updating some of its components and adopting the federal changes on a more timely basis.