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Make Rate Changes As Well As Indexing

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By Lowell L. Kalapa
(Released on 01/28/07)

One of the proposals that the administration has put forward to provide tax relief for Hawaii residents is the indexing of the income tax brackets as well as the standard deduction and personal exemption.

Indexing allows the income tax brackets and the personal exemption and standard deduction to be automatically adjusted for inflation. So as the consumer price index (which is the common measure of inflation) increases, the amount of the standard deduction and personal exemption would be increased by the identical number that measures inflation. So if the CPI increases by 3% in a year, the standard deduction and the personal exemption amounts would also be increased by 3% for that year. Similarly, the amounts that determine the beginning and end of an income tax bracket would be adjusted by the rate of inflation. The federal income tax has been indexed for a number of years and the idea has been a part of the recommendation of the state’s Tax Review Commissions dating back to the first Commission report made in 1985.

So one would think that there should be a collective sigh of relief that indexing is now being embraced at least by the administration. But wait, lawmakers and administration officials need to ask whether or not the current tax rates and brackets are appropriate or should they be further adjusted to bring them into line with what they were when they were originally adjusted after statehood.

At that time, the top income tax rate was set at 11% and kicked in at $30,000 of taxable income for individuals and $60,000 for heads of households. More than 20 years had passed before lawmakers adjusted tax rates and brackets and then only because Congress made a number of changes to the federal tax Code that basically broadened the income tax base.

The federal Tax Reform Act of 1986 took away a lot of breaks which allowed taxpayers to reduce the amount of income that was exposed to the income tax such as the deduction for state sales taxes and the deduction for consumer credit interest also known as credit card interest. The Waihee administration, which had just been elected to office in 1987, seized the opportunity to adjust income tax rates, but professed that because the true impact of the income tax base broadening was unknown, they wanted to take a cautionary approach to adjusting rates.

As a result, the administration proposed dropping the top tax rate by one percentage point from 11% to 10% and instead suggested that to compensate for the marginal adjustment, that a tax credit of a flat dollar amount be offered to offset any effect of the base broadening. And in a moment of genius, they named the credit the “Food Tax Credit” as if to imply that it was to offset any tax paid on the purchase of food. The credit and adjustment of rates were supposed to be only temporary while officials assessed the impact of the base broadening.

But when officials realized what a windfall the new rates produced, they made the income tax rate adjustment permanent along with the food tax credit. The money continued to pour in and administration officials continued to spend the money as fast as they could and when they couldn’t spend it fast enough, lawmakers resorted to creating the infamous special funds into which they could tuck tax dollars so that it created the illusion that there was no surplus.

With the 1990’s came a turn in the economy as the Japanese bubble burst. Now lawmakers were faced with a downward spiral in the economy and a slump in tax revenues. To keep government running and insuring that their favorite programs were not cut, lawmakers resorted to sacking many of the special funds they had been established in the better times of the late 1980’s. And when it looked that a sour economy might jeopardize the reelection hopes of the governor in 1998, lawmakers and the administration joined together to propose lowering income tax rates provided the general excise tax rate was increased to make up the lost revenue. But ballot-box sensitive lawmakers refused to concur on the general excise tax rate increase and adopted only the income tax rate adjustments, dropping the top tax rate from 10% to 8.25% and lifting the top threshold from $21,000 to $40,00 for individuals and to $80,000 for joint filers.

Last session lawmakers were coerced into adjusting the brackets yet again, raising the top threshold to $48,000 for individuals and $96,000 for joint filers. But the top tax rate remains at 8.25%. That top rate, as well as all the other rates, needs to be adjusted for inflation over the past 20 years. So what should the top tax rate be? The 1986 Tax Reform Act treated the taxation of capital gains with the ordinary income tax rate. The 1987 legislature set the tax rate on capital gains for Hawaii income tax purposes at 7.25%. So perhaps that is a start. 

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