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Quest For Broader Tax Base Puts Property Tax In Back Seat

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By Lowell L. Kalapa

(Released on 05/06/07)

Last week’s commentary prompted a number of queries about why the real property tax is not used to finance schools in Hawaii aside from the fact that the educational system is under the purview of the state.

To find that answer one has to look back nearly a hundred years when Hawaii became a territory of the United States. From kingdom to provisional government to republic to territory, the only form of taxation that territory leaders knew was the real property tax. Note well that these Islands were governed by a territorial government which was highly centralized. Prior to 1906 there was no such animal as a county government and even though local governments were formed about 100 years ago, they were merely extensions of the territorial government that dictated how much money they got.

In fact, the territorial government imposed a general property tax which included not only real property, but personal property as well. But by the early 1920’s, so many exemptions for personal property were adopted that the territorial government abandoned the personal property tax on property owned by individuals and taxed only personal property that was used for business purposes. Taxation of commercial personal property was finally abandoned a couple of years after World War II and today only real property is subject to the property tax.

However, because Hawaii in the early 20th Century was an agrarian economy with a small urbanized population, there was not a whole lot of real property of any substantial value that could produce the revenues the territory needed. And with the advent of the Great Depression, the territorial government was particularly hard-pressed for resources. On the mainland, state and local governments had begun experimenting with the retail sales tax and the idea caught the fancy of Hawaii’s territorial leaders. So when revenues from the property tax fell short of estimates in 1932, a special session of the legislature was convened to deal with the shortfall. Amendments to the existing property tax structure were adopted and a new “business excise” tax was adopted. This latter tax was imposed for the “privilege of doing business” in Hawaii. Looking back on that tax, it has many similarities to what is known as a “valued added tax” or VAT commonly found in Europe.

However, because the business excise tax was only on the additional value added to products, its tax base was rather small and could not produce the revenue needed. So in a couple of years the territory was again faced with huge shortfalls. The governor then convened a task force to again look at the territory’s tax structure. At that time, the property tax provided more than half of the resources to run government in Hawaii, but the combination of the new business excise tax and the tax on personal property and intangibles was seen as detrimental to the competitive standing of goods made in Hawaii.

The governor’s task force undertook an evaluation of the tax system and came up with recommendations to repeal the personal property tax, change how financial institutions were to be taxed, repeal the exemption for dividend income and adopt a broad-based gross income tax that was to become known as today’s modern general excise tax. Enacted by the 1935 session, the general excise tax proved to be far more productive than had been estimated by the task force, surpassing initial estimates by more than 25% by the time fiscal biennium came to a close. So generous were the collections of the general excise tax that when the territorial legislature finally repealed the personal property tax in the years following World War II, it chose to compensate the counties for the loss of the personal property tax collections with a portion of the general excise tax collections.

Those resources were needed by the counties because until 1965 the counties were responsible for the construction of educational facilities and the county hospitals. Those responsibilities were ultimately transferred to the state in 1965 at which time the formula for sharing the general excise tax collections was altered. And since that time, the state has assumed all the financial responsibility for funding education in Hawaii and none of the property tax is used to fund education.

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