On July 10, Hawaii Governor David Ige (D) signed a bill that significantly alters Hawaii’s taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. code. The bill, HB 209, has two main provisions. Together, the provisions implement a state-level Earned Income Tax Credit and reinstate top marginal individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rates that had been allowed to expire. While the tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. is widely supported, it may affect only a small portion of eligible residents. On the other hand, the increased top individual income tax rate could raise costs for local businesses.
The State Earned Income Tax Credit
At the federal level, the Earned Income Tax Credit (EITC) is a tax credit targeted at working low-income individuals. Taxpayers receiving the credit can use it to directly offset their tax liability, and receive different credit amounts based on their income and the number of children they have. The credit is also refundable, meaning that if the credit awarded is greater than the tax obligation, the taxpayer can receive a cash refund.
The state-level EITC passed in Hawaii is based on the federal credit, with the state credit awarding 20 percent of value of the federal credit the taxpayer receives. For example, if a single mother received a $3,000 credit at the federal level, she would receive a $600 credit against her Hawaii state income tax liability.
Unlike the federal EITC, the Hawaiian credit is nonrefundable, meaning that a credit in excess of payable tax cannot be redeemed for cash. However, taxpayers can carry remaining credit value over to subsequent years without any limitations.
In 2014, 16.7 percent of Hawaiians received a federal earned income tax credit, according to the IRS. For those taxpayers who have a state income tax liability, the new Hawaii EITC could offer significant relief. The Hawaii Department of Taxation anticipates a revenue loss of $16.7 million in 2018 from providing the state credit. However, the state EITC would not reach everyone who benefits from the federal EITC.
For some low-income families, the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and other tax provisions may already eliminate any state income tax liability. Due to the nonrefundable structure of the credit, these families would not gain through the legislation, reducing its scope. In fact, some estimate that two-thirds of Hawaiian families who are eligible for the EITC would not benefit under the new law.
Reinstatement of High Top Marginal Income Tax Rates
In 2009, Hawaii passed a temporary tax increase on high-earners, which expired in December 2015. HB 209 reinstates those rates on a permanent basis. The hike is expected to bring in $51 million in additional tax revenues in 2018. With the EITC expected to cost $16.7 million, the state anticipates that the rate adjustment will bring in an extra $20 million to $40 million in annual tax revenue, after accounting for a separate refundable food/excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. credit for low-income families that is now being made permanent.
Currently, Hawaii has a top marginal income tax rate of 8.25 percent for a single filer making over $48,000. HB 209 will create three new brackets with new corresponding rates. In the highest bracket, single filers will face an 11 percent tax rate on all income over $200,000.
This has serious economic implications for Hawaiian businesses. In particular, the application of the new top rate to pass-through businesses is concerning. These businesses report their income on an individual’s personal tax return, rather than on a separate corporate filing, and are thus taxed at individual rates.
According to the latest available IRS data, about 8,000 Hawaiians making over $200,000 listed income from pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es on their tax returns. These filers accounted for only 22.9 percent of pass-through businesses, but contributed 84.5 percent of net pass-through income in 2014.
With the new law in place, Hawaii will levy the second highest top rate in the nation on these businesses. Such a high top marginal rate could discourage business investment in Hawaii, particularly among small businesses. In 2013, small businesses accounted for 96.2 percent of Hawaiian employers, and employed over half of the state’s workforce. Even though not all small businesses are pass-through entities, the impact on those that are could be tremendous.
Given the impact of the 2008 recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. on businesses, it is hard to measure the impact of the temporary increase in rates from 2009 to 2015 in Hawaii. However, theory would suggest that implementing such a high top marginal rate will have a negative impact on business.
Raising the tax rates on pass-through entities will not only stunt the growth of small firms, but it will also discourage new business investment in Hawaii. Higher tax rates leave small companies less money after taxes to reinvest into their businesses, translating into less growth at the firm level. Similarly, high tax rates can prove prohibitive to new investment as they represent an added cost to doing business.
While HB 209 was passed with good intentions, it could have unintended economic consequences. Given the structure of the credit as nonrefundable, it’s unclear how many Hawaiians will actually benefit from the expansion. Given the likely effects of the higher rates on job creation, the new policy could well prove counterproductive.Share