To Tax or Not to Tax: Making a High-Quality State Revenue/Tax System
by James Mak, UHERO, March 6, 2020
When Hawaii’s state lawmakers gather each year at the State Capitol to begin their annual legislative session, tinkering with the tax system always seems to consume much of their work. Hawaii citizens can count on seeing a slew of bills introduced to raise taxes on somebody while other bills are introduced to lower taxes on somebody else, often at the request of politically influential special interest groups. Sometimes lawmakers simply give taxpayer money away in the form of tax credits to targeted beneficiaries without verified evidence of public benefits in return. Justification for passing these bills is usually couched in lofty language—called “finding (s)”—at the beginning of each bill. This year is no different.
For example, HB 2728 would “impose a visitor surcharge on passengers arriving and leaving the state. The surcharge shall be deposited into a special fund to be used to recruit and retain police officers.” There are separate House (H.B. 1930 H.D.1) and Senate (S.B. 2687 S.D.2) bills to increase the daily car rental tax to fund highways. H.B. No. 2719 proposes “to appropriate funds for a feasibility and implementation plan focused on the establishment of a green fees program…” to protect Hawaii’s natural environment. Green fees are “eco-taxes, tourist taxes, green taxes, and environment, conservation and tourism levies.” Supporters of these bills obviously like to hike taxes on out-of-state tourists.
Then there are tax breaks. H.B. No 2156 “provides a tax credit for locally produced, organic food; and exempting locally produced organic food from the general excise tax.[GET].” Curiously, the tax credit is not based on the amount spent on organic food production but “shall be twenty-five per cent of the qualified taxpayer’s taxable income for the taxable year…(subject to an unspecified cap).” S.B. No. 2542 S.D.1 aims to alleviate the shortage of physicians and advanced practice registered nurses by exempting them from the GET. Also, H.B. No. 2530 H.D.1 promotes menstrual equity by exempting feminine hygiene products from the general excise tax. And S. B. 2112 S.D.1 would “exempt from the general excise tax the fundraising income of tax-exempt charitable, religious, and educational organizations, while retaining the general excise tax on these organizations’ unrelated business taxable income.” The GET’s broad tax base is under assault in the 2020 Legislature. (The tax base is what is taxed. Thus, the amount of tax revenue generated = the tax base x the tax rate.)
It is not the purpose of this blog to advocate for or against any one of these bills. They all claim to achieve a public purpose. (One, possibly two, of these bills, if enacted, may violate the U.S. Constitution’s commerce clause.) But it is noteworthy that there is no big picture of how the state’s revenue/tax system would be affected if these bills were enacted into law. Would the changes improve or worsen the state’s revenue system?
Principles of a High-Quality Revenue System
There is surprising agreement on what constitutes a high-quality revenue system at the state and local government levels. A representative source is a report by the National Conference of State Legislatures (NCSL). NCSL uses the terms revenue system and tax system to mean all the ways a government uses to raise revenue. The term system recognizes that relationships exist among the components. For example, Hawaii has both a GET and an income tax; the GET is regressive, but that is balanced in part by the income tax which is progressive. Relying on both allows the state to have lower tax rates on both than if only one tax were used. Changing one tax may impact the other. The following are NCSL’s list of principles of a high-quality state revenue system:
1. A high-quality revenue system comprises elements that are complementary, including the finances of both state and local governments.
2. A high-quality revenue system produces revenue in a reliable manner. Reliability involves stability, certainty and sufficiency.
3. A high-quality revenue system relies on a balanced variety of revenue sources.
4. A high-quality revenue system treats individuals equitably. Minimum requirements of an equitable system are that it imposes similar tax burdens on people in similar circumstances, that it minimizes regressivity, and that it minimizes taxes on low-income individuals.
5. A high-quality revenue system facilitates taxpayer compliance. It is easy to understand and minimizes compliance costs.
6. A high-quality revenue system promotes fair, efficient and effective administration. It is as simple as possible to administer, raises revenue efficiently, is administered professionally, and is applied uniformly.
7. A high-quality revenue system is responsive to interstate and international economic competition.
8. A high-quality revenue system minimizes its involvement in [people’s] spending decisions and makes any such involvement explicit.
9. A high-quality revenue system is accountable to taxpayers.
Each of the nine principles is explained at length at https://www.ncsl.org/research/fiscal-policy/principles-of-a-high-quality-state-revenue-system.aspx
From Universal Principles to Local Applications
If lawmakers in every state have read these nine principles, one might imagine that the revenue systems in all fifty states would be quite similar. They are not. There are vast differences in the states’ revenue systems. Some don’t have personal income taxes. Others don’t have general sales taxes. Sales taxation of services vary greatly from state to state. Some states grant their local governments more taxing authority than others; Hawaii is not one of them. Why?
The NCSL report explains that “In theory, fiscal experts could develop a single model for a high-quality state revenue system. This theoretical model, however, would fail to reflect the vast differences in state economies, resource endowments, demographics, history and citizens’ differing expectations of what government ought to do and how taxes should be levied. Realistically, a revenue system cannot be created in a vacuum, so it is up to the political process to determine fiscal priorities in each state and how these priorities will affect the revenue system.”
Desire to increase the competitiveness of its economy was a central guiding principle in fiscal reform in Connecticut in the past decade. The same desire prompted Hawaii state lawmakers to reduce the top marginal personal income tax rate during the Cayetano Administration when the economy was mired in a prolonged slump.
History can play a big role in shaping a state’s revenue system. Hawaii’s extremely centralized revenue (fiscal) system is a legacy from the days when Hawaii was a monarchy. The monarchy ended in 1893, but centralization continued to the present day. More than in most other states, Hawaii’s state government continues to guard its taxing powers jealously from the counties, and prefers to dole out grants to the counties to mitigate imbalances in their fiscal capacities. This is contrary to the accountability principle which states that the unit of government that has the expenditure responsibility should also have the responsibility to raise the revenue to pay for it. While recommendations occasionally come from various sources to increase spending responsibilities and revenue-raising authority for the counties, it hasn’t happened.
Hawaii’s GET, too, has deep historical roots. The GET was enacted in 1935 during the Great Depression when the territorial government was strapped for money to maintain its services. A tax commission was appointed to come up with solutions. It recommended a gross income tax levied on vendors (not consumers). To spread the burden of the tax “equitably”, the original GET had an extremely broad base. It taxed everything—goods and services, intermediate and final sales. It had 4 rates: .25% on producing, wholesaling, and certain manufacturing; .50% on professional services; 1.00% on printing and publishing; and 1.25% on retailing, services other than professional services, sugar processing and canning, contracting, theaters, amusements, rentals and everything else. The GET turned out to be a prolific revenue generator. So prolific that state lawmakers since then have been reluctant to narrow its tax base out of fear of unacceptable revenue losses. The current GET has three rates: .15% on insurance commissions, .5% on wholesaling, producing and manufacturing, and 4.0% on final sales. Recommendations in the past to eliminate the .5% rate and exempt transactions under that rate from the GET have been unsuccessful even though the .5% rate doesn’t generate much revenue. Because of its broad base, the GET base also serves as a useful barometer of the overall performance of the state’s economy.
Taking the Future Into Consideration
In deciding whether the current bills if enacted will improve the quality of the state’s revenue system, lawmakers need to consider the State’s fiscal health in the future, i.e. the ability to raise sufficient revenue to pay for desired future expenditures. UHERO’s recent research brief—Charting a New Fiscal Course for Hawaii: A Fiscal Architecture Approach—paints a sobering picture of Hawaii’s fiscal health during the next 30 years. Rapid population aging and projected long-term slow-down in Hawaii’s economy are likely to significantly erode the state’s current tax bases and, thus, the state’s ability to raise revenue even as the costs of providing government services are expected to rise. Looming climate change further adds as yet undetermined future costs on the State. How AI will affect the Hawaii’s fiscal health in the future also remains unclear. Hawaii has been trying to get remote sellers to collect the GET for the state to prevent further erosion of the GET base. With the coronavirus posing a potentially serious threat to the state’s economy, is this a good time to contract the GET base further with the proposed tax breaks?
Cutting taxes on one group of taxpayers means somebody else’s taxes will have to be raised in order to collect the same amount of revenue. Who is that somebody else? U.S. Senator Russell Long of Louisiana famously said, “Don’t tax him. Don’t tax me. Tax the man behind the tree.” In Hawaii, the man behind the tree is a tourist.
It is sound tax policy to ask tourists to pay for the cost of public services that they use. It is also sound tax policy to ask them to pay for the costs of any harmful spillovers—e.g. environmental pollution– they cause while in Hawaii. Tourists and tourist businesses should pay for the money spent by the Hawaii Tourism Authority on destination promotion and marketing, and the cost of the Hawaii Convention Center. Beyond that, it becomes controversial. Often the best attractions of Hawaii—beautiful scenery, weather and the Aloha spirit– are unpriced. Tourism businesses are able to exploit these attractions for their own profit. (Economists refer to such profits as “economic rent.”) Former mayor of Honolulu, Frank Fasi, once argued that “Even if tourists are paying a ‘fair share of expenses’ there is nothing wrong in charging the tourist who enjoys the cream of our resources a little bit more [via a hotel room tax] for that privilege.” Economists who study these things would tend to agree with the mayor.
The most common tourist tax in the U.S. and around the world is the hotel room/occupancy tax. HVS’s 2019 Lodging Tax Report—USA shows that in 2018 Hawaii’s combined tax rate (including the GET) on tourist lodging was 14.25 percent (14.75% in the City and County of Honolulu). Among the 50 states, only Connecticut had a higher combined rate (15%). Among 150 urban centers, Omaha was at the top at 20.50%; Honolulu ranked 58. Among popular tourist destinations, New Orleans (17.75%), Anaheim (17.00%), and San Francisco (16.75%) all had higher lodging tax rates than Honolulu, while Orlando (12.50%) and Las Vegas (13.38%) had lower rates. Washington D.C. (14.80%) was about the same as Honolulu. The difficulty is determining the tipping point where further tax increases on the man behind the tree will begin to harm Destination Hawaii’s competitiveness.
The main purpose of this blog is to point out that in considering whether any, some or all of the bills mentioned above should be passed, it is important to look at the big picture on how the proposed measures affect the State’s overall revenue system today and going forward. Will Hawaii be better off or worse off with these changes?
Thanks to Bob Ebel for generously sharing his considerable state tax policy experience and knowledge as I prepared this blog.
UHERO BLOGS ARE CIRCULATED TO STIMULATE DISCUSSION AND CRITICAL COMMENT. THE VIEWS EXPRESSED ARE THOSE OF THE INDIVIDUAL AUTHORS.