A highly compensated Bishop Street executive recently complained his effective state tax rate was something on the order of 16 percent even though the nominal maximum state income tax rate is 11 percent for those folks with big incomes.
A highly compensated Bishop Street executive recently complained his effective state tax rate was something on the order of 16 percent even though the nominal maximum state income tax rate is 11 percent for those folks with big incomes.
How could someone be paying an income tax rate greater than the nominal maximum rate? Well, for these high-income individuals, making charitable contributions is one way not only to benefit the community, but also to reduce the amount of their income exposed to the income tax. Earlier this legislative session, the Senate Ways and Means Committee held a hearing on the subject of limiting the amount of itemized deductions that could be taken by high-income individuals. The folks who showed up were not the high-income taxpayers, but the people who benefit from those charitable contributions.
Last year, lawmakers decided another way they could raise taxes to fill the budget shortfall was to limit the amount of itemized deductions high-income earners could deduct, as well as denying those same taxpayers from taking state income and sales taxes paid as an itemized deduction. Once a single taxpayer realized $100,000 — $200,000 for couples — of federal adjusted gross income, the limitation would kick in.
In the case of overall itemized deductions, once taxpayers reached those thresholds of federal adjusted gross income, no more than $25,000 could be deducted by single taxpayers or more than $50,000 joint filers. Perhaps lawmakers felt taxpayers making that kind of income could afford to pay more in state income taxes by limiting those itemized deductions. And, no doubt, those assumptions are probably true.
The problem, as many discovered, is the wealthy are the very people who can afford to write a $10,000 check for a lead gift to a charitable organization. Committee members, upon hearing the bill that would have repealed that limitation on itemized deductions, discovered literally hundreds of charitable organizations reported the limitation affected their ability to solicit major gifts for their organizations. Thus, while lawmakers may have been eager to rake in more taxes, the unintended effect of the limitation on itemized deductions is many charitable organizations will find it difficult to solicit large contributions at least until the limitation sunsets on Jan. 1, 2016.
The other limitation lawmakers adopted last year is a limit on the deduction for state income and sales taxes by both corporate and individual taxpayers. Sponsored by the administration, the limitation is based upon the argument taxpayers can’t deduct the federal tax paid and withheld during the tax year from their federal adjusted gross income, therefore, they shouldn’t be allowed to deduct state income and sales tax from their state taxable income.
The problem with that logic is for more than 50 years the state has attempted to maintain similarity, or conformity, between the federal definition of taxable income and the state definition of that income. Maintaining conformity was cited as a top priority when lawmakers adopted the current conformity statute in 1978. It made it easier for taxpayers and allowed administrators to use audits conducted by the Internal Revenue Service rather than having state officials undertake their own audits of net income tax returns.
By deviating from the federal definition of income, the differences mean one more calculation for taxpayers in figuring out their state income tax return. Since the state income or sales tax deduction is available for federal purposes and not for the state, it will mean the bottom line for itemized deductions will differ, sending state officials scrambling to figure out what created the difference between the federal and state return.
The limitation on the deduction of state income and sales taxes will be permanent, unlike the limitation on all itemized deductions. While arguably it is true one cannot deduct federal income tax from adjusted gross income for federal or state purposes, eliminating the deduction of state income and sales taxes actually creates an additional cost for both the taxpayer and the administrator.
Lowell L. Kalapa is president of the Tax Foundation of Hawaii.