Hawaii should index income tax brackets, deductions to inflation

If Hawaii wants to stem the flow of residents to the mainland, it must change the state’s tax system — soon.

Andrey Yushkov, a senior policy analyst with the Tax Foundation based in Washington, D.C., suggested that the state look at improving its income tax system in particular, which is the second highest in the country.

“We see this recent trend that people tend to relocate to those states which do not impose income taxes at all — states like Florida, Texas, Tennessee, Washington state — or to those states where they do have a flat income tax and where they have pretty simple income tax systems,” he told Keli‘i Akina, president of the Grassroot Institute, on the Sept. 12 episode of ThinkTech Hawaii‘s “Hawaii Together” program.

Yushkov said indexing Hawaii’s tax brackets, personal exemption and standard deduction to inflation are straightforward reforms that would prevent taxes from automatically increasing with inflation.

“From 2016 to 2021, in nominal terms, the median household income [in Hawaii] increased from $72,000 to about $82,000. …  So, their wage was adjusted for inflation,” he explained. ” But as a result, … in 2021, they [paid] $700 more in state income taxes than they did in 2016. … [T]here were no legislated changes in those tax schedules, in those tax brackets, in the standard deduction or personal exemption, right? But still, they do have to pay more now than they did five or seven years ago.”

Akina noted Gov. Josh Green proposed inflation indexing in his “Green Affordability Plan,” but the Legislature declined to pass that portion of his “bold” plan.

“That may be a best practice in some states, but it’s just unheard of here,” he said. “Our Legislature was not in favor of that.”

Yushkov said adjusting for inflation “does not have many cons,” and that doing so will lead to lower tax revenues if the state’s economy is not growing.

His discussion with Akina also focused on how Hawaii could become friendlier to businesses. He said firms could benefit from changes to the state’s expensing law, and that “permanent full expensing” would boost business investment and create jobs.

Hawaii allows businesses to write off new equipment purchases from their taxes in the same year in which those purchases were made, but a federal law set to expire in 2025 could put that in jeopardy.

To view the entire conversation, click the image below. A complete transcript follows.

9-12-23 Keli‘i Akina hosts “Hawaii Together”

Keli‘i Akina: Aloha, everyone, and welcome to another episode of “Hawaii Together” on ThinkTech Hawaii. I’m your host, Keli‘i Akina, president of the Grassroot Institute. 

If you live in Hawaii, then you know that everything is expensive here. Everything costs so very much. And there are many, many reasons for this. But one of the reasons that residents mention most often is the high taxation rate here in the state for people who live here. And many people are actually shocked when they find out how much we pay in taxes.

It’s often one of the reasons why Hawaii has trouble attracting and retaining certain professions and industries. And that’s especially difficult for us now in the aftermath of the Lahaina fires, where we absolutely have taken a huge hit in terms of the personal toll of the fire, and not only that — the economy.

So, taxes is something that is all the more relevant to us today. For that reason, I’ve gone to a gentleman on the mainland to ask for his expertise in this matter. 

Andrey Yushkov. He is my guest today, and he covers tax policy in his role as a senior policy analyst at the Tax Foundation’s Center for State Tax Policy.

We’ve done a lot of work with the Tax Foundation, at least the national organization. I’m so glad that Andrey can join us today. 

Welcome to the program, Andrey. 

Andrey Yushkov: Thank you Keli‘i for having me, and I will be happy to answer any questions about tax policy in Hawaii. 

Akina: Well, Andrey, my colleagues are quite impressed with you. They met you at a recent conference and said I definitely need to talk with you about our tax policy. 

You’re in an interesting position from Washington D.C. One of your jobs is to actually study the tax policies of the state of Hawaii. 

But first, before we get started, tell me how you got into this line of work. Did you just grow up as a little boy and say, “When I grow up, I want to be a tax policy analyst?” 

Yushkov: Well, not quite like that, but still. Well, I was born in Russia, and then I studied in many different places — in Russia, Germany, in the United States of America, where I got my Ph.D. from Indiana University. 

But, well, before I came to the United States, I was doing some policy work. I participated in several international development projects, and they were all on public financial management at the state and local level. So, I was doing research, policy expertise in a variety of different — in several different countries. 

And, you know, I love working with state and local governments, exploring their tax policies. And I think the United States is an excellent place for that because, again, you have a very competitive version of federalism here. So, states compete among each other and they have a, well, completely different tax regimes. 

So, it’s quite interesting for me to be in this role and to analyze, compare different states, to study best practices, the worst practices, and make some policy recommendations to the states.

Akina: Well, that’s a fascinating background you have. Your perspective from the international level to the Hawaii level as well, as you study the tax systems of the different states. 

So, let me just ask you this right off at the start: What did you mean when you talked about federalism? That’s a very interesting word, and it’s a very important word when it comes to understanding how taxes and people work and their relationship with the government. 

When you talked about that, what did you mean? 

Yushkov: So to me, as a public finance analyst, federalism, of course, means fiscal federalism. So, by fiscal federalism, I mean this complex assignment of different functions to different levels of government — and also, horizontally. 

So, how different states and localities structure their tax policies, how they interact with the federal government and also how they, well, decide what to spend on. 

So it’s again, this complex public financial issue. And in America, well, the system is much more competitive than for instance, in Germany or in Russia. Because there, they do have a version of cooperative federalism where the federal government’s role is much more important; it tries to equalize fiscal capacity across different regions or states. 

And in the United States, it is not the case. So, states actually can compete for human capital; they can compete for physical capital, money, resources, et cetera — and they do it in a very active fashion. 

Akina: As I understand it, our Constitution of the United States protects the rights of states in terms of what is meant by federalism: that certain powers — and only those powers — are delegated to the federal government, and the others are actually left with the states themselves.

In terms of tax policy, it looks sometimes as though we’ve reversed that direction. And in many cases, it feels that the federal government is getting the lion’s share of the benefit of tax policy here in the United States. 

But we’ll move on from that, and let me ask you a bit about Hawaii. You’ve looked at states across the nation — how would you compare Hawaii’s tax policy in a general sense to the tax policies of other states in the United States? 

Yushkov: So Hawaii, of course, is a little different from all other states because it is not a mainland state. Still, there are some similarities and some differences between Hawaii and many other states.

Of course, one of the most important taxes everywhere is the individual income tax. And unfortunately, Hawaii is not very competitive on that front — specifically because many states have recently implemented policies to lower tax rates and to improve the tax structure with respect to the individual income tax.

And Hawaii, right now, it has one of the highest top marginal income tax rates in the country. It’s actually second to California. 

Akina: Andrey — if I might interrupt just briefly — I just want to make sure that our audience is following us. 

When you talk about the top marginal income tax rate, with respect to our tax rates in Hawaii and the brackets that we’re in, could you pause for a moment and explain how that’s determined?

What do we mean by that? 

Yushkov: So, the top marginal income tax rate applies to the last dollar of your income. So basically, if you earn — if you are a single individual who files a single tax return, then if you earn more than $200,000, then in Hawaii, actually 11% is applied to the last dollar of your income. So, this is the top marginal tax rate. 

And actually, this rate — the top marginal tax rate — is one of the highest in the country at 11%. So again, in California, it’s 13.3[%]. But it applies — well, it doesn’t — well, sort of, it doesn’t apply to income of say, $200,000; it applies to only incomes above $1 million.

So again, with respect to the tax bracket system in general, Hawaii is less competitive than many other states because Hawaii has 12 brackets — and this is quite unique. And it creates, of course, complications, and well, the tax code in Hawaii is pretty complex. And this is one of the problems that definitely needs attention.

Akina: Well, I often hear of the complexity of our tax code from two different audiences. One audience is those who are coming to Hawaii and discovering it — particularly those of higher income. And the other audience is those who are leaving Hawaii. 

Over the last several years, we’ve had a large exodus of our people — one of the highest rates in the nation. And when we interview them, one of the most common reasons they give — second or third to the cost of housing — is the high tax burden. 

Now, is this something that you hear commonly across the country, or is this unique to Hawaii? 

Yushkov: Absolutely, and we have done some research on that. And it turns out that, of course, when people make those relocation decisions in a high mobile economy — which we have right now — well, they have a variety of factors, right, that affect the decisions. 

So, one of these factors is, of course, taxes — in particular, income taxes, also property taxes, sometimes sales taxes. But, in general, income taxes are very important. 

And we see this recent trend that people tend to relocate to those states which do not impose income taxes at all — states like Florida, Texas, Tennessee, Washington state — or to those states where they do have a flat income tax and where they have pretty simple income tax systems. 

So, I would say that, of course, there are many other factors that affect those decisions, including the cost of living in general, including the cost of housing, amenities, rights over tax benefits package.  

But taxes are quite important, and you see that people move away from California, from New York, from Illinois — even though Illinois has a pretty competitive tax system compared to New York. But they move to Florida, Texas, Tennessee and other states with simpler tax systems. 

Akina: Often in some of the states you mentioned, the discussion of taxes — the relative benefits in some states and the burdens in other states — is discussion amongst those who are partisan in nature: Republican versus Democrat. 

And sometimes states are called blue states or red states with respect to their tax policies or the friendliness of their policies. That discussion generally doesn’t take place in a large way here in the state of Hawaii because we are predominantly of a single party. 

Yet, during the last legislative session, our governor — Josh Green — proposed a sweeping tax plan, and I take my hat off to him for some of the recommendations he made.

They weren’t all accepted, and one of those items that wasn’t accepted was quite revolutionary for Hawaii. And that would be to have indexed the state’s tax brackets, personal exemption and standard deduction to changes in inflation. 

That may be a best practice in some states, but it’s just unheard of here. Our Legislature was not in favor of that. 

What would be the pros, you’d say, of that? What would be the benefits to Hawaii of inflation indexing? And tell me whether there are some other states that have experienced benefits from doing that. 

Yushkov: Yes, absolutely. This is a very important recent trend as well. 

So, many states now — well, states that do have, do impose taxes on wage income — most of them now index different tax provisions, including tax brackets, the standard deduction, the personal exemption — index them for inflation. 

And this has a reason behind that. Because what you want to prevent in this case, you want to prevent unlegislated changes and unlegislated tax increases for those people, right?

So, I did some simple analysis for Hawaii. I did some tax simulation for our discussion today and it turns out that, well, the median household income in Hawaii, it remained pretty constant over the last five, six years, right? So, from 2016 to 2021, in nominal terms, the median household income increased from $72,000 to about $82,000. In real terms, right — in inflation-adjusted terms — it was pretty constant. 

So, of course, well, working families, working individuals, they increased, they had those raises — say, COLA [cost-of-living adjustment] adjustments, right? So, their wage was adjusted for inflation. But as a result, they experience now higher effective tax rates. 

So as the median, again, working family of two, they now — well, say, in 2021 — they pay $700 more in state income taxes than they did in 2016.

So, it’s quite a significant change, right? Because there were no legislated changes in those tax schedules, in those tax brackets, in the standard deduction or personal exemption, right? 

But still, they do have to pay more now than they did five or seven years ago. So, this is one reason why we encourage states to index tax brackets, as well as the standard deduction and personal exemption for inflation. Because this situation can be — this harmful situation can be prevented.

Akina: What is the trend among states? How many have started to index according to inflation? 

Yushkov: So, right now, again, it’s important to understand that 11 states, they have a flat income tax rate, right? So they have, well, a single tax rate, and it is a very simple tax system in that case. 

And nine states do not tax wage income at all. Among other states, 14 states do have, well, do index either tax brackets or tax brackets and standard deductions or personal exemptions for inflation. And you see that in total, it’s already 34 states. 

And in that case, Hawaii is very far behind most of those states. And again, for states that have a flat income tax system, they do not have to index tax brackets for inflation because they technically do not have tax brackets, right? They apply a single tax rate to all income, right — or most of it.

Akina: Well, I certainly hope the awareness in our Hawaii population of growing inflation, particularly for housing and for food — actually for everything, for that matter. I hope that that growing awareness will make people all the more open to the idea of indexing for inflation.

But at the same time, there are some criticisms that have been raised to this. And as I mentioned before, the governor’s bold proposal did not pass. 

Well, what is your response to some of the critics who feel that this would not be a good move for Hawaii? 

Yushkov: Well, I believe this move does not have many cons. Of course, if your GDP is not growing, right? If your personal income in the state is not growing, then adjusting those tax brackets for inflation will lead to lower tax revenues. 

But, of course, tax revenues need to be a function of economic growth, right? Because your economy grows, and you can expect to benefit from it as a state. 

In that case — I mean, if your economy is growing, if personal income is growing, and if that is your target — then adjusting for inflation will not, well, complicate the system, right? 

So, your revenues will still stay constant or will even slightly increase as a result. So, I guess the focus here should be on improving the prospects of economic growth by maybe lowering some taxes, including the income tax, and then thinking about inflation indexing, because it will help working families and many other families in that case as well.

But then, tax revenues can still be relatively high even if you adjust it for inflation. 

Akina: Well, Andrey, I couldn’t agree with you more. It just does not make sense to punish people for not earning the money they need to earn in order to get governments more tax dollars. 

What we really need to focus on is stimulating the economy. We need economic growth; we need higher revenues. Those higher revenues will logically produce higher tax returns for the government, and that should be the aim of all of us instead of working counterproductively toward that. 

Now, let’s talk a little bit about the impact of federal tax policy on Hawaii. There’s a term that is used frequently that I would appreciate you explaining to our audience called “full expensing.” And how in the world does that work in Hawaii?

Yushkov: So, full expensing, again, now we talk about corporate income taxes, right? So, we are very much in favor of full expensing. Because when a particular firm invests in, well, physical capital, improves its, well, capital — something to produce their goods and services, right? 

In the current system — well, again, the current system has changed with the Tax Cuts and Jobs Act. This Act of 2017, well, allowed full expensing, right? And some states conform with the federal legislation in that respect. 

But unfortunately, the Tax Cuts and Jobs Act — unless some of these provisions are extended by Congress — it will phase out in 2025. It actually has already started phasing out. And in this case, we actually recommend the states to make full expensing permanent at the state level. 

And this would allow companies that invest in technologies, right? That invest in new machinery and equipment to deduct those capital expenditures from their tax base fully, right? And this is quite important for businesses or companies — in particular, manufacturers. 

Akina: Andrey, if Hawaii as a state adopted full expensing — regardless of what the federal government does — what benefit would it bring to our economy and to the businesses if we did? 

Yushkov: That’s a great question. Again, we expect that it will incentivize investment. And investment, as we know — all economists know that investment is one of the primary drivers of economic growth. 

So, if you have a way to incentivize investment — to incentivize investment in manufacturing — then, of course, you can expect your future economic growth to accelerate. So, this would be one very important benefit of this particular provision.

Akina: One of the laws that was passed most recently, in the recent legislative session, had to do with allowing businesses in the state to lower their federal taxes by getting around state and local tax caps, or deduction caps as we refer to them. 

Could you explain a little bit about this? And in particular, how that workaround has benefited other states and how it might benefit Hawaii?

Yushkov: Right. So, first of all, I would like to advertise the Grassroot Institute because Jonathan Helton has a very nice piece about well, this specific SALT [state and local tax] cap workarounds in Hawaii and those recent changes. So, I encourage everybody interested in tax policy in Hawaii to read his piece on that.

But in general, the SALT cap, well, is a very important federal provision, right? So, people usually, when they file their federal tax returns, they have an option whether to use the standard deduction or to itemize their deduction, right? And typically, when they itemize their deductions, one of those itemized deductions is the state and local tax deduction.

So, people who pay a lot in state and local taxes, they can deduct a particular amount of money from their federal tax base, right, from their adjusted gross income. The Tax Cuts and Jobs Act, again, capped these total deductions at $10,000. So, this was an important change. 

But the IRS nowadays, it allows those states that have high state taxes to implement those workarounds, and Hawaii was one of the states that implemented that. 

So, it is important for — not for all businesses — but specifically for pass-through entities, right? So, pass-through entities, including S corporations, partnerships — they definitely benefit from this workaround, because they now need to pay less in federal tax.

However, we believe that this is — well, this violates the principle of neutrality, unfortunately, because it doesn’t treat everybody as equals, right? It creates this preferential treatment for pass-through entities, and it doesn’t create the same preferential treatment for wage employees, right, wage earners and C corporations, for instance.

So again, it may be beneficial for a subset of individuals, but you need to understand who is included in this subset of individuals, right? And usually, when we talk about itemizers — well, people who itemize — those are people who earn relatively high wages or business income as well.

So, these workarounds may be very helpful for S corporations, partnerships, et cetera, but we need to understand the whole structure of your economy. And if this is only, say, 15% of your, well, combined businesses in Hawaii, then maybe it’s good for them, but it’s not good for all businesses and for all people who file their taxes, right?

Akina: Yes, You know, talking about the complications of the impact of tax policies on those at different levels of income raises a philosophical question, and I’m wondering if I can just throw this out to you. 

There are many here in Hawaii who are averse to any benefits that businesses or higher income individuals get in terms of tax reform and say that that does not benefit those at the lower income levels — that it doesn’t really trickle down; it doesn’t really help the populace. 

But instead, there’s the Robin Hood effect that — that, and in other words, they propose the solution should be to take from the rich and give to the poor. 

What are some general thoughts you may have about the equity involved here and the issues that people address when they look at benefits that may occur to those at the higher income levels or at business levels?

Yushkov: So again, I would say that the individual income tax system in Hawaii is progressive, and maybe it is overly progressive, again, compared to some other states, right? 

And you have to compete for human capital. And you mentioned that, well, people unfortunately leave Hawaii because of its tax policy in particular, right?

So, I would say that it’s the tax system that you now have. It is already progressing; it already takes more from the rich than from the poor. And you also have the standard deduction that unfortunately is not indexed for inflation and personal exemption. And those provisions actually help, well, the people who are relatively poor.

So, I would say that from the perspective of equity, well, the state of Hawaii is actually very high on this ranking. But again, if it comes at the cost of future investment, then again, it can be dangerous for future population growth, for future economic growth, and it can have many other detrimental effects, unfortunately.

Akina: Recently, you wrote on throwback rules. As we close quickly in the next moment, would you care to say anything about that and how these may work in Hawaii?

Yushkov: So, the throwback rule is an important provision, again, in the corporate income tax code. And, well, those provisions are now frequently being repealed in many states — and there is a reason for that. 

Again, the corporate income tax system is very complicated. So, you need to make a small example here, right? So, consider you have a firm in Hawaii, and this firm sells goods and services not only to the residents of Hawaii, but to other states as well. 

And then the question is about the portion of corporate income of this particular firm, right? So, you have a complicated — different types of apportionment rules, and some of them are more efficient than others. And also, you have these throwback rules. 

So, throwback rules were intended to tax “nowhere income.” So for instance, if a firm sells something to a particular state where this income is not taxable because the firm does not have an exit in that state.

Then the idea was to throw this income back to the tax base of Hawaii, right? And unfortunately, these rules may lead to overtaxing corporate income. So, for some firms, it may lead to taxing more than 100% of their corporate income. And that is the reason why many states actually repealed those rules.

Akina: Well, thank you, Andrey. This has been a fascinating conversation and I appreciate your work, your expertise and what you do with the National Tax Foundation. Thank you for your consultation with us at Grassroot Institute. Good having you on board. 

Yushkov: Thank you very much, and thank you for having me. 

Akina: My guest today has been Andrey Yushkov, who happens to be a tax policy specialist at foundation, or the Tax Foundation — the national organization — and we’re just grateful for his work.

Thank you for being with us today. I’m Keli‘i Akina. You’re watching ThinkTech Hawaii’s “Hawaii Together.” Until next time, aloha.

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