At the Honolulu City Council’s June meeting there was an impromptu debate as notable for its acrimony as it was for the wonkish subject matter: the fairness of Hawaii’s tax structure, and how to pay for the Honolulu rail project.

The Legislature in May had considered increasing Oahu’s general excise tax by about $2.6 billion over 10 years to pay for the 20-mile rail line. At the June council meeting, Randall Roth, a retired tax law professor, testified against raising the general excise tax, saying the tax masks rail’s cost and unfairly burdens lower-income people.

That drew sharp questions from the council’s vice chairman, Ikaika Anderson. He argued raising the excise tax was fairer than raising the property tax.

The debate was more than academic.

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With the Hawaii Legislature poised to hold a special session in July or August to address paying for the over-budget, $10 billion rail project, the question of which tax is best to pay for rail will take center stage.

The project will run out of money next June if policymakers don’t find a long-term revenue source. Although state and local leaders have considered three options, interviews with tax experts suggest it’s a Hobson’s choice: a general excise tax that’s largely hidden but that unfairly burdens the poor, a less regressive property tax that taxpayers clearly see, or a tax increase on the powerful and already heavily taxed hotel industry.

“It boils down to – there’s no free lunch,” said Roth.

General Excise Tax Burdens the Poor

Among tax experts, there’s little debate that Hawaii’s general excise tax is regressive, which means it places a disproportionately higher burden on low- and middle-income people. The tax applies to virtually all goods and services sold in Hawaii.

Because those on the bottom rung of the economic ladder spend virtually all of what they earn to survive, Hawaii’s general excise tax means lower-income people pay a far higher percentage of their income in taxes compared to wealthier earners. As a result, Hawaii ranks second nationally when it comes to taxing the poor, the nonpartisan Washington, D.C.-based Institute on Taxation & Economic Policy reported in a recent national study.

“The main reason for that is the general excise tax,” said Carl Davis, the institute’s research director. “It’s a tax that applies very broadly, even to basic necessities like groceries.”

To understand how the excise tax is regressive, consider how much an average low-income household pays for food versus a higher-income household.

According to a 2016 study by the Hawaii Department of Business, Economic Development and Tourism, the average household with income less than $50,000 had household expenditures of $38,131 in 2013-14; of that, $7,473 or 19.5 percent, went for food.

By contrast, food costs represented only about 12 percent of expenditures for households with incomes of more than $100,000. Although the wealthier households spent more in general — $88,894 annually, and more on food, $10,862 — the percentage of income the wealthier households spent on food, and excise taxes paid on those transactions, was relatively low.

When factoring in all expenses, the disparity becomes more striking.

According to the tax institute’s study, households with income in the bottom 20 percent paid 11 percent of their earnings in general excise taxes, while those in the top 1 percent paid just 1.2 percent.

A person in the middle tier, with $50,000 annual income, paid about $3,250 in general excise taxes annually, the tax institute reported.

Part of the problem is that the general excise tax applies throughout the economy on almost all activities, which means the cost of the tax on multiple transactions gets added to the costs of a good by the time it reaches store shelves. So while buyers might think they are paying 4.5 percent in taxes at the register, the buyers are likely paying considerably more.

“There is a pyramiding effect,” said Vaughn Cook, a Hawaii island accountant who serves on the Hawaii Tax Review Commission, a state agency that studies tax policy.

He noted the excise tax is an enormous revenue generator. The tax produced about $3.2 billion for Hawaii in 2016, the Department of Taxation reported.

The 0.5 percent paid on Oahu for rail generated $255 million in 2016. At that amount, extending the Oahu rail tax for 10 years, as the Legislature considered, would increase the Honolulu general excise tax by about $2.6 billion.

Seth Colby, tax planning and research officer with the Hawaii Department of Taxation, agreed the general excise tax is generally regressive. But Colby, who in June gave a presentation on the general excise tax to the Tax Review Commission, said the tax is less regressive than often thought. One reason is that middle-age workers often save more than young and elderly people, which means they spend less as a percentage of income in general excise taxes.

“GE tax is less regressive when you account for the entire life cycle of the taxpayer,” Colby reported to the commission.

Would Higher Hotel Room Taxes Drive Away Tourists?

In some ways the most politically expedient way to raise money would be to increase the state’s hotel room tax. After all, the vast majority of people who pay the transient accommodation tax, or TAT, don’t vote in Hawaii, said Carl Bonham, executive director and professor of economics of the University of Hawaii’s Economic Research Organization.

“You often find that, politically, taxing people who don’t vote is a good thing,” Bonham said. But he noted there’s risk that taxing the state’s largest industry will drive tourists away.

That risk sparked an uproar among Honolulu city officials and business executives in May, after House and Senate leaders struck a tentative deal to raise the TAT from 9.25 percent to 12 percent for 10 years starting in 2018. The move would have generated $1.3 billion for the rail project over that time. But it also would have made Oahu’s tax on hotel rooms one of the nation’s highest, at 16.5 percent, including TAT and general excise taxes.

Bonham said opposition to increasing the TAT is understandable.

“At what level is the TAT too high, so it really starts to do damage?” Bonham said. “At some point, it will be too high, and we don’t necessarily know what that level is.”

Although the hotel room tax shifts a considerable burden to visitors from out of state, studies have shown a significant amount of general excise and real property taxes also are paid by tourists and out-of-state property owners.

Colby’s presentation, for example, cited studies showing that an average of about 30 percent of general excise taxes are paid by non-residents, namely tourists and non-resident military personnel. Similarly, about 30 percent of property taxes are paid by non-residents in Hawaii, DBEDT reported in March.

Is Property Tax Fairest And Most Transparent?

A third option is increasing the Honolulu property tax.

To the extent that residential and commercial landlords pass on property taxes to renters, property taxes are regressive, Davis said. But research shows landlords, who tend to be wealthier than renters, tend to absorb a fairly high portion of property taxes rather than passing on all the costs to tenants, he said.

In fact, Davis said, property taxes are generally fairer and less regressive than general excise taxes, so he believes an increase in Honolulu’s property tax would be a fairer way to raise the money for rail.

“The shifting is somewhat less dramatic than what we see with consumption taxes,” Davis said.

The institute’s study found that people across all income levels in Hawaii paid about the same percentage of their income in property taxes, about 1 to 2 percent.

But the idea of raising property taxes appears to strike some politicians as a profoundly bad idea. Indeed, during the City Council meeting debate between Roth and Anderson in June, the most heated exchange involved Roth’s suggestion that raising the property tax would be fairer and more transparent than increasing the general excise tax.

Anderson sharply questioned whether it would be fairer to have approximately 260,000 property owners pay for rail rather than spreading the cost among roughly 9 million annual visitors and about 1 million residents.

“I think you’re failing to understand exactly what the numbers are, with all due respect,” Anderson said.

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After watching a video of the debate on YouTube, Davis said Anderson’s analysis didn’t account for the fact that the general excise tax applies to many transactions and gets baked into the cost of goods. That means people essentially pay more in general excise taxes than the amount they pay at the point of sale, Davis said.

“The big picture takeaway is that taxes on property are significantly less regressive than consumption taxes” such as general excise taxes, he said.

Colby of the Department of Taxation agreed that increasing property taxes makes sense. Property taxes in Hawaii are already the lowest in the nation, Colby said. Higher property taxes also would discourage people from buying properties as second homes and not using them, he said.

Of course, Colby said, the government wouldn’t want to impose a tax that would drive elderly people or others on fixed incomes from their homes. But he said there could be a way to factor in a reduced property tax rate based on income.

So why the focus on the general excise tax if a property tax would be more equitable and promote efficient land use?

“My take on it is the GE tax is easier to hide,” said Tom Yamachika, president of the Tax Foundation of Hawaii, a nonprofit research organization. “It’s a nickel here and a nickel there. But the property tax is paid in one big chunk – boom.”