Federal tax reform is unmasking high-tax states

Federal tax reform is unmasking high-tax states
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Call it a statement on politics in the age of social media, but rarely has a tax cut created so much chaos.

The partisan back-and-forth created ample opportunities for confusion, and even Hollywood got caught up in the mess. Actress Jenna Fischer actually apologized on Twitter for contributing to a misunderstanding about the teacher’s deduction for classroom supplies.

But the most interesting fallout has been at the state and local levels, where changes to state and local tax deductions have helped expose taxation issues closer to home.

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Hawaii, for example, witnessed one of the strangest possible sights: a line of people desperate to pay their taxes early.

 

Because the new tax law caps the state and local tax (SALT) deduction at $10,000, Hawaii residents were lining up to pay their 2017 property taxes before the year’s end, in the hope that it would save them money. This was thanks to a statement from the IRS informing taxpayers that prepaying 2018 state and local real property taxes could be deductible under certain circumstances.

Though most people would save less than $1,000 dollars by prepaying, the folks standing in line in Hawaii said it was worth it — which leads to the deeper issue of what effect the federal tax changes will have on state competitiveness.

When it comes to singling out states with high marginal tax rates, most analysts like to point to California as the biggest offender. With its income tax rate of 13.3 percent on residents earning a million dollars or more, it definitely gives millionaires an incentive to live elsewhere.

But what many people miss about Hawaii is that it’s just become the state with the second-highest tax rate in the country — and losing its millionaires could wreak substantial financial havoc.

During the 2017 session, the Hawaii legislature reinstated an income tax rate of 11 percent on earners who make $200,000 or more. Though only about 2 percent of Hawaii’s residents fit into that category, they pay about 35 percent of the state’s income tax bill.

Many people ignore the SALT deduction because it doesn’t benefit them, nor will they be particularly affected by the new $10,000 cap. But those in the top tax brackets do use it. And now Hawaii — with its high cost of living, high regulation and high taxes — looks even more expensive than usual to top income earners.

If the highest earners start fleeing Hawaii for less costly pastures, this may be a situation where a trend that started among the lower and middle economic brackets has trickled up. In recent years, the state has experienced a significant drain of local talent. In 2017, 13,357 locals left Hawaii, and many of them cited the high cost of living as the primary reason.

So will Hawaii’s top earners follow suit? The state’s high cost of living and limited opportunities certainly were enough to drive away average residents with strong family and community ties.

It may be that the wealthy often have other reasons for settling in the Aloha State, but they respond to incentives — and disincentives — too. When there are other, less costly options available, the richest segment of taxpayers have fewer barriers to leaving then those with lower incomes.  And losing a significant part of that high income tax base could affect state tax revenues, the state’s budget and future state programs.

By joining the ranks of the nation’s highest-taxing states, Hawaii is encouraging its richest residents to look for tax havens. The changes in federal tax law clearly make it more attractive for high-income earners to settle in low-tax areas.

So far, the state has shown little compunction about soaking the rich. But will the changes to federal tax law change that?

Ideally, the new federal tax plan will spur local legislators to take a second look at their newly enacted tax hike. Based on the questions flying around at the state legislature’s recent review of the state budget, there are many concerns about how the tax changes will affect Hawaii.

The best approach would be for local legislators to lower state income taxes and generally work to lower the Aloha State’s notoriously high cost of living.

Malia Hill is the policy director of the Grassroot Institute of Hawaii (@GrassrootHawaii), a public policy think tank dedicated to the principles of individual liberty, free markets and limited, accountable government