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Last week the Hawaii legislature sent Governor Neil Abercrombie a package of tax changes designed to help close the state’s yawning budget gap.  Among its most notable components are the partial repeal of the state’s nonsensical deduction for state income taxes paid, and a new limitation on itemized deductions taken by wealthy taxpayers.  Both of these changes will help mitigate the upside-down, regressive nature of Hawaii’s itemized deductions — a move that ITEP has urged many states to consider.

If Governor Abercrombie signs the legislature’s tax package into law — as he is expected to do — Hawaii will become the first state in the nation to place a cap on the overall size of itemized deductions. 

Married taxpayers earning over $200,000 per year will be prevented from sheltering more than $50,000 of their income from tax via itemized deductions, while single taxpayers earning over $100,000 will be limited to a $25,000 deduction. 

ITEP recommended a similar option in its August 2010 “Writing Off Tax Giveaways” report, and the Hawaii legislature actually passed a cap of this type last year that was eventually vetoed by then-Governor Linda Lingle.

If this bill becomes law, itemizers will still be able to take a deduction much larger than the $2,000 per-spouse “standard deduction” enjoyed by many Hawaii residents.  Nonetheless, the cap will go a long way toward reducing tax regressivity while also raising much-needed revenue for the state.

Hawaii’s legislature chose to collect additional revenue from itemized deduction reform by partially repealing the deduction for state income taxes paid.  Hawaii residents earning over $200,000 per year (or $100,000 in the case of a single filer) will be unable to take this deduction, while taxpayers earning under that amount will continue to benefit. 

Allowing taxpayers to deduct their state taxes on their state tax forms is a bizarre policy with no real rationale.  Instead, it exists only because Hawaii has “coupled” its itemized deduction laws too closely to federal rules, where the state tax deduction is used as a form of revenue-sharing. 

Gov. Neil Abercrombie rightly called the state tax deduction an “absurdity” in his State of the State address.  The vast majority of states have already abandoned the state income tax deduction — most recently in New Mexico and Rhode Island, both of which repealed the deduction in 2010.

In addition to these progressive reforms, the legislature’s plan also raises significant revenue by temporarily suspending various sales tax exemptions for business activities, and by delaying a scheduled increase in the state’s standard deduction and personal exemption.  Rental car taxes, vehicle registration fees, and the vehicle weight tax are also slated to rise under the legislature’s plan.

Perhaps the most disappointing part of the final package is that it does not include the Governor’s proposal to eliminate the pension exemption for middle- and high-income retirees.  This already costly tax break is almost certain to grow rapidly in size as Hawaii’s population advances in age.  Moreover, this break creates inequities between Hawaii residents with different forms of income, offering nothing to low-income, elderly residents that must continue to work in order to make ends meet.

But while the legislature deserves some criticism for failing to rein-in costly retiree tax breaks, it also deserves much praise for including revenues as part of its budget solution, and in particular for using itemized deduction reform as tool for enhancing the fairness and adequacy of Hawaii’s tax system.