Pitfalls of the Subcontractor Deduction
By Tom Yamachika, President This week we’ll look at another general excise tax exemption that the State Auditor has put under the microscope in Report No. 20-05. It affects the construction industry, and the price tag the Auditor put on it, based on 2018 numbers, was $19 million. The primary benefit of this exemption occurs when a construction contractor hires and pays other people qualifying as contractors to build a project. Suppose, for example, a general contractor is paid $100,000 to build an annex to an existing house. The general contractor hires a plumber and an electrician, paying $5,000 to each. Current law says that the plumber and electrician pay GET on the $5,000 each that they get, and that the general contractor is only taxed on the remaining $90,000. If a subcontractor needs to sub out part of its job, say the electrician needs to hire another electrician and pays the second one $2,000, the same rules apply at that level. The first electrician pays GET on only $3,000, and the total tax on the project remains the same. There are, of course, wrinkles . First, the contractor hiring the subcontractor needs to be a contractor in the construction industry. Many vendors who do work for the government are called contractors, but they do not qualify as contractors in the GET sense. Next, if money is paid to someone not a contractor, then the special treatment fails. Let’s say the plumber hired a design consultant and bought pipes from a supply house, and paid each $1,000. The plumber still needs to pay GET on the $5,000, and the plumber’s vendors each need to pay GET on the $1,000 as well, although at the 0.5% tax rate, assuming the transaction is documented properly. If we suspended this GET provision as we did in 2011-2013, then all sub-vendors would be in the same situation as the plumber in this example. The general contractor would have to pay GET on the whole $100,000. Each sub-vendor, and each sub-sub-vendor, would have to pay GET as well. The result would be even higher construction prices than what we are suffering through now. Is that what we want when the lack of housing, affordable or otherwise, is a major problem here? At the same time, the complexity of the current system is a major problem. Many of the clients I’ve represented were confused over at least some of the aspects of the subcontract deduction system I’ve briefly explained above. Maybe we should transition over to a simpler system. Guam has a gross receipts tax, and they had a subcontract deduction system like the one in Hawaii until 2010. As we have written about before, Guam’s system is that there is no subcontract deduction, so the general contractor pays tax on the whole contract, but the subcontractors are exempt on their payments from the general contractor. In theory, that system yields the same tax revenue as the current one, but there are fewer moving parts. Issues about whether the subcontractors are really subcontractors or are simply wholesalers can be sorted out at the vendor level without putting the tax on the main contract at risk. And if for policy reasons we want to forego GET on the main contract, such as if the contract is to build affordable housing, then we allow an exemption at the general contractor level instead of increasing complexity by letting the exemption propagate through to all of the subcontractors. How about that, lawmakers? Let’s do something constructive for the construction industry and our economy.
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The Giant Sucking Sound
By Tom Yamachika, President You may remember back in the 1992 U.S. Presidential campaign, independent businessman and candidate Ross Perot argued, on live TV: “We have got to stop sending jobs overseas. It's pretty simple: If … you can move your factory South of the border, pay a dollar an hour for labor, ... there will be a giant sucking sound going south.” We are going to have a similar problem, and soon. In 2016, Pacific Business News observed: “Over six years, from 2010 to 2016, we lost 30,000 more people than moved here from other states. And the flight rate has been increasing … 2016’s outmigration rate was 10 times higher than 2010’s.” On June 1, University of Hawaii Economic Research Organization’s Executive Director Carl Bonham told lawmakers that we’re going to lose another 30,000 people in just two years. A more pessimistic scenario assumes we are going to lose that 30,000 people in ONE year. Schlurrrrp! Why is this happening? “Because tourism is such a dominant piece of the economy, many other state economies and county economies will recover, much more rapidly, and the job opportunities will simply not exist here that will exist in the rest of the country,” he said. “Think about at the end of this year and into January when our extended unemployment benefits have expired; if you don't have family ties in Hawaii, and you were working in tourism here and your unemployment benefits run out, there's absolutely nothing to keep you here.” So how are our lawmakers reacting to this? Our public worker unions seem to have zero sympathy for the plight of our taxpayers. HSTA’s Corey Rosenlee argued last month in Civil Beat that demands for “shared sacrifice” because of budget shortfalls should be rejected. UPW’s Dayton Nakanelua wrote that his union “must vigorously and respectfully oppose however, any plan to reduce public employee pay at any level, amount or through furlough.” HGEA’s Randy Perreira wrote a similar letter opposing a furlough (or pay cut) affecting his union members. So, where is the money for public workers going to come from? We could borrow it, but we’d eventually have to pay any loan back with interest. We could turn over rocks hoping to uncover moneys that various departments have squirreled away – but that will last only so long. Could we get lots of money through “revenue enhancement,” otherwise known as raising taxes? If we try that, we can certainly expect the giant sucking sound to get louder and deeper. In addition, the taxpayers who are left might not be able to pony up increased taxes because they simply aren’t able to afford it in addition to rent, utilities, and other costs of doing business. If anything, we need to make it easier to do business. If we in the private sector are allowed to do business and with fewer nonessential restraints, we don’t mind sharing some of the profits with government. We also need to think seriously about cutting costs. Just as there are obscure special funds we are currently finding, there are obscure programs and services that no longer can be justified. These need to get out of the way so the tax dollars the government does get can be more efficiently utilized. Is Our GET Too Soft on Sales to the Feds?
By Tom Yamachika, President Our Legislature will be reopening soon, and some lawmakers are undoubtedly thinking of ways to make our budget balance because the grim reality is that much of our economic engine has ground to a halt and is no longer spinning out tax revenues. Our State Auditor has thought about this too and came out with Report 20-05. Following the Great Recession of 2008, our lawmakers enacted Act 105 of 2011. That statute suspended the operation of several exemptions and other taxpayer-favorable provisions under the General Excise and Use Tax Laws from July 1, 2011 to June 30, 2013. The State Auditor, in his report, tried to put a price tag on all of the previously suspended exemptions using 2018 activity. He apparently thought that some lawmakers would be interested in switching off some or all of those exemptions again. Of these, the one that seems to be the most lucrative is the exemption of sales of tangible personal property to the federal government, priced at $49 million. But it has a history that needs to be understood. This exemption, HRS section 237-25, is a strange beast. It says that if you sell tangible personal property to the Government and nothing else, then what the Government pays you is exempt from GET. However, it says that if you sell tangible personal property and services together, then there is no exemption either for the tangible personal property or the services. Thus, if a Government office needs a new TV and pays $1,000 for it, none of the $1,000 is subject to GET. But if the TV needs repair and the technician that comes to do it charges $200 for parts and $300 for labor, then all $500 is subject to tax. Why does this exemption work so strangely? Part of the reason may have to do with a complementary tax law called the Hawaii Use Tax. Normally, if a buyer has a choice between buying a local product in a sale subject to GET and an out-of-state product in a sale not subject to GET, and the buyer chooses the latter, then we impose tax on the buyer, at the same rate as the GET, so the tax isn’t a factor in the buyer’s decision (and so the State gets its tax either way). If the buyer is the Federal Government, however, this system doesn’t work because no State can tax the Federal Government. The Government could bring in goods from out of state with no tax consequence. So, for tangible personal property we needed to get our tax out of the way to help our local businesses sell to the Government on a level playing field. Not so for services, however, because if a seller, wherever located, comes here to do physical work, the seller is subject to our GET. There wasn’t the same need to exempt local competitors. Lawmakers also need to understand that when the Government buys goods, its tremendous buying power often results in contracts with thinner-than-usual profit margins. Changing the law to charge vendors 4% or 4.5% tax on those contracts may make the contracts money-losing propositions. That’s why when the exemption was suspended in 2011, there was a mad rush to qualify every existing contract for grandfather clause protection through last-minute contract amendments. As a result, the tax brought in by the suspension of this exemption fell short of expectations. Many of the exemptions that were suspended by the 2011 act had similar back stories. This is just one of them. As we have said before, tinkering with the tax code to raise more money has the effect of putting the brakes on what little spin we have left on our economic engine. We hope that lawmakers think long and hard before deciding to go down this path once again. |
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