Pitfalls of the Subcontractor Deduction

by Tom Yamachika, President, Tax Foundation Hawaii

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.