Falling Off the Cliff

by Tom Yamachika, President, Tax Foundation Hawaii

When I was growing up there was a hilarious cartoon involving a roadrunner and a coyote. The coyote was always trying to catch the roadrunner, presumably to make it that evening's dinner, but never succeeded. More often than not, the coyote would find the bird resting near the edge of a dangerous cliff. The coyote would lunge at it, the roadrunner would deftly sidestep, and the coyote found himself past the edge of the cliff with nothing but air under his feet. Wheeeeeee...splat.

There are also treacherous cliffs in the tax world. Take, for example, our conveyance tax that is imposed on real estate transactions. The tax rate on commercial property is 0.1% if what is paid for the property is less than $600,000, and 0.2% if it's $600,000 or more but less than $1 million. However, when the second tax rate kicks in it applies to the whole transaction price, not only the amount over $600,000. This means that if the transaction price is $599,999, the tax is just a shade under $600; but if the price is a dollar more, the tax jumps to $1,200. Our conveyance tax has five more brackets, for transactions with progressively higher amounts, and in each case a taxpayer who falls off the cliff and lands in a higher bracket is taxed at that rate on all of the dollars that otherwise would have been in lower brackets. To take another example, if a property is sold for $5,999,999 the tax is just a hair under $42,000; a dollar more and the bill is $54,000. These bracket changes can start costing serious money.

Another tax cliff example is in the City & County of Honolulu's real property tax system. This year the tax on residential property is $3.50 per $1,000 of assessed valuation. But if the property is worth at least $1 million and no homeowners' exemption is in place, then a "Residential A" property classification applies and the tax rate springs to $6.00. A family with a $1 million home close to work and a $1 million beach house at the North Shore will wind up paying $3,500 for one home and $6,000 for the other. If the second home was worth $1 less, both would have similar tax bills. What a difference one dollar makes!

When I hear from people who know of the cliffs in the system--especially from those who fell off one--I hear nothing but complaints. People have groused that the cliffs are unfair at best, and some have ventured to say that they are unconstitutional. They don't mind progressive taxes, namely where higher income or higher transaction size is taxed at a higher rate, but they expect something like the income tax system where there are no cliffs.

Why do lawmakers pass tax legislation with cliffs in them? My theory is that they put in the multiple rates and don't know or don't care about the cliffs. Both the conveyance tax and the real property tax on residential real estate use to be single rate taxes. Lawmakers then added more rate brackets with wording similar to the existing law. That created the cliffs.

So what can be done about these cliffs? It takes more work to design a tax system without cliffs, but it is not an impossible task; lawmakers just need to follow the wording in the income tax system. With fewer cliffs there is less anxiety experienced by taxpayers close to the cliff lines, and fewer hard feelings by taxpayers who have experienced the "wheeeeeee...splat."

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