Taking Exemptions Without Really Knowing

by Tom Yamachika, President, Tax Foundation Hawaii

These days, our General Excise Tax (GET) contains exemptions and reduced rates that are supposed to reflect commercial reality but often contain leaps of faith.

One common example is the wholesale rate. If I sell you a mango that you then resell to someone else, then I need to pay not the 4% or 4.5% retail rate, but the lower 0.5% wholesale rate, on my income from selling that mango.

The only problem is that I am not you, and I have no way of knowing what you really did with the mango once you bought it from me. Did you eat it yourself? (That would explain the suspicious orange stain on your chin.) Did you give it to Auntie down the street? Did you use it to make mango jam, and if so, did you sell the jam?

If I get audited by the State, the auditor will ask me those questions, not you, because I am the one who claimed the tax benefit even though you benefited from it when I tacked on only wholesale GET on my invoice to you. And if I simply told the truth and said that I had no idea whether you ate the mango, the auditor will charge me the 3.5% or 4% rate difference plus interest and penalties.

To bridge this information gap, the State has forms known as “resale certificates,” such as Form G-17. Before I lower the tax rate I charge you to 0.5%, I need you to fill one of these out and give it to me. It says that you are reselling the mangoes you buy from me unless you tell me otherwise, and that if you’re lying to me you are going to pay the extra tax and interest that the auditor charges me. (I probably won’t get charged penalties if I whip out your certificate and tell the auditor that I relied on it.)

Taking a certificate from the buyer helps bridge the information gap for some of the common GET exemptions such as wholesale goods, wholesale services, and some export sales. There are, however, more complex exemptions such as contracting in an enterprise zone, helping build or maintain an air pollution control facility or a federally funded scientific facility, providing certain nonscientific logistic and support services to a federally funded scientific facility, or for helping plan, design, finance, construct, or sell certified or approved affordable housing projects. The Department hasn’t prescribed certificates for all these exemptions.

Often an operator of one of these preferred facilities will approach a vendor and say, “Hey! This facility has a tax exemption that applies to you, so we won’t accept your adding GET to any invoice you send us.”

I pity the vendor in that situation. The vendor usually has no clue whether the customer is in a tax-preferred facility or not, and usually takes the customer’s word for it to keep the commercial relationship intact. But if the vendor gets audited, the vendor needs to establish the customer’s tax-preferred status, sometimes with minimal or no help from the customer. If the vendor loses, the vendor gets charged additional tax, penalties, and interest, even though the vendor gave the economic benefit of the claimed exemption to the customer (which, by this point, has probably made itself scarce). The vendor is taking most of the risk regarding the exemption and little or none of the reward.

What can be done about this? First, lawmakers shouldn’t be enacting complex exemptions that put the risks and rewards in different places like this. Second, if they really want to use the exemption in this situation, they need to provide for a mechanism to bridge the information gap to reposition, or at least distribute, the risk. Third, they should be thinking of clear, verifiable rules to determine the beneficiaries of any exemption consistent with the social policy they seek to advance.