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Hawaii's Tax Pyramid plan crippling small businesses

State's answer to its budget deficit is crippling small construction companies

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Illustrations by Andrew J. Catanzariti

A state tax increase imposed last year is killing off construction projects, raising the cost of other projects and encouraging law-breaking, say leaders in the construction industry, who want to make sure the tax increase is not extended after its planned two-year run.

They say the full consequences of the law are not yet evident because many projects now under way were launched quickly last year to avoid the tax law’s start date of July 1.

“The government is effectively killing more activity by having this act in place,” says Greg Thielen, president of Complete Construction Services Corp. and president-elect of the Building Industry Association of Hawaii. “That’s going to more than offset any gain (in tax revenue) they’re going to see coming in.”

“It just makes it that much harder to start projects, to make that decision to go forward,” adds Quentin Machida, VP of Gentry Homes Ltd.

Small general-contracting companies are the hardest-hit victims of the law, which ended some exemptions on the 4 percent General Excise Tax. Now the contractor and all its subcontractors must pay the full tax, creating what is called “pyramiding.” That means more revenue for the state government, but higher costs for construction projects and/or lower revenues and profits for construction companies.

The building industry is the main victim, but not the only one. Transportation companies such as Matson and Hawaiian Airlines, plus businesses in other industries, are also hurt by the pyramiding tax.

For some contractors, it means less business, as customers are unwilling to OK new projects that cost 4 percent more at every level of work. Other companies are gritting their teeth and absorbing the tax increase without passing it on.

Last year’s state Legislature needed to balance the budget but faced a shortfall of what was estimated at $1.3 billion for fiscal years 2012 and 2013 (the fiscal years run from July 1 to June 30). Despite opposition from local businesses, lawmakers passed Act 105, Gov. Neil Abercrombie signed it into law and it took effect July 1, 2011. The law suspends 29 GET exemptions and deductions for certain businesses for two years, with the exemptions and deductions being restored June 30, 2013.

Sen. David Ige, chair of the Senate Ways and Means Committee, defends the law as painful but needed. “You may recall we faced a $1.3 billion deficit over the biennium and we’d already cut $600 million,” Ige says. “There weren’t any other cuts we could make without hurting other areas like education. We had to generate income and this was the path chosen. … To the extent that tax is viewed as anti-business, this act ends up being attacked as such.”

Weak recovery

llustrations by Andrew J.. Catanzariti

The official end to the global recession in June 2009 didn’t lead to a recovery in Hawaii’s construction industry. Leaders in the industry were optimistic about a recovery in 2011, but Act 105 put some of that optimism on hold.

The suspension of the subcontractors’ deduction is expected to provide $135 million in tax revenue to the state’s general fund over the next two years, according to the state Department of Taxation, but some contractors believe that estimate is inflated. The Tax Department says it is too early to know how much tax revenue the act has actually brought in so far, but a spokeswoman for the department did not return repeated calls for more information.

Contractors say that to avoid the tax increase, many contracts were pushed through before the act took effect, so the amount and dollar value of work in the first half of 2011 are likely relatively high. However, contractors say that since the law went into effect, the number and dollar amount of contracts, especially in the private sector, have shown no gains and are unlikely to pick up again until the act sunsets.

Act 105’s suspension of the subcontractors’ deduction has made it difficult for small- and mid-size contractors to compete with large contractors. Smaller contractors need help from consultants and subcontractors because they lack the necessary licenses to complete all aspects of a project themselves, while big contractors often have the staff to do all the work in-house.

“For all jobs, we use subcontractors,” says Jaroslaw Jurek, VP of Site Engineering Inc., a small, general-contracting firm based in Honolulu. Act 105 “makes our price high for work because several subcontractors’ GETs are in our (contract) bids.”

Steve Baginski, president and CEO of Kaikor Construction, shares that perspective. “It (Act 105) unevens the playing field, giving bigger companies an advantage and hurting small, local contractors. Lots of those larger companies aren’t even locally owned,” he says.

With fewer contracts to go around, competition is fierce and every penny counts. In an effort to cut costs, some contractors have considered applying for more licenses to minimize the need to subcontract work out. This would hurt other subcontractors and could lower the quality of work as contractors do work with which they are less familiar.

Another alternative is cutting the subcontractor markup on tools and materials, making it more difficult for subcontractors to make a profit.

Some companies are doing cumbersome workarounds to reduce taxes. “I can say to my subcontractors, ‘Hey, I want you to do this job for so much money,’ but I’ll purchase the materials directly to avoid their markups on the material,” says John Cheung, president of CC Engineering and Construction Inc. “This way, we save money on tax as well.”

There is a fear that Act 105 will exacerbate the already rampant problem of some contractors skirting the rules, particularly in the private sector, where monitoring and enforcement are minimal, says Thielen. “The owner-builder exemption is rife with abuse of contractors’ licensing requirements, with many owners pulling their own permits and hiring unlicensed individuals who do not pay taxes or maintain insurance as licensed contractors are required to do.

“Even with licensed general contractors,” he adds, “there is a lack of adherence to contractors’ license laws in the use of subcontractors. Instead, many general contractors see their license as being sufficient to perform all work, except plumbing and electrical trades, and do not hire licensed contractors for much of their work.”

Contractors that adhere to the law are at a disadvantage compared to those that do not, because unlicensed subcontractors often work for cash and do not pay taxes on that money, and therefore work more cheaply than licensed contractors. In other words, the unintended consequences of Act 105 may include more law-breaking and less tax-paying.

“We have actually been begging the state for years to come up with a way for them to get more revenue out of the construction industry, and that is by cracking down on unlicensed construction activity,” Thielen says. “… But for the state, it’s just much easier to put more burden on the guys who are already playing by the rules than go out and try to enforce the rules and collect revenue from those other people.”

Act 105 has shaken the construction industry at a time when contractors say that stability and growth are desperately needed. The state government is doing little to aid the ailing industry, says Mike Masutani, president and founder of Site Engineering Inc. “We know (the revenue) doesn’t come back to us in capital improvement projects. It’s being spent (elsewhere).”

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Apr 6, 2012 05:00 pm
 Posted by  WCLoeffler

This is an excellent article and everything written is very true. Now we have to band together to make sure it does not roll over....Our State is killing the hand that feeds the bird.

Apr 26, 2012 02:52 pm
 Posted by  Happicat

Great article! The State continues to make it difficult for all small businesses in Hawaii to thrive. We always say "lucky we live Hawaii" ... but that only goes for the weather!

Jul 18, 2012 11:44 pm
 Posted by  Virtual

Awesome article! When a construction project is bonded, payments are made to the bonding company rather than to the prime contractor for the project. The bonding company will pay the subcontractors, retain any amounts due to it, and pay the remainder to the prime contractor.
In this situation, the bonding company is only
considered a custodian of the funds, and will be taxed
on its share of the income only.

Jul 18, 2012 11:47 pm
 Posted by  Virtual

In this situation, the bonding company is only
considered a custodian of the funds, and will be taxed
on its share of the income only. The prime contractor,
however, must report as gross income the contract
amount, although it may claim any allowable
deductions such as the subcontract deduction.
Why should the contractor pay the 4% on the full contract amount when he only gets paid for the labor that he provides. example: 400,000.00 job and he gets only 150,000.00? WHERE'S THE JUSTICE IN THIS!!

Jul 18, 2012 11:52 pm
 Posted by  Virtual

AND YES, WHO IS ENFORCING THE PVL LAWS? A TEAM OF INSPECTORS WOULD ENSURE THE INCOME THAT THEY SEEK AND THE LICENSED TRADESMEN WOULD BE ABLE TO SECURE THE BIDS THAT ARE NOW GOING TO THE UNLICENSED ELEMENTS WHO ARE RIGHTFULLY NOT PAYING INTO THE THE POT! IT'S THE SAME OLD THING, THE GOVERNMENT CREATES THE LOOP HOLES FOR THE CHEATERS! LET THE CHEATING BEGIN, IT'S ALL FAIR GAME OUT THERE ACCORDING TO THE STATE OF HAWAII WHO FAILS TO RECOGNIZE THE NEEDS OF SMALL BUSINESS!

Aug 15, 2012 05:58 am
 Posted by  brettlee

Thank you for sharing this information this post is very useful.
Burlington Airport Transportation

Aug 15, 2012 05:59 am
 Posted by  brettlee

Your article is wonderfullthanx for sharing this. Vorsorgen

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