Hawaii’s Tax Pyramid plan crippling small businesses

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

April, 2012

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

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).”

Other industries hurt

The suspension of Hawaii’s sublease GET deduction is expected to bring in the second-most revenue from Act 105, according to the Tax Department, at $105 million, over the next two years. It increases the amount of tax paid by sublessors and is often passed on to sublessees, many of whom are small business owners. To recover costs, small business owners try to pass the cost on to consumers, but that is not easily done, says Steven Sofos, president and principal broker at Sofos Realty, because it affects businesses’ ability to compete.

Sofos adds that sublessors and sublessees dealing with space in a building on leasehold land – land that is leased by owners such as Kamehameha Schools or Queen Emma Land Co. – are affected the most because of the added layer of cost from the leased land.

Some other GET exemptions that were suspended affected Hawaii ocean and air transport services, but companies have chosen to absorb the costs instead of passing them on to consumers.

Keoni Wagner, Hawaiian Airlines’ VP of public relations, says, “Hawaiian is paying millions more in tax now – millions that out-of-state competitors don’t have to pay – as a consequence of Act 105.”

The air transport-related exemptions existed to level the playing field so locally based airlines could compete with those based elsewhere, as well as to promote more infrastructure investment by local airlines. With the suspension of Act 105’s suspension of the those exemptions, some of Hawaiian’s competitors have an advantage.

Hawaiian’s fares have not been increased as a direct result of the act, but Wagner acknowledges, “Anything that adds to operating costs increases pressure on fares and fees.”

To address the added GET expense, Matson, Hawaii’s largest shipping company, announced to customers last June that a $52 fee would be added to every container; however, the fee was retracted before it could take effect. Jeff Hull, head of Matson public relations, says the company decided to absorb the cost instead of passing it on to consumers.

Act 105’s future

Proponents say Act 105 is necessary so the state can balance its budget, and they stress that the suspension of the GET exemptions is temporary. However, Sen. Sam Slom, the only Republican in the state Senate, who voted against the final version of the bill that became Act 105, says, “They say temporary, it’ll sunset in two years, but what will likely happen is it will be extended, or the sunset provision will be taken out.”

Sen. Ige says that won’t happen without a full discussion. “We’d have to pass legislation again, so there will be lots of debate,” he says. “Everybody would know about it and we’d also have answers regarding impacts and revenue by then.”

Hawaiian Air’s Wagner says his company thinks the exemptions will return. “With tourism and the economy now rebounding strongly, thanks in part to Hawaiian’s growth plan, we expect the legislation to sunset next year as it was designed to.”

The construction industry also hopes the tax increase will die as scheduled on June 30, 2013, but many in the industry fear it will be extended.

“We have to be optimistic in this industry, but I don’t think the state’s financial situation is going to improve any next year, so my personal opinion is that there will be another act that will continue this,” says Michael Brant, Gentry Homes’ VP of engineering and past president of the Building Industry Association of Hawaii. “The state typically looks at ‘How can we increase revenues,’ but the better alternative is to look at reducing costs. We just don’t feel that there was much of an effort put into that.”

How Pyramiding Raises Costs

GET exemptions were created in the past to prevent some, but not all, of the excise tax pyramiding on goods and services in Hawaii. Here’s an example:

A company building a custom home would subcontract the foundation work to a subcontractor that is an expert in that area. That company would sub-subcontract the excavation and steel-reinforcing parts of that job to two other experts. Similar subcontracts might go to plumbers and electricians.

In the past, the contractor, subcontractors and sub-subcontractors would pay the full 4 percent state general excise tax only on work they performed themselves. Now, each layer must pay the full GET on the entire value of their contracts. This means part of a job that might have cost, say $76,000, including the tax, might now cost $84,000 with three layers of tax worked in.

It means more revenue for the state, but someone has to foot the bill – either the contractors, subcontractors or homebuyer, or the higher costs kill the project altogether.

 

Honolulu shows Highest Cost increase

This chart shows the hypothetical cost of similar construction bids in 11 U.S. cities and how those costs have changed since last year. The chart was created by Rider Levett Bucknall, a global property and construction consulting company. It indicates that Honolulu had the biggest construction-cost increase from January 2011 to January 2012 – an increase more than double that of any other city. RLB says this index tracks the true bid cost of construction, including labor and materials, general contractor and subcontractor overhead costs, fees (profit) and the standard taxes for construction contracts in that city.

 

Honolulu construction: poised for an upturn?

This chart estimates the current position of each city is its construction-business cycle, according to Rider Levett Bucknall, a global property and construction consulting company. RLB says current indicators show that the cities on the left appear poised for an upturn in construction activity; the closer the city is to the rising line, the closer it seems to be to a significant upturn. Honolulu is furthest from the rising line, indicating it may be the last of these cities to rebound. Cities on the right side of the chart are at the end of a construction cycle and there is no evidence yet of a pending rebound in construction activity there. For example, indicators show that Las Vegas is the major city that is furthest away from a construction upturn.

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