Bold and politically risky, Gov. Neil Abercrombie’s proposal to tax pension income for retirees would bring equity to tax policy and help reduce the state’s budget deficit.

A state tax on pension income — with an exemption for low- to middle-income retirees — could generate $114 million a year, among the largest single sources of potential revenue the governor has identified to close a projected two-year deficit in excess of $700 million.

The past two reports by the Tax Review Commission have recommended that Hawaii follow the federal government and most other states and tax pension income, arguing that a tax policy that distinguishes between traditional pensions, which are tax-free, and individual retirement accounts and other defined-contribution plans, which are taxable, is inherently unfair.

Abercrombie, 72, has described it as a shared sacrifice — "I’m not going to ask anybody to do anything that I’m not willing to do myself," he said in his State of the State address — but retirees are preparing to rebel.

Many seniors spent years planning for their retirement and see their pensions as a contract.

"I think there is really deep concern, right across the board. I haven’t gotten one call from anyone that is in favor of it," said Barbara Kim Stanton, state director of AARP Hawaii. "And it’s not that they’re just saying, ‘I don’t think this is a good idea.’ They are saying, ‘I think this is a terrible idea.’

"I mean, they’re adamant. It’s a very, very strong opinion."

Seniors on fixed incomes, she said, may find it difficult to absorb a pension tax along with what many predict will be increased costs for health care and long-term care in the coming years.

"This one is a real hot potato, because we haven’t provided the kind of services that the seniors, the elderly, will need as they get older," Stanton said.

Abercrombie said he does not want retirees who are most dependent on their pensions to be taxed. One proposal under consideration would exempt retirees with federal adjusted gross incomes of $37,500 or less for single returns or married people filing separately, $56,250 for heads of households or surviving spouses, and $75,000 for joint returns. An alternative would be to base the tax solely on pension income, exempting retirees with smaller pensions.

Kalbert Young, the governor’s interim budget director, said there is an issue of equity. The federal government taxes traditional pensions. The state taxes the distribution from individual retirement accounts.

"So there is really no concept that pensions are free from taxation," he said.

Traditional pensions are defined-benefit plans paid by employers when workers retire. Individual retirement accounts and 401(k) accounts are defined-contribution plans where workers — and employers — can invest to help build retirement savings.

The Tax Review Commission, in 2003 and 2007, found that the tax treatment for different types of retirement income was not even handed and should be the same.

The commission, however, recognized that some people have made employment decisions based on the expectation that their traditional pensions would be tax-free by the state upon retirement. Others may have chosen to retire in Hawaii because of the state’s tax policy.

The commission also predicted that the financial effect of the state not taxing traditional pensions would decline over time as more people move to individual retirement accounts and 401(k) accounts.

Hawaii, according to the National Conference of State Legislatures, is one of 10 states that exempt pension income from taxation.

"Tax situations do change. And with the economy the way it is, it is an area that has been looked at many times," said state Rep. Isaac Choy (D, Manoa), an accountant who was the chairman of the Tax Review Commission that made the recommendation for 2007.

Choy said many employers have moved away from traditional pension plans because they are too costly, and now offer 401(k) and other defined-contribution options. Many of the people with traditional pensions in Hawaii are local, state and federal government retirees and military veterans.

"Hopefully, we have a good phase-in period and we lessen the impact," he said. "We don’t want to have a shock wave."

Rep. Karl Rhoads (D, Chinatown-Downtown), chairman of the House Labor and Public Employment Committee, called Abercrombie’s proposal "wildly unpopular politically" but not unusual given the approach by the federal government and most other states.

"With an (income) threshold, it seems like a pretty fair idea to me," he said.

Sen. Clayton Hee (D, Kahuku-Kaneohe), chairman of the Senate Judiciary and Labor Committee, said that from his early read, the idea has not been well-received in the Senate.

Hee recalled that a proposal to tax pensions came up during the 1980s when he and Abercrombie served together in the Senate. He said the governor needs to be clearer about the income threshold as well as prepared to defend claims that a pension tax will deter people from retiring in Hawaii.

"Instinctively, unless there is more meat on the bone, I don’t think it’s going to be well-received," Hee said.

Sen. David Ige (D, Aiea-Pearl City), chairman of the Senate Ways and Means Committee, said the proposal to tax pensions will definitely engage the public.

"There are lots of retirees on fixed incomes, which any kind of tax would create an issue for," he said. "It will really be just trying to look at how they plan to do it and see whether it’s fair and who would be impacted by the tax."