Nearly 60 percent of Hawaii taxpayers could lose the deduction for state income taxes under Gov. Neil Abercrombie’s proposal to streamline the tax code and help balance the budget.

The governor wants to immediately eliminate the tax deduction for higher-income taxpayers and phase it out over two years for lower- to middle-income taxpayers.

The shift in tax policy would generate $64 million next fiscal year, $79 million in fiscal year 2013 and $94 million annually thereafter, the administration estimates.

While the governor’s proposals to tax pension income, raise taxes on alcohol and soda, and end Medicare reimbursements for retired public workers have drawn the sharpest reaction, eliminating the state tax deduction could have the broadest application.

The Abercrombie administration estimates that 58 percent — about 311,470 taxpayers — itemize on their state tax returns.

Abercrombie, in his State of the State address, called the deduction "an absurdity in the tax code, the elimination of which is long overdue."

Single and married taxpayers who file separately and earn less than $75,000 in federal adjusted gross income a year, heads of households and surviving spouses who make less than $112,500 a year, and couples who earn less than $150,000 a year would lose 50 percent of the deduction next fiscal year and 75 percent in 2013. All other taxpayers who itemize would lose the entire deduction.

A family of four with income of $40,000 a year, according to the administration, would pay $159 more per year in state taxes once the deduction is phased out. A family of four with income of $200,000 a year would pay an additional $1,419.

The current tax code is "a nonsensical policy because basically you’re taking a deduction from the same source that is taxing the income," said Dean Hirata, deputy director of the state Department of Budget and Finance. "This policy is irrational and basically poor tax policy. So this is one of the structural deficiencies that we’re trying to address with this measure."

Abercrombie has presented state lawmakers with a package of tax revisions and state program cuts to contain a projected two-year budget deficit of $700 million. Many of his ideas have been met with public resistance, but lawmakers will have to decide whether to accept the governor’s suggestions or come up with their own proposals to balance the budget.

The Internal Revenue Service gives taxpayers who itemize the option of claiming state and local income taxes, or state and local sales taxes, on federal tax returns. Hawaii is one of nine states that allow deductions for state income taxes on state tax returns, according to a recent analysis by the Wisconsin Legislative Fiscal Bureau, but three of those states give taxpayers the choice of deducting either income or sales taxes. Nine other states allow for the deduction of state sales taxes only.

Lowell Kalapa, president of the Tax Foundation of Hawaii, said the state tax deduction is basically an acknowledgment of the state income taxes withheld during the year on workers’ paychecks.

"The logic behind the deduction is to recognize that you have not had use of that money, because it went to the state," he said. "It recognizes that the state used your money in the 12 months prior."

Marilyn Niwao, a certified public accountant and attorney in Wailuku, said she understands Abercrombie is in a difficult position with the budget and is asking people to sacrifice. But she said tax deductions help many working families offset their tax burdens.

"I see the working people having trouble right now with paying their bills, paying their mortgages and everything," she said. "So everybody is really hit in this economy. And, yes, it would be nice if everybody can pay their share, but I wish that there are ways to lower the cost of government rather than putting more burden on the working people."

House Minority Leader Gene Ward (R, Kalama Valley, Hawaii Kai) said that while it is good that Abercrombie would phase out the deduction for the middle class, rather than eliminate it all at once, he believes it will take money out of the economy. He said middle-class taxpayers would feel the loss, while higher-income taxpayers may be less likely to invest and create jobs.

"I’m not sure it’s going to help other than to get a little money to balance the budget," Ward said. "But in terms of the economy and the economic thrust of it, I think it’s going to be a negative and counterproductive."

State House and Senate lawmakers who will be drafting their versions of the budget said they will consider ending the deduction. While some of Abercrombie’s proposals have been unpopular and might be rejected, lawmakers believe they do have the options available to close the deficit.

Abercrombie and lawmakers have been resisting a broad-based tax increase, such as raising the general excise tax, because many worry about harming the state’s economic recovery. A People’s Pulse survey taken by OmniTrak Group Inc. for the Hawaii Business Roundtable and the Pacific Resource Partnership found that 68 percent of respondents opposed raising the excise. It was the second least popular option to reduce the deficit, behind raising income taxes, which 78 percent opposed. The survey was based on telephone interviews with 700 people statewide in January.

Sen. David Ige (D, Aiea, Pearl City), chairman of the Senate Ways and Means Committee, said lawmakers have to juggle three related components: revenue generation, such as tax revisions; budget cutting, such as the governor’s move to reduce welfare and Medicaid spending; and labor savings, which are entirely up to the governor and public-sector labor unions in collective bargaining.

Abercrombie has said he wants 5 percent labor savings in contract talks with unions.

"You’re trying to move forward while juggling these three big pieces," Ige said. "And we have no say on labor savings. We can have a conversation or whatever, but we don’t have a say on what that looks like at the end of the day. The only two things that we can deal with are the cuts and the revenue side."

Rep. Marcus Oshiro (D, Wahiawa), chairman of the House Finance Committee, said the House would likely look at some of Abercrombie’s ideas along with eliminating general excise tax exemptions, reducing or ending tax credits, and placing a cap on itemized deductions.

"I think, as far as the House goes, given what we’ve looked at, explored and considered the last several years, I feel we’re in pretty good shape," he said.