When the Territorial Legislature created the general excise tax in 1935, lawmakers recognized that the broad-based tax should not be applied on every business transaction.

One of the first exemptions, according to territorial records and researchers at the state Department of Taxation, was for contractors. Contractors would be able to deduct the amount they paid to subcontractors when calculating their tax liability on construction projects.

The subcontractors’ deduction has survived in Hawaii’s tax code for more than 75 years, one of a host of exemptions that smooth out the pyramid effect of the general excise tax or function as an incentive for economic growth.

State lawmakers, up against a projected $1.3 billion budget deficit over two years, want to temporarily suspend nearly two dozen tax exemptions — including the subcontractors’ deduction — to generate about $200 million a year in revenue.

They say lifting the GET exemptions is the largest potential source of new revenue to balance the budget as House and Senate negotiators move into conference committee over the next two weeks.

Many lawmakers believe suspending tax exemptions is a matter of equity — a few years of pain inflicted on special interests that enjoy tax breaks others do not. Some lawmakers also contend that the exemptions were never meant to be permanent and should be periodically reviewed to determine whether they still make sense as tax policy.

“I think exemptions and credits, by policy, should always come up for review,” said state Rep. Pono Chong (D, Maunawili, Kaneohe), adding that state spending levels on education and social service programs routinely get evaluated.

A look at the history of several of the tax exemptions targeted shows that many were granted to offset the negative impact of the general excise tax on business-to-business transactions or to attract economic activity.

The 4 percent general excise tax — 4.5 percent on Oahu because of a mass transit surcharge for the Honolulu rail project — is applied on most business transactions and is the largest source of state revenue.

While the GET is imposed on businesses — not consumers — tax experts consider it a consumption tax that is passed on to consumers mostly through the costs of goods and services.

Recognizing the pyramid effect of the tax, lawmakers have set a lower 0.5 percent rate on wholesale transactions where businesses buy products from other businesses to sell as retail.

But lawmakers have also awarded tax exemptions — like the subcontractors’ deduction — to minimize the pyramid effect.

According to the most recent estimates by the Department of Taxation, suspending the subcontractors’ deduction and imposing a 4 percent tax could generate the largest amount of new revenue — $66.6 million in fiscal year 2012 and $68.6 million in fiscal year 2013.

The revenue estimates are considerably lower than previous predictions because tax analysts suspect that lifting the exemption could change behavior among contractors.

Bob Dewitz, owner of American Electric Co., an electrical contractor, predicts general contractors will not subcontract out as much work on projects if they have to pay higher taxes.

Higher taxes, Dewitz said, would also likely increase the cost of new construction and renovation projects, potentially depressing construction at a time when the industry is trying to recover from the recession.

“I think it would have an immediate dampening effect on the construction industry in a significant way at a time when we’re just starting to recover,” he said.

Dewitz, like many others, also doubts a suspension will be temporary.

“There’s no such thing as a temporary tax,” he said.

Suspending a sublease deduction could bring in the second highest amount of new revenue — $51.6 million in fiscal year 2012 and $53.2 million in fiscal year 2013.

Lawmakers granted the exemption in 1997 to correct what they described as a pervasive structural problem caused by the pyramid effect of the general excise tax. They thought it was unfair for businesses that lease property and then sublease to one or more other tenants to have to pay the full tax at each transaction.

Outrigger Enterprises Group has sought to preserve the exemption.

“We believe that this will hurt the small-business owners, because the small-business owners are the one who are your typical sub-lessee,” Max Sword, an Outrigger lobbyist, told the House Finance Committee in testimony. “Take a walk around Waikiki. That is very evident.”

The state could generate $34.2 million in fiscal year 2012 and $35.2 million in fiscal year 2013 from lifting an exemption on the sale of liquor, tobacco and other products by local vendors to the federal government, mostly military bases. Territorial records and tax researchers suggest the exemption was first offered as a temporary one-year tax break in 1951.

Lifting an exemption for leasing aircraft for interstate transport could bring in $19.4 million in fiscal year 2012 and $20 million in fiscal year 2013.

Lawmakers provided the exemption in 2001 to help Hawaiian Airlines and Aloha Airlines remain competitive. The local airlines had sought tax breaks after the Department of Taxation determined that about $20 million in back general excise taxes was owed on leased aircraft from the mainland.

Lawmakers also awarded an exemption in 1997 to help persuade Continental Airlines to build a $24 million maintenance facility at Ho­no­lulu Airport.

A year later, lawmakers expanded the exemption to cover the local airlines.

Both Continental and Hawaiian still operate maintenance facilities. Suspending the exemption could generate $8 million in fiscal year 2012 and $8.2 million in fiscal year 2013.

Keoni Wagner, vice president of public affairs at Hawaiian Airlines, said that losing the exemptions could cause the airline to scale back expansion plans, lay off workers, or increase fares.

He said Hawaiian expected that the tax exemptions would be permanent.

“I think that there was that expectation, because these exemptions level the playing field for local carriers,” Wagner said.