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Budget and Taxation
The State Tax Burden

Taxes represent the price we pay for government, so a reasonable tax burden is of benefit to the citizens who consume the services they fund. Unfortunately, the price of government in North Carolina has grown dramatically over the past two decades, and is no longer reasonable. More recently, while state lawmakers reduced taxes in the mid-1990s, they raised them even more earlier in the decade and then again in 2001 and 2002, resulting in an overall growth in the tax burden of more than $1 billion.

A Growing Tax Burden

North Carolina’s marginal tax rates on individual and corporate income are the highest in the Southeast (see table) and among the highest in the United States. This represents a strong disincentive for individuals to work, save, and invest in our state. Even after adjusting for exemptions and deductions, North Carolina's effective tax rate — tax collections divided by personal income — is 7.3%, ranking 21st in the nation. North Carolina also tops the Southeast in effective tax rates on individual and corporate income and has a high gas tax.

However, because North Carolina relies more heavily on state funding for such core services as schools and roads than its peers do, its high ranking on state taxes is somewhat offset by low ranking on local taxes. Still, the combined state and local tax burden in North Carolina of 10.1 percent of income is second only to Georgia (10.2 percent) in the Southeast, and is half a percentage point higher than in 1992. Overall, North Carolinians pay an average of 31 percent of their income in federal, state, and local taxes, ranking the state 35th in the nation.

Research has demonstrated clearly that taxes have a significant economic impact by discouraging out-of-state businesses from relocating and by limiting new business starts. High marginal rates on income, in particular, have been shown to reduce economic output, so North Carolina’s relatively heavy reliance on high income tax rates is troubling. A 1997 study for the Locke Foundation by N.C. State economist Michael Walden found that state income taxes had a large negative impact on job growth and personal incomes in North Carolina.

Recent State Actions

Before the 1994 elections, the General Assembly had enacted or approved five major tax increases since 1983, including hikes in sales taxes, income taxes, motor fuels taxes, and excise taxes. The last two, implemented in 1990 and 1992, had a combined fiscal impact more than $1.8 billion in 2001. Subsequent cuts beginning in 1995 saved taxpayers $1.4 billion in the same year meaning that, over the decade, the state tax burden actually rose by about $427 million. Furthermore, while tax increases in the early 1990s hiked marginal tax rates, recent tax cuts have focused primarily on exemptions, deductions, and credits, leaving our high marginal tax rates intact.

The situation worsened considerably in 2001 when the General Assembly raised various income, sales, and business taxes by the annual equivalent of $609 million. Thus, from 1990 to 2002, North Carolinians experienced a net state tax increase of more than $1 billion. At this writing, it is likely that legislative budget decisions in the summer of 2002 will impose another $770 million in new state taxes by FY 2003-04, raising the state’s tax burden significantly above the national average (see table).

Recommendation

North Carolina policymakers should make it a goal at least to reduce taxes enough to bring the state tax burden in line with where it was at the start of the 1990s. Of particular concern should be the state’s high individual income tax rates. Over time, reducing the current 6%, 7%, 7.75%, and 8.25% rates to a flat rate of 5.75% would dramatically improve the state’s economic competitiveness and save taxpayers well over $1 billion a year.

To view higher quality graphs, download Agenda 2002 [560KB Acrobat].