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Budget and Taxation
State Tax Reform

North Carolina has a high state tax burden by regional standards, and its top marginal tax rates on individual (8.25 percent) and corporate (6.9 percent) income are among the highest in the U.S. Since 1990, the state legislature has imposed a net tax increase of more than $1 billion, with additional tax hikes likely in coming years. Clearly, more effort is needed to alleviate the tax burden on North Carolina families and businesses. But the issue before state policymakers is not only the total size of the tax burden but also whether the tax code is efficient, equitable, and comprehensible to average taxpayers.

Principles of Tax Reform

The state should levy taxes in order to fund government programs, not to manipulate personal and family behavior or try to “steer” the state’s economy in directions that politicians might like. There are three main principles that should guide the creation of a fair and efficient tax code:

• Simplicity — Can taxpayers understand the tax code and reliably predict their tax liability over time?
• Neutrality — Does the code create biases in favor of particular taxpayers, regions, or economic decisions?
• Equity — Do taxpayers pay for government roughly in proportion to the benefits they receive?

Tax codes that violate the simplicity principle waste time and resources trying to enforce complex rules that most taxpayers cannot understand without professional assistance (and sometimes even with such help). Tax codes that violate the neutrality principle attempt to use taxes to benefit special interests, thus interfering with the efficient operation of a free-market economy. If subsidies for particular forms of behavior or classes of businesses are justified, they should be appropriated in the normal budget process for all to see.

The equity principle is most frequently misunderstood. Some argue that equity means imposing taxes based on one’s “ability to pay.” That is nothing more than income redistribution or, less charitably, larceny. Rather, taxes should as much as possible relate to the benefits one receives from government programs. For enterprises such as highways that the state operates but for which individuals do not have a constitutional entitlement, equity demands that users pay for the system through such means as gasoline taxes and tolls.

For entitlements such as public safety or education, equity demands that citizens pay according to how much they benefit from a safe or well-educated society. At the state level, a good way to measure that benefit is annual consumption. A person consuming twice as much of his income as another, and thus presumably deriving twice as much benefit from living in the state, ought to be pay about twice as much in taxes. Similarly, the value of local services such as police and fire protection rises in proportion to the ownership of physical assets, so a property tax that compels one with twice as much property value to pay twice as much tax fulfills the equity principle. Of course, the tax code violates this principle when it imposes either “progressive” taxes — more than one marginal income tax rate, for example — or “regressive” taxes, such as per-home impact fees or stormwater charges that do not correlate with property value or the use of local services.

Problems with North Carolina’s Code

Like most states, North Carolina has developed its state tax code in a piecemeal fashion rather than using tax reform principles to build a coherent and efficient system. As a result, a variety of special rates, exemptions, exclusions, deductions, and credits litter the code. In the corporate tax code alone, special tax credits for job creation, research and development, machinery, worker training, and other expenditures will total $75 million in 2002, or about one-fifth of all corporate income taxes the state will collect. Another problem is the income tax code’s bias against savings and investment. A dollar of income that is immediately consumed is taxed only once. But income that is invested is taxed multiple times, particularly if used to purchase corporate equities; the dollar is reduced before it is invested, then the return is reduced by both corporate and individual income taxes. Neutrality demands that only current consumption, not future consumption (i.e., investment), be taxed.

Although many of the problems in the income tax code stem from the federal system, state leaders still have options for reform. The goal should be to broaden the tax base while reducing the number and amount of tax rates. For income taxes, North Carolina should move toward a flat consumed-income tax in which 1) one low rate is applied, 2) it is applied only once to the same dollars, and 3) the base is limited to consumption by subtracting savings from income. A sound income tax code, in other words, would not tax capital gains or corporate dividends. Such a system would also exempt as much as possible investment not just in financial capital but in “human capital” such as family expenditures for education, health care, and child rearing that, like other investment, yield future taxable income. Tax-free savings accounts for these expenses would suffice.

Recommendations

1. State policymakers should remove special exemptions, deductions, credits, and rates from the state tax code that are inconsistent with principles of simplicity, neutrality, and equity. In every case, the goal should be to lower tax rates while offsetting at least some of the revenue loss by broadening the tax base.
2. North Carolina should reform its income tax system over time to create a single-rate, easy-to-understand tax on consumed income that ends multiple layers of taxation on savings and investment, including human capital. This must include either making corporate dividends tax-deductible or abolishing corporate income taxes.

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