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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 of 8.25 percent for individual income and 6.9 percent for corporate income are among the highest in the United States (see chart, "N.C.'s Income Tax Rates — Highest in the Region"). Tax cuts in the 1990s did not fully make up for tax increases earlier in the decade. Since 2001 the General Assembly has increased the annual burden by a total of $1.4 billion.

Clearly more needs to be done to gain control of the spending that leads to higher taxes. State policymakers must also consider whether the current tax code is efficient, equitable, and understandable to the average taxpayer.

Former Gov. Jim Hunt’s Emerging Issues Forum in February 2006 addressed some of the issues of tax reform. The Forum’s working group made recommendations to reform individual taxes and the entire tax code, and many people associated with the forum advocated expanding the sales tax to cover services as well as goods.

Problems with the Tax Code

The current state tax code violates the basic principles of a fair and efficient tax system. It developed piecemeal with explicitly lower rates, deductions, and tax credits for favored behaviors such as job training, and higher rates for undesired behaviors such as smoking. The tax code, whether intentionally or not, penalizes saving and investment more than consumption.

In short, North Carolina is saddled with a system that is not simple, neutral or equitable. Those principles are the keys to reforming the state’s tax code.

1. Simplicity. The tax code is too complex for even professionals to understand. Individuals cannot plan for the future; they often suspect that they are paying more than they should. Resources devoted to avoidance, compliance and enforcement are a drag on the economy.

2. Neutrality The tax code favors home buyers over renters, pensioners over workers, large companies over small ones, new companies over existing ones, and borrowing over saving and investing. The tax code should neither benefit nor penalize any individual, group, industry or economic decision more than another.

3. Equity. The tax code’s progressive rates based on one’s “ability to pay” are nothing more than income redistribution or, to put it less charitably, larceny. Equity demands that users pay for services, such as highways, that are not constitutional entitlements. A flat-rate consumption tax and a flat-rate property tax would each be equitable, and each would be a way to approximate demand for public goods. Progressive income taxes and regressive housing impact fees are not. Corporate taxes are not equitable; corporations merely collect taxes from their workers, investors and customers.

A Plan for Reform

A flat tax on consumed income fits all three principles. A single rate applied to yearly spending and not yearly saving is understandable and makes future taxes more predictable for the taxpayer.

Excluding capital gains and interest income from taxation, or excluding income that is saved or invested would make the tax code neutral by ending the current pro-consumption bias. Some spending on education and health care should also be considered investments that produce future income and should be excluded from taxation, although direct cash payments to individuals would better promote these activities without distortions.

Establishing a consumed income tax eliminates the current bias favoring the purchase of personal and other services as substitutes for products in the current sales tax (see chart, "How Income Taxes Penalize Saving and Restrain Economic Growth").

Business purchases of equipment and other goods should be exempt from the sales tax to preserve the principle of equity. These purchases eventually are incorporated in the goods and services purchased by consumers, and any tax paid on these purchases also becomes incorporated in that price.

Finally, because corporations are only intermediaries in the tax system, the state should end the corporate income tax.

Recommendations

1. State policymakers should remove tax provisions 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 to eliminate bias.
2. N.C. should reform its income tax system to create a single-rate, easy-to-understand tax on consumed income that ends multiple layers of taxation on savings and investment. This would either make corporate dividends entirely tax-deductible or abolish corporate income taxes. It could also offer tax exclusions for household investment in education, health and other private human-capital formation.

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