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N.C. should replace current income tax with flat-rate consumed income tax

JLF expert says existing system penalizes activities that boost economy

Contact: Dr. Roy Cordato
919-828-3876
rcordato@johnlocke.org

April 03, 2012

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Click here to view and here to listen to Dr. Roy Cordato discussing this Spotlight report.

RALEIGH -- North Carolina would boost economic growth and wealth creation by replacing its existing income tax with a new "flat-rate consumed income tax." That's the prescription the John Locke Foundation's top economist offers in a new Spotlight report.

"The state's current income tax penalizes work, saving, investment, and entrepreneurship," said report author Dr. Roy Cordato, JLF Vice President for Research and Resident Scholar. "Those are the very income-generating activities that lead to the production of goods and services that spur economic growth. If you're interested in growth, a flat-rate consumed income tax is a much better option."

As its name implies, a flat-rate tax would apply just one tax rate, regardless of the amount of income taxed, Cordato said. "Unlike our existing system, a flat-rate tax offers no disincentive for people to work overtime, take a second job, or make other decisions that generate additional income. The next dollar of income is taxed at the same rate as the previous dollar."

Focusing taxation on consumed income would remove the existing bias against saving and investment, said Cordato, a Ph.D. economist.

"The current state income tax distorts people's choices about whether to spend or save the money they make," he said. "Once the state has taxed a dollar of income, you can spend the remaining money without any additional tax penalty. Save the rest of that dollar, though, and you will face a form of double taxation when the state taxes any interest, dividends, or capital gains that result from the savings. This discourages saving, investment, entrepreneurship, and business expansion in favor of consumption."

Cordato offers more evidence of the problems linked to the current income tax. "Any income tax distorts a taxpayer's choice between work and leisure," he explained. "The higher the tax, the greater the so-called 'wedge' between the rewards related to work effort and the rewards for nonwork activity. Think about how much work people would be likely to do if they faced a tax rate of 100 percent: None."

North Carolina's income tax system magnifies the tax penalty in two different ways, Cordato said. "First, this state's income tax rates are high relative to the national average and particularly high relative to other Southeastern states. Our top marginal rate of 7.75 percent is the highest in the region. Even our bottom rate of 6 percent is equal to or higher than the top rate in all other Southeastern states, except South Carolina."

North Carolina's "steeply progressive" rate structure creates the second problem, Cordato said. "A progressive rate structure means that North Carolina takes a higher percentage of people's incomes as they earn more," he said. "People earn more as they make themselves more productive. So North Carolina's tax system punishes them for making productivity-enhancing changes in their lives."

The existing tax structure creates major disincentives for saving and investment, Cordato said. "Apply North Carolina's top marginal rate, and you find that it reduces rewards to current consumption by 7.75 percent," he said. "It reduces investment returns by about 15 percent. In other words, North Carolina has an implicit top marginal rate on saving and investment of almost double the statutory rate."

Lawmakers should strive to keep income tax rates as low as possible, Cordato said. They also should avoid progressive taxation.

"If some form of progressive taxation is politically necessary, the best option is a large 'zero tax bracket,'" he said. "In other words, set one flat income tax rate, and apply it to all income above a certain threshold."

"For example, the state could charge no income tax for a family of four making up to $20,000," Cordato explained. "Set the flat rate above that threshold at 5 percent, then a family making $30,000 would end up paying an average tax rate of 1.6 percent. A family making $100,000 would pay an average tax rate of 4 percent. While the effective tax rate would rise with income, the rate on the next dollar earned would remain constant."

Exempt all saved income from the tax base, and the system would create much less bias against the activity that leads to economic growth, Cordato said.

"Any tax damages productivity and economic growth, but a flat-rate consumed income tax would reduce existing biases against productive activities," he said. "This idea should go hand in hand with other tax reforms, such as overhauling the state sales tax and abolishing the corporate income tax. Taken together, these changes would boost productivity and employment in North Carolina."

Dr. Roy Cordato's Spotlight report, "The Consumed Income Tax: Efficient and Fair Tax Reform for North Carolina," is available at the JLF website. For more information, please contact Cordato at (919) 828-3876 or rcordato@johnlocke.org. To arrange an interview, contact Mitch Kokai at (919) 306-8736 or mkokai@johnlocke.org.

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