North Carolina needs to reform its approach to taxing capital gains. As I have noted in a previous analysis for the John Locke Foundation, the current system ignores the fundamental nature of capital gains taxes, namely that they are a form of double taxation on savings, which favors consumption spending and therefore penalize economic growth and discourage investment and entrepreneurship.

Capital gains, as a return on saving, investment, or entrepreneurship, are realized in several different ways, all of which relate to the purchase and sale of assets. Those assets can take a variety of forms, including stocks or bonds; a home, family farm, or other property; and most importantly for entrepreneurs, businesses that were purchased or built from scratch. Indeed, for a business, particularly a small business, one of the most important ways that returns on investment are realized is through increasing its market value, which, in turn, is realized as a capital gain when the business is sold.

In North Carolina, capital gains are taxed the same as regular, wage income – at a flat rate of 5.25 percent. Under such a system, returns from capital investments are taxed twice. First, they are taxed when the funds used for the investment are initially earned. This is an application of the simple accounting principle, which recognizes that when the principal amount used for investment is taxed the future income stream, i.e., the returns to that investment, is reduced by a similar percentage. The gains are reduced a second time when they are added into ordinary income and taxed again.

This can be demonstrated with a simple example. If someone earns $100 that he expects to invest in a stock that returns 5 percent (or $5.00), but the $100 is taxed by 10 percent first, it not only leaves the investor with only $90 to invest but reduces the returns to that investment by 10 percent, from $5.00 to $4.50. A capital gains tax applied to the $4.50 reduces this return a second time, i.e., the investment returns are double taxed. This discourages capital investments of all kinds, including and maybe especially small business and startup investments. Many of these investments are made not only to improve the current profitability of the business but to increase its longer-term capital value, a gain that would not be realized until the business is sold.

The second problem with taxing capital gains is that typically the gains are not adjusted for inflation before being taxed. If someone buys a plot of land as an investment at a price of $20,000 and sells it five years later for $25,000, the capital gains would be $5,000. But if that gain is eroded by 10 percent inflation over that period, the real, inflation-adjusted, gain is only $4,500. Over time, all capital gains are eroded by inflation, but this is not adjusted for in the tax code. Under the current system at both the stated and federal level, the investor is still taxed on the full $5,000. Adjusting capital gains for inflation is not only an issue of economics but of basic tax fairness.

Clearly, the ideal remedy would be to not tax capital gains at all. But, short of that, there are modest reforms that can be made that would ameliorate these problems.

In the federal tax code, the problems mentioned above have always been dealt with by applying a lower rate to capital gains than to ordinary income. For example, under current law, while the top rate for ordinary income is 37 percent, it is only 20 percent for capital gains. On the other hand, capital gains in the federal code are not adjusted for inflation.

North Carolina can begin to move toward the same approach taken by federal law without incurring significant costs to the state treasury. My suggestion would be to cap the tax on capital gains at the current 5.25 percent. This is the rate that applies to all taxable income in the state. In addition, all gains should be adjusted for inflation so that people are only taxed on the real returns from their investments.

What this means is that a differential between ordinary income and capital gains, similar to the approach taken by the Federal Reserve, would open up in the future if the legislature decides either to raise the current flat rate on ordinary income or to institute a progressive rate structure that takes the top rate above 5.25 percent. As the top rate increases, a differential between the top rate and the capped capital gains rate would widen. While this would not begin to eliminate the double taxation of capital gains and the penalty against income from capital gains investments relative to wage income, it will insulate capital gains against future rate hikes. If there are future tax increases, the bias against income from capital investments, relative to other forms of income and consumption spending, will be reduced.

It should also be noted that this would be a rate cap, not a rate freeze. If there are further reductions in the income tax rate below the current 5.25 percent, the rate on capital gains should fall along with those reductions. Also, adjusting capital gains for inflation will further ameliorate the overall bias against capital investments by ensuring that only real returns, and not returns strictly due to inflation or so-called phantom returns, are taxed.

In addition to reducing the existing tax bias against investment and entrepreneurship, another advantage to this approach is that it makes for a more secure investment environment. Entrepreneurs and other investors will be secure in knowing that the tax rate applied to the returns on their investments will not be subject to increases in the future. At the margin, a higher than expected tax rate or inflation rate can make the difference between a positive and a negative real return and therefore a profit or a loss.

Over the last half dozen years, North Carolina has implemented significant and economically sound tax reform. These changes have moved the state from 44th in the Tax Foundation’s business tax climate index to 12th. But while important changes have been made, there are still areas that need improvement. The tax treatment of capital gains could be the most important of those areas. The suggestions made here, while not ideal, are realistic. The enactment of such a change would be a relatively low-cost way to move the move the ball forward on this issue and help create a more favorable investment environment for North Carolina taxpayers.