For many years, it was recognized that North Carolina’s tax system was in need of a major overhaul. The system was a model of hodgepodge tax policy with high marginal rates on personal and corporate incomes and numerous exemptions carved out for the favored few. This led to tax system that penalized investment, entrepreneurship, economic growth, and therefore job creation.
The tax reform process began with the passage of sweeping tax legislation in 2013. In addition to implementing pro-growth reforms in the personal and corporate income tax, the legislation also incorporated across the board tax cuts that benefit most households in all income groups. The deliberative process that lead to these changes was thoughtful and, in large part, ignored the kind of special interest pleadings that typically plague such reform efforts. But there is more to be done.
- In 2013, the state of North Carolina implemented fundamental tax reform which has become a model for states across the country.
- From the perspective of economic growth, the two most important reforms were those made to the personal and corporate income taxes.
- The new tax code replaced a three rate progressive income tax that ranged from 6.0 to 7.75 percent, the highest in the region, with a flat-rate tax of 5.75 percent. This rate is scheduled to be lowered even further to 5.49 percent in January 2017.
- The low flat rate has ameliorated the bias against work effort and productivity that plagued the previous progressive rate structure.
- The corporate tax rate has been reduced from 6.9 percent, also the highest in the Southeast, to 4.0 percent and could be reduced even further to 3.0 percent.
- To increase government transparency and spur economic growth, the corporate tax should be completely abolished.
- The sales tax rate did not change, but the base has been expanded to some services.
- The average North Carolina household in every income category received a tax cut from the 2013 reforms.
- North Carolina continues to double tax saving and investment by taxing investments and capital gains.
- Full repeal of the capital gains tax would save taxpayers $500 million but would require comparable budget cuts. A 25 or 50 percent exclusion would save taxpayers $125 million and $250 million, respectively.
- By following federal depreciation schedules for the deduction of capital equipment and real estate, North Carolina’s tax code also penalizes investment in longer-term capital equipment.
- Future reform efforts need to focus on eliminating savings from the tax base, which will eliminate biases against saving, investment, and entrepreneurship that remains in the tax code. A good first step in this direction would be to eliminate taxation on capital gains or, at least, create a capital gains exclusion.
- The reduction in revenue from eliminating the capital gains tax should be paid for by eliminating economic development programs that subsidize particular enterprises and types of businesses. (See section titled “Economic Growth”.)
- Businesses should be allowed to deduct all business purchases in the year they are incurred. This would mean replacing the current system based on depreciation over time with immediate expensing.
- In the long run lawmakers should seek to completely eliminate the double taxation of saving and investment returns by converting the current system into a “consumed income tax.” This is done by adjusting the tax base to allow people to deduct saving and investment from their taxable income. Both the principle and the interest would be taxed when it is removed from saving and spent. This is similar to the way “individual retirement accounts” (IRAs) are treated under the tax code, except there would be no age limits or other restrictions on withdrawal.