Policy Position

Tax Reform

in Budget, Taxation, and the Economy

Introduction

For many years, it was recognized that North Carolina’s tax system needed a major overhaul. The system was a model of hodgepodge tax policy with high marginal rates on personal and corporate incomes and many exemptions carved out for the favored few. This led to a tax system that generally penalized investment, entrepreneurship, economic growth, and therefore job creation.

The process of improving the tax code began in 2011. A 1 percent temporary increase in sales tax put into effect in 2009 was set to expire. Governor Beverly Perdue was in favor of continuing the higher rate past its expiration date. Ultimately, it was allowed to sunset but only as a result of an override of Perdue’s veto of legislation by the newly elected Republican majority in the General Assembly.

Two years later, lawmakers initiated sweeping tax reform. In addition to implementing pro-growth reforms in the personal and corporate income tax, lawmakers also incorporated across-the-board tax cuts that would benefit most households in all income groups. The deliberative process that led 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. North Carolina’s tax code still has a number of features that create biases against saving and investment. This needs to be remedied.

Key Facts

  • In 2013, the North Carolina General Assembly 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 personal and corporate income taxes.
  • The 2013 tax reforms replaced a three-rate progressive income tax that ranged from 6 to 7.75 percent, the highest in the region, with a flat-rate tax of 5.8 percent. This rate was lowered to its current 5.499 percent and will fall to 5.25 percent in January 2019.
  • The low, and still declining, flat personal income tax rate has ameliorated the bias against work effort and productivity that plagued the previous progressive rate structure.
  • The standard deduction, also known as the zero tax bracket, has been dramatically increased from $6,000 prior to the 2013 reforms to $20,000 for a couple filing jointly in 2019. This was a way of building progressivity into what is essentially a flat-rate system.
  • The corporate tax rate has been reduced from 6.9 percent in 2012, the highest in the Southeast, to 3 percent, the lowest of any state that taxes corporate income. It is scheduled to go down to 2.5 percent in 2019.
  • The sales tax rate did not change, but the base was expanded to some services. Business-to-business sales continue to be taxed. This is a hidden double tax embedded in the system.
  • 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 an estimated $500 million a year, which would need to be compensated for with budget cuts. A 50 percent or 25 percent exclusion would save taxpayers $250 million or $125 million annually, respectively.

Recommendations

  1. Future reform efforts need to focus on eliminating savings from the tax base. This would eliminate the bias against saving, investment, and entrepreneurship that still exists in the tax code.
  2. A good first step in this direction would be to eliminate taxation on capital gains. At the very least, lawmakers should create a capital gains exclusion as a first step.
  3. The reduction in revenue to the treasury from abolishing the capital gains tax should be replaced by eliminating economic development programs that subsidize business. (See section titled “Economic Growth.”)
  4. Businesses should be allowed to deduct all purchases of capital equipment and land in the year they are incurred, which is known as expensing. This approach has recently been adopted at the federal level and will also apply to North Carolina. But federal policy in this regard will expire after five years. North Carolina should go beyond federal tax policy and make immediate expensing a permanent feature of the tax code.
  5. In the long run, lawmakers should seek to 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 principal 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.
  6. There should be a moratorium on any new expansions of the sales tax base until business-to-business sales are exempted from the tax.

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