December 18, 2005
RALEIGH – As North Carolina policymakers and analysts prepare for a major debate on reforming the state tax code, a new report from the John Locke Foundation calls into question the value of state estimates of “tax expenditures” that could be eliminated to raise additional revenue.
Joseph Coletti, a fiscal policy analyst at the Raleigh-based think tank, examined the North Carolina Department of Revenue’s latest Biennial Tax Expenditure Report. It is supposedly an analysis of tax “loopholes,” but Coletti found several significant problems with the Revenue report.
“Its starting point is arbitrary, and its assumption is that income is the property of the state,” Coletti said. “But more importantly, it overlooks how North Carolina’s tax code is heavily biased against certain forms of economic activity: saving, investment, and entrepreneurship.”
For example, taxing corporate income is another way of taxing personal income, in that corporate dividends and capital gains from the sale of stock are reported as income to shareholders. Yet North Carolina offers no lower rate or exclusion to investors in corporate stock, thus yielding a higher tax burden than on income from other business forms.
“Corporations are legal entities,” Coletti said. “They don’t pay taxes — they collect taxes. The report takes no notice of this fundamental truth.”
He added that because the state taxes both the income used to make an investment as well as the earnings on that investment, it creates a tax bias in favor of current consumption over future consumption. These issues are ignored in the Revenue report, Coletti said, as are major exclusions from the tax base such as mortgage interest and the value of non-wage compensation such as health benefits.
“The report contains a long list of small-dollar items while ignoring the largest exclusions and biases in the tax system,” Coletti said. “Thus it misleads public officials about the nature of the problem as well as the proper solution.”
One source of confusion in the report, Coletti said, is that it reflects uncertainty about the definition of tax expenditure. The state is following the lead of the U.S. Department of the Treasury, which in 1992 threw out several provisions from its list of tax expenditures. By chaining themselves to a flawed federal methodology, he said, state officials have generated a list that lacks any real analytical value — focusing only on tax “expenditures” and not on the corresponding number of tax “penalties.”
“Wine, for example, is taxed at a much higher rate than other consumer goods,” Coletti said. “This creates a tax surcharge. And fortified wine is taxed at an even higher rate than unfortified wine.”
Rather than accepting the current, flawed definition of the tax base and then trying to “close loopholes,” as many state officials seem inclined to do, Coletti recommends that North Carolina choose a more rational definition of the tax base. For example, since the current personal and corporate income tax creates a bias against investment, while the current sales tax creates a bias against goods-producing industries in favor of service industries, the best approach would be a “consumed-income tax” that applies a single rate on all annual income that is not saved.
“A flat tax on consumed income would be the fairest and the most economically productive choice — but its virtues would never be seen by those basing their analysis only on the Revenue Department’s flawed study of tax expenditures,” Coletti said.
Joseph Coletti’s Spotlight report, “End All Tax Biases: Report on Tax Expenditures Misses Half the Story,” is available on the John Locke Foundation website. For more information, contact JLF Fiscal Policy Analyst Joseph Coletti at 919-828-3876 or [email protected].