N.C. can build on economic momentum with capital gains tax cut

September 14, 2014

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

RALEIGH — North Carolina can continue the positive economic momentum of its recent tax reforms by reducing or repealing the state’s tax on capital gains. That’s a key conclusion in a new John Locke Foundation Spotlight report.

“The sweeping tax reform package instituted in 2013 began the process of making North Carolina’s tax system more efficient and more consistent with liberty,” said report author Dr. Roy Cordato, JLF Vice President for Research and Resident Scholar. “A logical next step in the state’s movement toward a truly efficient tax system would be to reduce the tax on capital gains with an eye toward eventually repealing it.”

Even after lowering and flattening the state’s personal income tax rate, lowering the corporate tax rate, and eliminating many special privileges in the tax code, North Carolina lawmakers still have work to do, Cordato said.

“The recent reforms have been good for the economy,” he explained. “North Carolina has reduced the overall tax burden on its citizens, transferred more revenue from political control to more efficient private-sector allocation, and reduced the tax system’s bias against saving, investment, and entrepreneurship. But important areas of the tax code still need reform.”

The current system still contains special penalties for investment and entrepreneurship, Cordato said. “The capital gains tax offers a clear example of the negative bias, along with taxes on interest and dividends.”

The most straightforward way to address the issue is to eliminate the tax on capital gains completely, Cordato said. “While there are no U.S. states that do this now, a number of other places have taken that approach, including Belgium, New Zealand, and — not surprisingly — Hong Kong.”

If scrapping the tax proves too tall a task politically, lawmakers could reduce the tax in a couple of different ways, Cordato said. “North Carolina could take the same approach as the federal government and tax capital gains at a lower rate than ordinary income,” he said. “The federal capital gains tax rate is about half the rate for regular income. Using that model, North Carolina could have a differential rate for capital gains of about 2.9 percent.”

Some states use a different approach, Cordato said. They exempt a certain amount of capital gains from taxation. “South Carolina allows taxpayers to reduce their capital gains by 44 percent before applying the tax, while Wisconsin allows for an exclusion of 30 percent, and other states use different exclusion amounts,” he said. “By exempting part of the capital gains, you are in effect creating a differential tax rate for capital gains.”

Whatever approach North Carolina takes, lawmakers should avoid creating a distinction between long-term and short-term capital gains, Cordato said. “Some people advocate for a lower rate for long-term capital gains and a higher rate for short-term gains, but that amounts to nothing more than using the state’s tax code for central planning of investment decisions.”

There is nothing inherently better about long-term gains, Cordato said. “These kinds of decisions can be made efficiently only if they are based on the investor’s entrepreneurial insights and actual market conditions,” he said. “A tax code that tries to influence investment decisions in one direction or the other cannot improve upon this process. The fact that North Carolina’s code already has biases of this nature built into its structure is a great reason for reform in the first place.”

Cordato’s report offers economic analysis of the penalty tied to a capital gains tax. “When returns on investment are taxed at the same rate as ordinary income, it amounts to double taxation,” he said. “Capital gains taxes impose a second layer of taxation on equity investments — anything from stocks and bonds to a plot of land or a home or business. A second layer of taxation on equity investments amounts to a second layer of taxation on entrepreneurship.”

Lawmakers considering the next round of tax reform ought to keep capital gains in mind, Cordato said. “Whatever the North Carolina legislature does, it has to decide to do something,” he said. “The current approach is a relic from our old tax system. It is inconsistent with our state’s new, economically more sensible approach to tax policy. Surely reform or even repeal of North Carolina’s tax on capital gains is something that should be considered in the next legislative session.”

Dr. Roy Cordato’s Spotlight report, “North Carolina’s Capital Gains Tax: It’s time to consider a change,” is available at the JLF website. For more information, please contact Cordato at (919) 828-3876 or [email protected]. To arrange an interview, contact Mitch Kokai at (919) 306-8736 or [email protected].