RALEIGH — North Carolina’s new tax reforms help set the stage for long-term economic growth in the state. That’s the assessment of the John Locke Foundation’s top tax expert, who analyzes the reforms and suggests future improvements in a new Spotlight report.
“This tax reform plan removes some important systemic obstacles to economic growth in North Carolina,” said report author Dr. Roy Cordato, JLF Vice President for Research and Resident Scholar. “North Carolina legislators deserve praise. They have helped level the playing field for taxpayers and eliminated some important roadblocks to prosperity.”
Cordato, a Ph.D. economist, outlines key changes in the 2013 tax reform plan and emphasizes benefits of reducing taxes by as much as $4.75 billion over five years. His report recommends future reforms targeting the personal income tax base and the eventual end of the corporate income tax.
“For many years, it has been recognized that North Carolina’s tax system needed a major overhaul,” Cordato said. “The system served as a model of hodgepodge tax policy, with high marginal rates on personal and corporate income and lots of exemptions carved out for the favored few. This has led to a tax system that generally penalized investment, entrepreneurship, economic growth, and — therefore — job creation.”
The “sweeping” tax reform measure approved by the N.C. General Assembly and signed into law by Gov. Pat McCrory starts to fix the problems, Cordato said.
“Throughout the process, reformers aimed to reduce the tax system’s general bias against productivity and job creation, reduce favoritism and special carve-outs, simplify the tax code, and reduce the overall burden on taxpayers,” he said. “The final version of the law made significant progress in accomplishing all of these goals.”
Lawmakers lowered personal and corporate income tax rates while broadening the tax base, expanded the sales tax base to include some services, and eliminated the estate or death tax. “The overall tax cut of $4.75 billion over five years works out to no more than 4 percent of expected state General Fund revenue during the period, and probably less if the economy grows as a result of reform,” Cordato said.
Cutting the overall tax burden will have positive effects, Cordato said. “Reducing tax revenues means transferring resources from political control to control by consumers and entrepreneurs,” he said. “This enhances economic efficiency, generating more useful output and greater economic growth and prosperity.”
From the perspective of economic growth, the two most important reforms targeted personal and corporate income taxes, Cordato said. Lawmakers replaced a graduated personal income tax system with current rates from 6 percent to 7.75 percent. The new flat rate is 5.75 percent.
“North Carolina no longer has the highest top marginal tax rate in the Southeast,” Cordato said. “That’s important because an income tax is in essence a penalty on productive activity of all kinds. The higher the rate, the greater the penalty. The old progressive rate structure also had the effect of penalizing people for earning higher incomes and becoming more productive. The new flat rate eliminates that problem.”
Future reforms should focus on the income tax base, Cordato said. “This year’s reforms did not address the problem of the income tax’s penalty on all forms of investment,” he explained. “Money saved or invested is taxed first as income and then taxed a second time as earnings when the savings or investment yields interest, dividends, or capital gains.”
Lawmakers can address that issue by removing either principal or interest from the tax base, Cordato said. “The John Locke Foundation has recommended addressing this issue through new universal savings accounts, USAs, that would exempt all deposits from taxable income while taxing any withdrawals,” he said. “Another option would be to lower or eliminate the tax on capital gains.”
On the corporate income side, North Carolina leaders dropped the tax rate from 6.9 percent, highest in the Southeast, to 6 percent in 2014 and 5 percent in 2015. The rate could drop as low as 3 percent in 2017 if the state meets revenue targets.
“Unlike the current corporate income tax, which combines a high rate with special breaks for favored businesses and industries, new lower rates will apply across the board,” Cordato said. “Loopholes and giveaways embedded in the current system, based on what is essentially a crony capitalist model, are eliminated.”
Future reform should focus on abolishing the corporate income tax, Cordato said. “It’s a hidden tax, and it creates a drag on the state’s economy by placing an additional layer of taxation on investment,” he said. “Lawmakers should repeal the legislation that enables the state to tax corporate income at all. This would make it difficult for future legislatures to reinstate the tax.”
Most of North Carolina’s weak economic recovery can be blamed on factors outside the state, especially federal government decisions involving health care, environmental regulation, excessive government spending and debt, and expansive new taxes, Cordato said.
“There is no reason for North Carolina’s government to be adding additional burdens on our state’s economy on top of those that are being thrust on us by Washington,” he said. “State lawmakers realize this and are working to remove obstacles to growth.”
Dr. Roy Cordato’s Spotlight report, “Tax Reform 2013: Setting the Stage for Economic Growth,” 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].