December 14, 2016
RALEIGH — North Carolina’s flat-rate income tax promotes economic growth while ensuring that taxpayers with higher incomes pay progressively higher tax rates. A new John Locke Foundation Spotlight report explains how.
“Some people believe that there’s a direct conflict between a flat-rate tax and the goal of tax progressivity, which means taxing a larger percentage of people’s income as they earn more money,” said report author Dr. Roy Cordato, JLF Vice President for Research and Resident Scholar. “In fact, there is no conflict. N.C. policymakers have ensured with their flat income tax that people’s tax rates climb along with their income. Yet the state continues to reap the economic rewards of a flat tax.”
North Carolina accomplishes these two goals — one flat rate for all taxable income and progressively higher tax rates for higher-income earners — through increases in the personal exemption, also known as the zero tax bracket. This exemption creates zero tax liability on all income earned up to a certain threshold.
“Lawmakers have dramatically increased the personal exemption since 2013,” Cordato explained. “Prior to the state’s major 2013 tax reform package, a couple filing a joint income tax return could take a $6,000 personal exemption. That number jumped to $15,000 with the initial tax reform. In other words, the zero tax bracket climbed from $6,000 to $15,000.”
The General Assembly continued along the same path in 2016, Cordato added. “The zero tax bracket was increased even further to $17,500, almost triple what it was in 2012,” he said. “This made the system even more progressive while maintaining a single flat tax rate.”
Cordato explained the difference by comparing two similar taxpayers with incomes of $100,000 and $50,000. Under a simple 10 percent flat-rate tax with no personal exemptions, the first taxpayer would pay $10,000 in income tax, while the second would pay $5,000.
With a $15,000 personal exemption, the first taxpayer pays $8,500, while the second pays $3,500. Both see the same $1,500 tax cut, but that cut represents 1.5 percent of the first taxpayer’s income and 3 percent of the second taxpayer’s income. “The impact is proportionally larger for the taxpayer with less income.”
Cordato emphasizes a distinction between marginal tax rates and average, or effective, tax rates. The marginal rate is the percentage of tax paid on each additional dollar earned. The average, or effective, rate indicates the total percentage of income paid in taxes.
In the example above, the marginal tax rate and average tax rate are equal — 10 percent — when there’s no personal exemption. With the $15,000 exemption, the average tax rate drops to 8.5 percent for the $100,000 taxpayer and 7 percent for the $50,000 taxpayer.
“It’s clear that the exemption leads to a higher average tax rate for the higher-income earner,” Cordato said. “And that’s true up and down the income scale. The average rate would drop from 7 percent all the way to zero for taxpayers making no more than $15,000. The average rate would get closer and closer to 10 percent as incomes climb.”
In the real world, N.C. lawmakers have increased exemptions while also slashing rates. Their initial tax reform package scrapped a three-tiered system of rates, topping out at 7.75 percent, with a single rate of 5.8 percent. That flat rate, taking effect in 2014, was lower than the previous low rate of 6 percent. The flat rate dropped again to 5.75 percent in 2015.
The rate will drop again next year. “With the statutory flat rate of 5.499 percent that will go into effect in January 2017, the effective rate for a couple with no children earning $100,000 will be about 4.5 percent, while the effective rate for a similarly situated couple earning $50,000 would be 3.5 percent. Families with children would see even lower rates because of per-child tax credits. These credits also lead to proportionally larger tax cuts for families with lower incomes.”
The report does not dwell on policy disputes about the benefits or drawbacks of progressive taxation. “Some people, particularly on the political Left, believe tax ‘fairness’ requires higher tax rates for higher-income earners,” Cordato said. “This notion is in contrast with a rights-based concept of fairness.
“This latter concept relies on the idea that people have an inherent right to keep what they earn, regardless of the level of earnings,” he added. “This is the notion of fairness built into the N.C. Constitution. But the report accepts the desirability of progressive taxation for the purposes of argument.”
Regardless of the merits of progressive taxation, North Carolina’s tax system builds in progressivity while taking advantage of a single flat statutory rate, Cordato said.
“Economists generally agree that, all else being equal, a broad-based flat-rate income tax is less harmful to economic growth than a system that relies on a tiered progressive rate structure,” he said. “A flat tax system, with the same tax rate applied to each additional dollar of income, does not penalize increases in productivity on the part of businesses and increased work effort on the part of employees.”
“If tax reformers who view progressivity as being important focus on the average or effective tax rate, rather than the marginal rate, the economic benefits of a flat tax can be maintained while seeing to it that income earners pay an increasing proportion of their income in taxes as their incomes grow.”
Dr. Roy Cordato’s Spotlight report, “Progressivity and the Flat Tax: Having your cake and eating it, too,” 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]