State Tax Reform

North Carolina has a high tax burden by regional standards, and its top marginal tax rates of 7.75 percent for individual income and 6.9 percent for corporate income are among the highest in the United States.

Tax cuts in the late 1990s did not fully make up for tax increases earlier in the decade, and the General Assembly has raised taxes by more than $1.5 billion since 2001.

Clearly more needs to be done to gain control of the spending that leads to higher taxes. State policymakers must also consider whether the current tax code is efficient, equitable, and understandable to the average taxpayer.

Groups from left and right, the Institute for Emerging Issues, and the legislature's State and Local Fiscal Modernization Commission have all addressed the need to reform North Carolina's tax system. Proposals include eliminating the death tax, shifting the balance of responsibility between the state and local governments, and expanding the sales tax to cover services as well as goods.

Problems with the Code

The current state tax code violates the basic principles of a fair and efficient tax system. It developed piecemeal with explicitly lower rates, deductions, and tax credits for favored behavior such as job training and higher rates for undesired behaviors such as smoking. The tax code, intentionally or not, penalizes saving and investment more than consumption.

In short, North Carolina is saddled with a system that is complex, biased, and inequitable — opposite the goals of good policy.

1. Simplicity. The tax code is too complex for even professionals to understand. Individuals cannot plan for the future and often feel that they are paying more than they should. Resources devoted to avoidance, compliance, and enforcement are a drag on the economy.

2. Neutrality. The tax code favors home buyers over renters, pensioners over workers, large companies over small ones, new companies over existing ones, and borrowing over saving and investing. The tax code should not benefit or penalize any individual, group, industry, or economic decision more than another.

3. Equity. The tax code's progressive rates based on one's "ability to pay" are nothing more than income redistribution or, less charitably, larceny. Equity demands that users pay for services, such as highways, that are not constitutional entitlements. A flat-rate consumption tax and a flat-rate property tax would each be equitable, and each would be a way to approximate demand for public goods. Progressive income taxes and regressive housing impact fees are not. Corporate taxes are not equitable; corporations merely collect taxes from their workers, investors, and customers.

A Plan for Reform

One tax that fits all three principles is a flat tax on consumed income. A single rate applied to yearly spending and not yearly saving is understandable and makes future taxes more predictable for the taxpayer.

Excluding capital gains and interest income from taxation, or excluding income that is saved or invested, would make the tax code neutral by ending the current pro-consumption bias. Some spending on education and health care should also be considered investments that produce future income and should be excluded from taxation, although direct cash payments to individuals would promote these activities better without distortions.

Establishing a consumed income tax eliminates the bias in the current sales tax favoring the purchase of personal and other services as substitutes for products.

Business purchases of equipment and other goods should be exempt from the sales tax to preserve the principle of equity. These purchases eventually are embodied in the goods and services purchased by consumers, and any tax paid on these purchases also becomes embedded in that price. Finally, because corporations are only intermediaries in the tax system, the state should end the corporate income tax.

Recommendations

1. State policymakers should remove tax provisions from the state tax code that are inconsistent with principles of simplicity, neutrality, and equity. In every case, the goal should be to lower tax rates while offsetting at least some of the revenue loss by broadening the tax base to eliminate bias.

2. North Carolina should reform its income tax system to create a single-rate, easy-to-understand tax on consumed income that ends multiple layers of taxation on savings and investment. This reform would either make corporate dividends entirely tax-deductible or abolish corporate income taxes. It could also offer tax exclusions for household investment in education, health, and other private human-capital formation.