Over the last few years, ever since the tax reform of 2013 took hold in North Carolina, there has been a steady push to expand the sales tax to services in an attempt to make it a more pure consumption tax. The idea, on the part of some analysts and law makers, has been to eventually eliminate the income tax and replace it with a broad based sales tax that taxes both goods and services. In other words, to replace the current income tax, where the base is both consumption and savings, with a tax that has only consumption in the taxable base.
I will not review the merits of replacing the traditional income tax with a consumption tax. These arguments have been gone over at length in several other papers. The whole point of making the move from an income based tax, i.e. consumption plus savings, to a consumption based tax is to eliminate the double taxation of saving, investment, and entrepreneurship which is an inherent bias in an income tax.
What I want to argue is that there is more than one way to accomplish this transformation, and the current push to do it through the elimination of the I income tax may not be the best approach.
Here at the JLF we have spilled a great deal of ink going over the details of how the state could convert the existing income tax, while staying within its established framework, into what is called a “consumed income tax.” As noted above, a person’s annual income is essentially divided into two components, what they spend (consumption) and what they save/invest. At its root, what a consumed income tax does is remove saving and investment from the equation leaving spending/consumption the only component to be taxed.
If one starts with his entire income, before any tax rate is applied to it, any amount that would go into a savings account or investment account of any kind would be subtracted out. On the flip side, any money that is withdrawn from savings and investment to be used to purchase something would be added back in. So all money that is spent, whether on goods or services, would be taxed. In other words, all savings would be treated like a regular IRA, except people would not have to wait until retirement to use their money and there would be no penalties for early withdrawal. By definition, an “income” tax structured in such a manner automatically is converted into a broad based consumption tax. In order to move in this direction, the Locke Foundation has proposed allowing bank and investment institutions in the state to establish what are called Unlimited Savings Allowance (USA) accounts that would function like these modified IRA accounts. We have also proposed eliminating capital gains and corporate income taxes. All of this is in an attempt to ultimately remove savings from the tax base and move toward a more pure consumption based tax.
It should be noted that the tax reform of 2013 has taken some important steps in this direction. In particular, by lowering and flattening the tax rate and by drastically reducing the corporate tax it has significantly reduced the tax penalty on all productive activity. Our hope is that the legislature would simply continue in this direction by taking a look at allowing saving and investment institutions to implement USA accounts, possibly through a pilot program ,and also by creating some kind of tax differential with respect to the rate or the base for capital gains income.
So why not convert the sales tax instead?
Theoretically, what I just described could be accomplished by reforming the sales tax and abolishing the income tax. Please note, the sales tax, like the income tax, would need reforming. It is at present not a pure, broad based consumption tax. It doesn’t tax services and penalizes investment by introducing a form of double taxation by taxing business to business sales. So in order to “purify” the sales tax, reform would have to include expanding the tax to all consumer services, but not business to business services, plus eliminating all current sales taxes on business purchases, which are investments. The exercise would be one of base broadening in one area and base narrowing in another.
This is theoretically possible, but politically it could be a nightmare. With each attempt to expand the current sales tax to a new service there would be fierce opposition from a new special interest group. Imagine the pushback from lawyers, accountants, doctors, hospitals, real estate agents, etc. when it is proposed that they need to start being tax collectors. It should also be noted that movement in the direction of trying to expand the sales tax to some services while leaving in place business to business taxes, which is largely what has occurred so far, may actually exacerbate the double taxation problem. The customers of a hair cutter who is paying taxes on his or her clippers, scissors, chairs, hair products, etc., is already paying a tax on the service, even though it is indirect and embedded in the price. To add the same tax to the hair cut itself is, to some degree, taxing it twice.
An additional problem is the rate. It has been estimated that to make the required reform of the sales tax and eliminate the income tax would require a sales tax hike to anywhere from 8 to 10 percent. Such high sales tax rates would enhance the competitiveness of out of state internet sales, which in many cases are not taxed at all.
Since 2013 North Carolina has moved a long way in the direction of sound tax policy, by both changing the tax base and lowering the rate. But in moving forward some important decisions will have to be made. Should we design future tax reforms to move the system in the direction of a consumed income tax or an expanded sales tax and a higher rate, with the goal of eliminating the entire income tax structure, leaving the bulk of tax collection, and the costs associated with it, to private businesses? The answer to this question will make a lot of difference in how we approach tax reform in the coming years.