John Locke Update / Research Newsletter (Archive)

Time to get serious about capital gains, the next step in tax reform

posted on in Economic Growth & Development, Spending & Taxes

Last week I discussed and endorsed the idea that, instead of trying to create a consumption tax by abolishing the income tax and reforming the sales tax, North Carolina should instead use the existing apparatus of the income tax to accomplish that same goal. I argued in favor of eliminating the direct taxation of savings in the income tax and implementing what is known as a “consumed income tax.” If income is simply consumption plus savings, which it is, then a consumption tax can be created by eliminating savings from the tax base.

North Carolina has been moving in this direction since 2013 when it implemented sweeping tax reform by switching from a steeply progressive and economic growth inhibiting rate structure to a low, single rate flat tax. It also has dramatically reduced the corporate income tax, thereby reducing the burden of that tax which is born completely by workers, consumers, and shareholders. The legislature also closed a number of loopholes and eliminated many special privileges. The consequence of these and other policy changes has been to bring about the fastest growth rates in the country over the last three years.

The question then arises, in terms of further enhancing economic growth, where do we go from here? First, it should be recognized by everyone, but isn’t, that it is not in expanding so-called economic development programs like JDIG, now called North Carolina Competes, or any targeted businesses subsidies programs, which the governor and the legislature did last year (See here and here). In fact, it would improve economic efficiency and therefore growth to repeal such programs. Instead, one of the best things we can do is to continue to reform the tax code in the direction of eliminating savings and investment from the base, i.e., in the direction of a consumed income tax. The logical next step should be to reduce the tax on capital gains with an eye toward eventually eliminating it.

To tax capital gains is to double tax investment and entrepreneurship. Capital gains are a return on equity investment and therefore entrepreneurship, which is the engine of all economic growth. This kind of investment includes anything from stocks and bonds to a plot of land, a farm, or one’s home or business. If a person invests in stock that costs him $5,000, and 10 years later he sells that stock for $10,000, his capital gain would be $5,000. Under current law in North Carolina, the $5,000 gain would be taxed at the same rate as regular income. So how is this investment “double taxed?” Let’s assume that in our example the $5,000 used to invest in stocks began as $5,555 in pre-tax income, and the way the investor ended up with $5,000 to invest is that the $5,555 was taxed at a rate of 10 percent. So in the absence of the tax, the person could have made a $5,555 investment. After the tax, however, the investment had to be reduced to $5,000. The value of the stock that could be purchased was reduced by 10 percent. In doing so the return that could be generated from that investment, in this case the capital gain, was also reduced by 10 percent. To tax the capital gain is to reduce it a second time and therefore is a form of double taxation.

In the coming years, the NC legislature has the opportunity to repeal this growth penalty. At the request of the John Locke Foundation, The Beacon Hill Institute at Suffolk University has calculated that complete repeal, not factoring in any positive economic growth effects of the tax change, would, at current tax rates, cost the state treasury about $500 million, and this should be the ultimate target. But if this is too big a hit to the budget to take on all at once, a more modest 50 or even 25 percent capital gains exclusion from taxation at a budget cost (taxpayer savings) of $250 or $125 million respectively would be a good beginning. And the first place to look for this money should be special corporate giveaway programs such as that cited above. To reduce capital gains taxes on the one hand and eliminate corporate welfare programs on the other would be a twofer when it comes to economic growth, both enhancing economic efficiency and reducing inefficiency at the same time.

In June 2019 Roy Cordato retired from his full time position as Senior Economist and Resident Scholar at the John Locke Foundation and currently holds the position of Senior Economist Emeritus at the Foundation. From January 2001 to March 2017,… ...

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