John Locke Update / Research Brief

Setting Tax Priorities

posted on in Fiscal Insight, Spending & Taxes
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With both chambers of the General Assembly agreeing to spend $22.9 billion in the fiscal year beginning July 1, the biggest differences between their budget proposals are what to do with the $1 billion they do not plan to spend.

The House would set aside $365 million for repairs and renovations of state facilities; the Senate $120 million. In contrast, the Senate reduces taxes by $323 million; the House by $120 million. What might a compromise look like?

Because businesses do not ultimately pay taxes, but pass the burden on to their owners, workers, or customers, cutting taxes on businesses helps the economy and workers. This principle applies whether the tax is on the value of the firm, its net income, or the machinery it purchases to make its products. The final tax plan should simplify the franchise tax base, reduce the franchise tax rate, and eliminate the tax on mill machinery. Lowering the corporate income tax rate would be a reasonable alternative to the franchise tax option and could provide a Senate win to balance a House win on ending the tax on mill machinery.

Franchise Tax

Both the House and the Senate seek to reduce the franchise tax, which applies to S corporations in North Carolina. Businesses pay $1.50 for every $1,000 (0.15 percent) of net worth or tangible property. An earlier proposal before the House (HB356) would have dropped the tangible property option, simplifying the tax basis for companies. Ideally, the committee negotiating a final budget compromise would revive this idea.

The Senate budget would set the tax at $200 for S corporations (not all companies) on their first million dollars, which would save money for all but the smallest companies, then charge 0.15 percent on the value above $1 million. The House budget would take a simpler approach, reducing the rate to 0.14 percent in January 2019. Good tax policy would take the House’s approach, keeping one rate for all firms. There could be room for a much larger rate reduction based on changes in other taxes.

Sales Tax

Mill machinery is almost always used to make other products. Sales taxes on business equipment like this gets embedded in the price of goods sold. Buyers in effect pay sales tax on the sales tax, which is not good policy. Eliminating taxation of an entire class of business goods is a worthwhile step toward the principle of ending all taxes on business inputs.

Corporate Income Tax

Senators have agreed to further reductions in the Corporate Income Tax rate, to 2.75 percent in January 2018 and 2.5 percent in January 2019. House members did not include a corporate income tax reduction in their budget. The Senate’s plan is projected to reduce revenue by $34 million in FY2017-18, $100 million in FY2018-19, and at least $140 million annually afterward. This frees more money from the government but applies to fewer companies than the franchise tax. The corporate income tax varies more over time than the franchise tax, as corporate incomes tend to grow more and fall more than the economy as a whole, but is less likely to fall short of expected revenue in a given year. There is also no reason to shift the basis of taxation to “market-based sourcing” which creates more complication in determining taxable corporate income.

Personal Income Tax

Both budget proposals would increase the standard deduction available to taxpayers. The Senate’s plan would raise the amount for married couples filing taxes jointly to $20,000 (from $17,500) for the head of household to $15,000 (from $14,000), and for single or married filing separately to $10,000 (from $8,750). The House proposes standard deductions of $18,500, $14,800, and $9,250, respectively. This increase may not provide as much economic benefit as a reduction in business tax rates, but it would go directly to families and have more effect on families with lower incomes.

Lowering the Personal Income Tax rate from 5.499 percent to 5.35 percent, as the Senate recommends, would reduce income to the state more and continue momentum toward the elimination of the personal income tax.

Changing the $200 child tax credit to a tiered tax deduction that phases out with income would create higher marginal effective tax rates at each income threshold. There is little to recommend this change.

Taxpayers who itemize instead of taking the standard deduction can also deduct the mortgage interest and property taxes they pay. Current law caps the deduction at $20,000 for any tax filer, which affects more people in major metropolitan areas where home prices are relatively high than those purchasing entry homes or living in communities with lower home prices. A married couple filing separately cannot claim more than $20,000 combined, though they apportion their deductions in any way within that limit.

The House budget would raise the deduction from $20,000 to $22,000. The Senate budget proposal would adjust the deduction based on filing status to end the different treatment of married couples filing separately and otherwise make the deduction comparable to other elements of the tax code. The main beneficiary of any version of a change here would be real estate professionals and local governments. A fiscal note on the House proposal estimated the two-year fiscal impact between $132 million and $148 million. That is a high price tag for little effect. Because the two chambers have differences, there is still a chance to reject changes to this deduction.


Each proposal seeks to simplify the tax code and reduce taxes on businesses and individuals. Because both would reduce the franchise tax, this is a reasonable first step, and making the reduction in the rate instead of creating two classes of businesses is a sensible approach. Shifting all businesses to the same standard of taxation, based on net worth instead of tangible property, is good for simplification. Eliminating the tax on mill machinery would remove a class of business inputs from taxation, which would reduce the cost of doing business in North Carolina.

If legislators also want to reduce the personal income tax burden, they should prioritize the standard deduction over converting the per-child tax credit to a deduction or adjusting the mortgage interest and property tax deduction.

A case could be made to maintain momentum and continue reducing the corporate and personal income tax rates, but their effects are becoming more concentrated while the franchise tax, mill machinery sales tax, and standard deduction have broader impacts. These changes would make it possible to prudently direct some of the Senate’s billion dollars in tax cuts instead to repair and renovations, the savings reserve, or obligations for retiree pension and health benefits.

As Senior Fellow, Joe examines fiscal and tax policy. He previously headed the North Carolina Government Efficiency and Reform initiative within the Office of State Budget and Management, which led to changes in automotive fleet management, natural and… ...

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