In 2013 North Carolina instituted sweeping tax reform and began the process of making its tax system more efficient and more consistent with liberty. It created a single rate system, bringing both the top rate of 7.75 percent and the bottom rate of 6 percent down to a flat rate of 5.75 percent. In addition, the base was broadened, eliminating many special privileges in the code, and the corporate income tax was reduced. Furthermore, the tax reform process was used to reduce the overall tax burden on NC citizens, allowing average citizens from all income groups to keep more of what was rightfully theirs in the first place.
All of these reforms are good for the economy. In addition to transferring more revenues from political control to the private sector allocation — i.e. from less efficient to more efficient uses — the changes in the rates and the base have reduced the tax system’s bias against saving, investment, and entrepreneurship.
But there was one important area of the tax code that was left unreformed: the tax treatment of capital gains. To do so would be a logical next step in North Carolina’s movement toward a truly efficient tax system, one that doesn’t contain any special penalties for investment and entrepreneurship as our current system still does.
Capital gains taxes, like all taxes on investment returns, impose a second layer of taxation on investment and therefore entrepreneurship. Capital gains are the increase in value of an equity investment. This kind of investment includes anything from stocks and bonds to a plot of land or one’s home, business. So, for example, 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. This is not the case at the federal level or in a number of other states where capital gains are taxed at a lower rate or part of the gains are exempt from taxation. The purpose of this differential treatment is to ameliorate the bias against capital investment created when subjecting the returns to regular income tax.
The problem stems from what happens when both an initial investment and the return on that investment, in this case the capital gain, are taxed. Let’s assume that in our example the $5,000 used to invest 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, everything else equal, the return that could be generated from that investment, in this case the capital gain, was also reduced by 10 percent.
To tax the gain is to reduce the return a second time. So when capital gains are taxed, it is a form of double taxation — once when the initial investment is taxed, and again when the gain on that investment is taxed.
The most straightforward way to eliminate this double taxation is eliminate the tax on capital gains completely. While there are no U.S. states that do this, there is a number of other places that do, including Belgium, New Zealand, and not surprisingly, Hong Kong.
If this way is considered to be too difficult a task politically, then there are ways at least to ameliorate the problem. North Carolina could take the same approach as the federal government and tax capital gains at a lower rate than ordinary income. The Feds tax capital gains at about half the rate of regular income. Using this as a model, North Carolina could have a differential rate for capital gains of about 2.9 percent.
Another approach that is used by a number of states is to exempt a certain amount of capital gains from taxation. For example, South Carolina allows taxpayers to reduce their capital gains by 44 percent before applying the tax, while Wisconsin allows for an exclusion of 30 percent. Other states take different approaches with different exclusion amounts.
Whatever the North Carolina legislature does in this regard, it has to decide to do something. The current approach is a relic from our old tax system and is inconsistent with our state’s new and economically more sensible approach to tax policy. Surely reform or even repeal of North Carolina’s tax on capital gains is something that should be considered in the next legislative session.
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