Tar Heel Tax Reform: Choices & Uncertainties

  LineItemFeb13

State Tax Reform
Options, Challenges & Creativity

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The February/March 2013 edition of ABFM’s newsletter, Line Item, features several articles on the pertinent topic of State Tax Reform. Click here to check out the rest of this special issue, and click here for information on a special webinar featuring contributors to this issue, hosted by AABPA on Wednesday, March 13th (1PM Eastern).

By Kenneth Hunter

Following years of debate, multiple studies and two years of political upheaval, North Carolina is poised to undertake considerable tax reform measures under its first united Republican, Executive-Legislative leadership in state history.

Between the election of former Charlotte Mayor Pat McCrory to Governor and continued Republican Party victories in the State House and Senate, multiple proposals appeared from a variety of sources, within and outside government, to address structural deficiencies with a state tax structure whose origins date back to the 1930’s.

Before Republicans assumed power at the State Capitol in Raleigh two years ago, however, initial tax reform efforts were undertaken by the administrations of Democratic Governors Mike Easley and Beverly Perdue, reflecting a bipartisan understanding among most lawmakers that the state needs a new tax structure that can match the economic realities of the 21st Century while collecting revenue for necessary and desired State services.

“I’m happy that we’re talking about it because it is an issue that does have a long-term impact on bond rating,” said State Treasurer Janet Cowell, who is among the strongest Democratic leaders remaining in North Carolina government, in an interview last week with the Rocky Mount Telegram. “We have encouraged that debate, and we are awaiting some of the details.”

However, while there is mutual agreement for “tax reform” within North Carolina’s elected leadership and policymakers, the exact shape the reform will reflect going forward is an area of significant contention.

Several different proposals have been presented and are under serious consideration. They include:

  • The State Senate proposal, which eliminates personal and corporate income tax and replaces them with a sales tax applicable to all goods and services taxed in at least one other state, elimination of preferential sales tax rates and loopholes, implementation of a 1% real estate conveyance fee and implementation of a business license fee levied on all businesses (base equal to assets minus liabilities minus retained earnings).
  • Proposal by John Locke Foundation, eliminating all state income and sales taxes, replacing them with an 8.05% tax on all consumed income (total income, minus savings and charitable donations).
  • Alternate proposal by John Locke Foundation, eliminate state incomes taxes, lowering the current state sales tax, and instituting a 6% consumed income tax.
  • The Tax Foundation, in conjunction with the Carolina Business Coalition, evaluated four different tax proposals, varying from eliminating income taxes, to broadening bases and reducing rates, to eliminating sales tax.

John Hood, President of the free-market-oriented John Locke Foundation, summarized the likely paths for tax reform in North Carolina as a choice between the following:

  • Abolish income taxes in North Carolina and pay for most state services with a broad-based tax on retail sales. The resulting state sales tax rate will be about 9 percent and the combined state/local rate will be approximately 11 percent.
  • Abolish the state share of the retail sales tax and pay for most state services with a consumed-income USA Tax. (Local option sales taxes would be left in place, as is.)
  • Keep both systems for collecting tax from North Carolina households (direct payment through income tax and indirect, business-collected payment through sales tax) but adjust the tax base and marginal rates to make the overall system less hostile to investment, business formation, and economic growth.

Generally-speaking, while the tax reform discussion does involve numerous players and significant variety in discussion of options, one key element is missing: the involvement of experienced academic researchers and public sector practitioners. While no single group has all the answers on this issue, the shift towards politically-oriented policy groups and away from independently-minded institutions with regard to research and evaluation limits open discussion on the issue, and serious consideration of advantages and disadvantages.

The New Way?

The consumed income tax, championed by Hood and the John Locke Foundation (funded in part by Arthur Pope’s family), reflects the most creative and challenging element of the proposals being considered. In place of state income and sales taxes, North Carolina residents can set up qualified savings accounts, with their annual deposits exempt from taxation. Residents would only pay taxes on the amount of income consumed (total income, minus savings and charitable contributions).

While the consumed income tax appears to address issues of compliance, administration, horizontal equity and elasticity, it also creates additional challenges. Perhaps most notable is the requirement that residents establish “xxx savings accounts” with banks or other financial institutions so that their savings of income can be monitored in order to ensure the proper level of taxation.

Likewise, those who are unable to save due to cost of living consuming all or nearly all of their income could experience higher tax burdens, similar to other consumption-based taxes. At the same time, utilization of a standard deduction, similar with Federal personal income tax, could help alleviate the problem for lower income earners and those who do not wish to set up the approved accounts.

Economic Emphasis

All of the proposals, however, do reflect a focus on reducing or eliminating North Carolina’s personal and corporate income taxes. Research shows that the effective and top marginal tax rates in the Tar Heel State are the highest amongst neighboring states. Given that Tennessee to the west only applies an income tax to investment dividends, and that top marginal income tax rates are lower in Virginia and South Carolina, some lawmakers and policy analyst are concerned about the influence of their higher tax burdens on economic growth.

“The income tax stands out in North Carolina, not only because our rates are highest regionally and compared to our neighbors, but also research shows income taxes are most damaging to economic growth,” said Brian Balfour, Policy Analyst with the Civitas Institute, who headed up the free-market policy group’s evaluation of the State Senate’s tax reform plan.

“We need to address our current state of economic stagnation,” Balfour said. “Research and theory points to consumption-based taxation being more conducive to economic growth.”

Those opposed to tax reform that increases reliance on consumption-based taxes, however, disagree with Balfour’s assessment. Cedric Johnson, a Public Policy Analyst with the Budget & Tax Center, a division of the liberal-oriented North Carolina Justice Center, took issue with the whole concern regarding the State’s tax rates and economic growth, contending the negative impact of associated vertical equity (regressivity) and limited revenue growth (inelasticity) will create more problems in the long-run, compared to short-term reductions in tax rates.

“Despite general agreement that North Carolina’s revenue system is inadequate for making investments needed for a modern economy and in planning for downturns,” Johnson wrote in a January 2013 report, “proposals put forward so far have focused on a problem that doesn’t exist – the claim that taxes are the main barrier to job creation and economic growth.”

Michael Walden, noted Economist from North Carolina State University, offered an independent assessment in an edition last year of his popular “You Decide” column.

“Economic research shows people may work more in response to the greater take-home pay from lower tax rates – especially from lower income tax rates. But the same research shows that – unless the beginning tax rate is very high (such as over 50%) – lower rates won’t generate more tax revenue than the higher rates.

“I should add one footnote to this discussion about tax rates and growth. The research evaluating the impact of tax rates on economic growth must proceed very carefully. For example, both inflation and population growth will cause tax revenue to increase. Isolating any link between tax rates and economic growth must account for these, as well as other, factors impacting tax revenues.”

Another issue generating disagreement between analysts is the role of “economic convergence” in explaining how North Carolina’s present economy compares to surrounding states.

Balfour does not believe that convergence plays a significant role in explaining how neighboring states, particularly South Carolina, have seen recent economic growth while North Carolina has languished with respect to unemployment and investment since the 2oo8 recession. In a recent follow-up to his work on the Senate’s proposal, he specifically addressed complaints regarding his downplaying of convergence:

“The finding that the convergence hypothesis – personal income across the states will tend to converge and therefore states with lower initial per capita income should experience faster income growth – being inconsistent is consistent with Besci (1996), who found that the strength of the convergence hypothesis diminished over time. Economic models, by definition, are simplifications of reality.”

Future research on state tax policy and its impact on economic growth, especially given the environment of competitiveness now existing between states for capital investment and job growth, should seriously look at the role of convergence and provide insight on its applicability and limitations.

Preparing for Reform

The last two years in the General Assembly have made one thing perfectly clear: if there is will amongst Republicans in the House and Senate for tax reform, just as there has been for other key legislative issues, a bill will be passed and put into law. Even if Governor McCrory were go against his party and “veto” reform legislation, supermajorities in both chambers proved will only build upon the significant track record of overrides approved during the final half of the Perdue Administration.

More than likely, North Carolina will see a shift from income to consumption-based taxation in the future, an environment that could also be impacted by additional efforts underway to eliminate the State Estate Tax. At the same time, the “revenue neutral” intent within current tax reform efforts does pose potential trouble for county and municipal governments, who will likely see their local option tax rates reset due to base broadening.

“I believe the Senate is mindful of the diversity of impact of broadening the sales tax base on local option revenues,” Balfour said. “It will be virtually impossible to predict how every county (in the state) will be affected.”

Balfour sees the possibility for the State Senate to incorporate “hold harmless” provisions, which have been used in the past in the state in order to address changes in sales tax policy.

As for State fiscal health, future budgets may need to include provisions for strengthening reserves in order to address potential revenue shocks associated with the elastic, volatile nature of consumption-based taxes.

“Sales taxes are estimated to be elastic making them sensitive to changes in the economy,” said Whitney Afonso, Assistant Professor with the School of Government at the University of North Carolina at Chapel Hill. “In result they are expected to be volatile, so if North Carolina chose to rely more heavily on sales taxes they may want to consider maintaining larger fund balances to help smooth spending over business cycles.”

The General Assembly has also already proven that it is willing to reduce spending in targeted areas in order to balance budgets, a necessity when it decided in 2011 to end a “temporary” sales tax increase adopted in 2009. The State’s healthy position with respect to proper funding of employee pensions minimizes one long-term concern, while state retiree health benefits remain a long-term issue that will require significant reform with respect to funding and benefit levels.

More than likely, starting off with a “revenue neutral” funding level and limiting growth will put pressure on the State Budget and facilitate the need for additional reductions. Once the tax reform debate passes, North Carolina leaders will need to work on crafting a strategic approach to budgeting that identifies funding priorities in a manner they can be supported with the revenue plan they crafted first.

Kenneth Hunter is Editor of Line Item and Budget & Evaluation Manager for the City of Rocky Mount, NC. This article is intended as a work of public information.  Any opinions derived from this article do not reflect those of the City of Rocky Mount, or any other jurisdiction in North Carolina.