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Opinion,Taxes and Budget

Three Models for Tax Reform

Apr. 9th, 2012
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RALEIGH – Fundamental tax reform is a bit like the weather. Everyone talks about it, but no one seems to do anything about it. Nevertheless, it is quite possible that in 2013 there will be a perfect storm of timeliness, opportunity, and leadership that leads to significant tax changes in North Carolina, with tremendous economic benefits.

After the Republicans won control of the North Carolina General Assembly in 2010, they were immediately faced with closing a multi-billion-dollar budget gap left by the previous Democratic legislature and Gov. Beverly Perdue. They chose to accomplish the task without raising state taxes. Indeed, they enacted some modest tax relief and allowed a temporary sales-tax increase to expire as scheduled.

There was neither the time nor the opportunity for lawmakers to craft sweeping tax-reform legislation in 2011. Nor is such a project likely during the 2012 session. But if the GOP retains the legislature and Pat McCrory wins the governor’s race this fall, all indications are that tax reform will be on their agenda in 2013.

Good. North Carolina’s tax code is archaic, unwieldy, unfair, and unfriendly to the creation of new businesses and jobs in our state. Compared to the average state, North Carolina relies disproportionately on income taxes biased against investment and sales taxes biased in favor of service industries. Judged by the standard criteria of broad tax bases, low marginal rates, and ease of compliance, North Carolina has the 8th-worst individual income tax and the 4th-worst sales tax in the United States, according to the Tax Foundation.

The states with the most favorable tax climates for investment and job creation don’t just have broader, flatter, fairer tax codes. They also tend to consolidate their taxes into fewer categories, a policy that reduces compliance costs and increases the amount of information voters have with which to hold their governments accountable. That is, eight states have sales but not income taxes, five states have income but not sales taxes, and New Hampshire has neither. Of those with both corporate and individual income taxes, eight states reduce the problem of double-taxing investment returns by either excluding some capital gains from the individual income tax or applying a lower rate. We do neither, a choice that when combined with our marginal tax rates gives North Carolina the 9th highest combined tax rate on capital gains, according to the American Council for Capital Formation.

Our goal ought to be to pay for most General Fund spending by taxing consumption. There are three different models to consider:

1. Phase out current income and sales taxes in favor of a flat-rate sales tax on all goods and services sold at retail. That means no individual or corporate income taxes and a state sales tax rate in the 7 percent to 8 percent range at current revenue.

2. Phase out current income and sales taxes in favor of a flat-rate income tax on all household income that is neither saved nor given away to charity. That means no state sales or corporate income taxes, and a consumed-income tax in the 7 percent to 8 percent range. (You’ll notice that the tax base for a consumed-income tax is essentially the same as that of a sales tax. After households save or give away some of their income, they spend the remainder on goods and services.)

3. Phase out only the corporate income tax and keep both income and sales taxes, reforming each to broaden the base and lower the rate. You’d probably end up with a state sales tax rate of about 3 percent and income-tax rates in the 4 percent to 5 percent range.

I happen to prefer the second option, which is sometimes called the USA Tax (for unlimited savings allowance). I like the idea of North Carolina taxpayers getting an annual state tax bill and preserving a simple federal tax deduction for itemizers, both features of an income tax. But any of the three would be a significant improvement over the current tax system, if structured and implemented properly.

We can’t do anything about the weather, but we can change North Carolina’s tax climate for the better. Let’s get started.

Hood is president of the John Locke Foundation.