Friday Interview: Flat-Rate Consumed Income Tax Would Promote Growth

North Carolina could promote economic growth and wealth creation by replacing its existing personal income tax with a flat-rate consumed income tax. That’s the assessment of Dr. Roy Cordato, economist and John Locke Foundation vice president for research and resident scholar. Cordato discussed the issue with Donna Martinez for Carolina Journal Radio. (Click here to find a station near you or to learn about the weekly CJ Radio podcast.)

Martinez: Why does North Carolina need to replace the current system?

Cordato: Well, our current income tax — and it’s not just our income tax, it’s the federal income tax also — has a built-in penalty, really a double taxation, of all kinds of returns to investment and entrepreneurship and saving — the things that generate economic growth. There’s a particular penalty with regard to those things. In addition to that, it penalizes work effort and people’s efforts to accumulate what’s called human capital — namely education, those kinds of things, so they can earn more money and be more productive in their job.

So it penalizes a whole group of activities that are responsible for economic growth and job creation. What I want to do is reform the tax to — if not completely get rid of some of those biases, which I would argue is probably impossible to do and still have a tax code — at least ameliorate them, make them less obtrusive and less onerous.

Martinez: Before we talk more about your recommendations, explain double taxation.

Cordato: It’s essentially the idea that in our tax code and in the federal tax code also, when you place a tax on, let’s say, a certain amount of income, $100 worth of income — let’s say you place a 10 percent tax on that — well, you reduce that $100 to $90. Now you have $90 to spend. And if you spend it on a stereo, you get the full $90 worth. But that 10 percent tax also reduced not just the amount you could spend, but it also reduced the returns to saving. So when you went to save the $100 — let’s say you had a 10 percent interest rate — you would have earned $10 on that. With the tax, you reduce it to $90 and you would earn $9. So that tax reduced the returns to savings, or the interest that you would receive.

Well, in North Carolina and in other places, that interest also gets taxed. So you’ve reduced it once by the initial tax, but then it gets reduced again when you tax it. So in North Carolina, for example, with our top income tax rate of 7.75 percent, well, that actually ends up reducing the returns to saving and investment by about 15 percent, not just 7.75 percent, because those returns are reduced twice. So that adds this penalty to investment and saving and the things that drive and generate economic growth and job creation.

Martinez: Your plan is to scrap the system you’ve just described and replace it. With what?

Cordato: It’s called a flat-rate consumed income tax. “Flat rate” simply refers to the idea that in North Carolina, we have what’s called a progressive rate tax system or tax structure where, as your income goes up, the tax rate that you pay goes up, up to a top rate of 7.75 percent.

Martinez: So the more you make, the higher you’re taxed.

Cordato: The higher your rate is. Under the plan, under the flat rate, you still pay more the more you make, but it would be a constant rate applied. This takes away the penalty for simply trying harder to earn income. The current rate structure penalizes people because they want to go out and earn more income. So if you do, you get hit with a higher tax rate. Well, we should take that away. We should want people to be more productive. On the other side of the tax is what’s called the tax base. The way the base is currently structured, where you tax both the principal and the interest, you double tax returns.

A consumed income tax treats all saving like an IRA does. What that means is you can exempt from tax everything you put into saving and investment so long as it stays in saving and investment. But when you take it out to spend it on whatever it is you want to spend it on — could be a new stereo, a new car, whatever it is — if you take it out of saving and investment, then both the principal and the interest [are] taxed. And that’s the way an IRA, for example, is treated. Except with an IRA you have a penalty for early withdrawal. So this would not have a penalty for early withdrawal. Whenever you withdraw it, you get hit with the tax, and if you reinvest it, you’re not taxed.

Martinez: Let’s talk more about the progressive nature of taxation. You would do away with that.

Cordato: Uh-huh.

Martinez: But critics of a plan like yours say it’s the progressive nature of the tax code that makes it “fair.”

Cordato: Yes, they would say that. Actually, I disagree. I don’t think it’s particularly fair to tax people who are more productive in society more, or to tax them at a higher rate. In fact, I think that’s distinctly unfair. There’s nothing fair about penalizing productivity, and that’s what a progressive tax system does.

Now, if for political reasons you have to keep some form of progressivity in the system, what I suggest in my paper is that instead of increasing the rate — what’s called the statutory rate — increasing it from 6 percent all the way up to 7.75 percent as your income goes up, you keep that rate the same. But what you do is, you have a large personal exemption, a large zero tax bracket at the bottom.

What that does is, as incomes go up, let’s say you exempt the first $20,000 of income from any taxation at all. Well then, as your income goes up above $20,000, on average you will be paying a higher percentage of your income in taxes, and that would add progressivity to the system, if in fact that’s what you want. As I said, I don’t buy into that notion of fairness. I think what is unfair is to penalize work, effort, and productivity.

Martinez: Roy, why is it we seem to have a view in society today that somehow people who invest their money rather than spend it on buying groceries, that somehow they deserve to pay a higher rate of tax? Where did that come from?

Cordato: I think there’s an anti-capitalist mentality. They use the term “unearned” income — unearned meaning you’re not swinging a hammer. But the fact is that strategic investment is an art. Knowing where to put your money has important social benefits because what you are doing is you are using your sensibilities to direct resources to their highest-valued use for society. That’s not something that should be penalized.