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Friday Interview: Real Tax Reform for North Carolina

Tax Foundation expert offers ideas to boost state's competitiveness

State Senate leaders broached the idea this year of launching a major overhaul of North Carolina’s tax system. The idea fell by the wayside during budget negotiations, but some lawmakers have expressed interest in pursuing tax reform in the months ahead. Early in the budget process, Joe Henchman, tax counsel and director of state projects for the Tax Foundation, discussed reform ideas with Mitch Kokai for Carolina Journal Radio. (Click here to find a station near you or to learn about the weekly CJ Radio podcast.)

Kokai: You have followed North Carolina’s tax system very closely now for a while, and I understand you have looked at what the state Senate has proposed [in its initial plan] in terms of changing, reforming the tax system. Are they looking at good ideas or not?

Henchman: Well, at the Tax Foundation, we have sort of the big-picture approach of being able to look at what’s going on in a number of different states, as well as the ability to sort of apply broad principles of tax policy to specific legislative proposals. Generally, our advice is, you want to look to broaden your base and lower your rate as much as possible, and there’s nothing partisan about that. Any economist and analyst will tell you that that’s sort of the ideal that you want to go for on tax policy.

So to the extent that the legislative proposal will broaden base and lower rates, it’s heading in the right direction. Unfortunately, it doesn’t look like it’s broadening bases enough. It’s leaving out a lot of politically popular services. It’s leaving a lot of politically popular credits, and by doing that, that prevents them from lowering rates that much. In fact, it’s a net revenue increase of $1.2 billion over the biennium, which means that it’s actually not lowering rates all that much, even with the broadening of base.

Kokai: There’s been a lot of discussion on that point in particular, that as the Senate went forward with this process, one of the goals at the outset was to raise revenue. How does that skew the whole process of reform, when you know at the outset that we want the end result to be $500 million a year higher than what we had before?

Henchman: Well, it makes it very difficult, especially if you don’t have consensus on that being the goal. Because, ultimately, you need to ask how big should North Carolina’s government be, and what should it be spending its money on? And if people disagree on that, then any compromise down the line isn’t going to be effective because people are going to disagree with its basic goals. Now, when you’re looking at how big the government should be and you finally decide — and you want to decide how to pay for it — you have to look at what’s the best way to raise that revenue in the least distorting way. Because you went at it with the intention of raising revenue, you’re not going to be able to get a consensus on what to get rid of.

You have all of these credits and deductions and exempt things in your sales and income and corporate tax — and the proposal gets rid of a lot of them, and that’s laudable. But because it doesn’t lower rates, you’re not really giving people sort of the great, golden choice of, get rid of these goodies that you’re getting, and in return you’ll pay a lower rate. Instead, you’re saying get rid of your goodies and pay a higher rate. Very few people are going to take that choice, so it might not be effective to get good tax reform passed that way.

Kokai: So the idea is that if you’re going to make people give up something that has benefited them in the past, they really need to get something good in return, and we’re not getting that with this package.

Henchman: I think so, yes. That’s sort of how the 1986 federal tax reform managed to get through, and we’re already seeing some pushback here in North Carolina. I understand a lot of the beneficiaries of these credits — the hospitals and some of the various service industries — are already complaining about this legislation, and it may end up being the death knell of it.

Kokai: We talked about some of the problems with the Senate’s plan. If we wanted real tax reform in North Carolina, what would the Tax Foundation recommend that we look at?

Henchman: Well, we at the Tax Foundation don’t endorse any one particular tax reform proposal. There are a lot of great ideas out there and a lot of different ways to get there, and it’s sort of a conversation that North Carolina has to have on its own. Should you have a flat income tax with no sales tax? Should you have a broad sales tax with a low rate, or none at all? Should you get rid of your corporate income tax, which is one of the worst ones for long-term economic growth? Should you tax the capital gains at a lower rate, since they’re so mobile? And of course the bigger question of how much should government spend each year?

These are questions I hope North Carolinians will take this opportunity to debate this year. Right now, a lot of your troublesome, volatile revenue sources are at their lowest ebb. This is the perfect opportunity to reduce your reliance on them for the future so that once this recession is over, North Carolina will be poised to be a strong regional, national, and international competitor, and lay the groundwork for long-term economic growth.

Kokai: Let’s explore that a little more. You’re saying that some of the taxes that are most distorting or worst for the functioning of the economy, are bringing their lowest amounts of revenue right now, so it’s a good time to get rid of them.

Henchman: Yeah, and this isn’t just in North Carolina; it’s all over the country. Taxes like taxes on capital gains, high income, or taxes on high-income earners, and taxes on corporate income, they yo-yo pretty strongly. When times are good, they’re rising very dramatically, and when times are bad, they fall pretty dramatically. More so than other stable, less volatile … tax sources. Right now, this year, 2009 and 2010, will be the year that these are at their lowest point, so when it comes to the pain of having to give up — you know “give up the revenue” — in order to get rid of these taxes, this is the best opportunity to do that. And then, once we get out of this, the current economic decline, you’re poised to do well and have a stable tax system for years to come, one that doesn’t have these huge … spending runups that lead to budget shortfalls.

Kokai: One of the things that you mentioned at the outset was the general idea of broadening the base and lowering the rate. Senate leaders, when they unveiled their tax package, they used that same terminology and especially applied it to their idea of expanding the sales tax to more services. Why does their plan not fall into this generally good idea of broadening the base and lowering the rate?

Henchman: Well, they don’t meet what they promise to do. The ideal sales tax should tax all consumption once and only once. It should tax services as well as goods, and it should not tax business inputs and manufacturing, because consumers will pay the sales tax on the final product when they buy it. Taxing at the production stage just means there’s double taxation. The [original] Senate legislative plan keeps taxes on inputs like that, and it doesn’t even extend the sales tax to all that many services. The big ones, the big politically popular ones — legal services, medical services — they would still remain untaxed.

And every time you carve out something from the sales tax, it means the rate on everything else has to be that much higher. So, my response would be that it doesn’t go far enough, and the danger with that is you would be in a situation like some other states have faced, where they draw up this list of services, a small list of services, and the special interests just pick over it, and you end up extending the sales tax to nothing at all.

Kokai: At the outset of the interview, I mentioned that one of the ideas that was used in touting this tax plan was that it would make North Carolina more competitive because some of the marginal rates would go down a bit. Based on your investigation of other states, would North Carolina’s changes, if they go forward as planned, make much of a difference in competitiveness with Virginia, South Carolina, Tennessee — our neighboring states?

Henchman: Well, every year the Tax Foundation looks at state tax burdens as well as state tax structure. Our look at structure is the State Business Tax Climate Index, which listeners can look at, at taxfoundation.org. And in our 2009 index, North Carolina came in at 12th worst in the country, and the worst in the South, in terms of business tax climates. There are a lot of possible ideas of how to improve that. I don’t know how exactly the current package will achieve that. Certainly it’s going to change, too. The product that we see right now will probably be different by the time this airs, and probably be very different by the time it passes the legislature.

But what North Carolina needs to do is something dramatic, something with really big umph to draw entrepreneurs and people with ideas from other states, people who are looking for where to settle. There are a lot of smart, young people who’ve lost their jobs in New York and all over the country who are looking to the place to go, and North Carolina is in the running. It just needs some big draw. Getting rid of one of your major taxes, or doing something dramatic with slashing rates, might be the way to do it.