North Carolina became more friendly to business over the past year, but still has a lot of room to improve, according to the Tax Foundation.
The Tar Heel state ranked 44th on the nonpartisan foundation’s State Business Tax Climate Index, making it the seventh-worst tax climate for business in the country. That’s better than last year, when North Carolina was ranked the fifth-worst. The state’s ranking improved because the General Assembly’s budget allowed two temporary taxes to expire. Gov. Bev Perdue wants to reinstate much of the revenue from those expired taxes.
The index, released Wednesday, is designed to assess the business friendliness of tax policy in each state based on principles of neutrality, simplicity, broad bases, and low rates. It evaluates the state in five categories: personal income taxes, corporate income taxes, sales taxes, unemployment insurance taxes, and property taxes, all as they relate to businesses.
North Carolina improved its ranking in 2011 because the sales tax rate fell from 5.75 to 4.75 percent and its 3-percent income surtax on people making more than $150,000 expired. Together, these changes improved the state’s rank from 46th to 44th for the 2012 fiscal year.
The budget by the Republican-led General Assembly allowed the taxes to sunset on schedule at the opening of the fiscal year July 1. Perdue vetoed the budget and wanted to keep 0.75 percent of the 1-percent increase in place. The legislature overrode the veto, but Perdue has said her final budget will include that 0.75-cent tax hike.
Even with the expiration of those taxes, sales tax and personal income tax are the two categories where North Carolina scores the worst.
While the 1-cent sales tax cut helped boost North Carolina’s score, the state still suffers from high sales taxes, said Tax Foundation economist Mark Robyn.
That’s because it allows localities to levy their own sales taxes on top of the statewide 4.75 percent. Local governments charge on average a little more than 2 percent, making the overall burden nearly 7 percent.
North Carolina also gets penalized for allowing local jurisdictions to define their own sales-tax base, meaning they get to decide what is and is not taxable.
“This creates two sales tax systems,” Robyn said. “You’ve got a state system with its own rate and its own list of things that are taxable, and you’ve got local tax systems — which can be different all around the state — each with their own rate and list of things that are taxable.”
“That adds a lot of complexity,” he said. “It’s a big compliance issue not only for brick-and-mortar stores, but especially for online stores.”
A state’s sales tax can hurt the business climate because as the rate climbs, customers make fewer purchases or seek out low-tax alternatives, Robyn writes in the report.
The effect of a higher sales tax rate is apparent when a traveler crosses city or state lines to go shopping, he continued. “Typically, a vast expanse of shopping malls spring up along the border in the low-tax jurisdiction.”
Individual income tax
The expiration of the 3 percent surtax on individuals making more than $150,000 per year also did a lot to help North Carolina’s business climate, Robyn said.
While North Carolina’s corporate income tax is pretty average compared to other states, its individual income tax is higher than most.
The individual income tax is important because about half of businesses aren’t incorporated and therefore report their income through the individual income tax code, Robyn said.
The number of individuals filing federal tax returns with business income has more than doubled over the past 30 years, from 13.3 million in 1980 to 30 million in 2009, he said. “Taxes can have a significant impact on an individual’s decision to become a self-employed entrepreneur.”
Another important reason individual income tax rates are critical for business is the cost of labor, Robyn said. Labor typically constitutes a major business expense, so anything that hurts the labor pool hurts business.
Laws of attraction
Evidence shows that states with simple, neutral, broad-based, low taxes will be the most attractive to new businesses, Robyn said.
Too often state lawmakers “are tempted to lure business with lucrative tax incentives and subsidies instead of broad-based tax reform.”
He cited North Carolina’s attempt to lure Dell Computers to the state with $240 million in incentives. Dell closed its plant after only four years of operation.
“Lawmakers create these deals under the banner of job creation and economic development, but the truth is that if a state needs to offer such packages, it is most likely covering for a woeful business tax climate,” Robyn said.
It’s more effective to improve the tax climate across the board, he said.
Sara Burrows is an associate editor of Carolina Journal.