North Carolina was among the hardest hit states in the 2001-02 recession, for a variety of reasons. An investment-led event from the start, the downturn has now become an upturn, but only modestly. Businesses and entrepreneurs are not buying many new machines, they are not forming much capital for new enterprises, and they are not hiring many new workers.
In short, they are not taking many risks.
In this sense, economic actors are not different from their movie counterparts. If you want them to take risks, like doing their own stunts or staring in hard-to-market films, you have to offer sufficient compensation. There has to be a return that makes the risk worth taking.
The Bush administration understand this. The president is poised to offer a new package of tax cuts aimed at eliminating distortions in the tax code that favor debt over equity, bonds over stocks, and tax shelters over job-creating investments. Bush’s so-called “Five Easy Pieces” will reportedly 1) reduce or eliminate the double-taxation of corporate income by making dividends tax-deductible, 2) expand tax-free savings accounts, 3) speed up scheduled reductions in marginal income-tax rates, 4) reform the way businesses write off major capital improvements, and 5) reform the way investors can write off capital losses.
These are all sound ideas, economically and politically. The goal should be to fashion a tax structure that increases the real expected rate of return on investment, thus helping the economy to build capacity for the next round of technology-led economic growth. This doesn’t mean tipping the balance in favor of investment over consumption. Only producers and consumers have the appropriate information to select this balance for themselves. The current tax code, however, is strongly biased against capital formation. The Five Easy Pieces will work together to reduce this bias.
On a political level, the Bush program is aimed at attracting and keeping the votes of the new investor class whose 401(k), IRAs, and pensions have gotten wobbly since the Clinton-Easley crash in the stock market (remember when it began: at the point that the former president’s mindless lawsuit against Microsoft, which our own attorney general joined, got going). Some one should write a book about how Investor Politics has the potential to transform the political landscape. . .
North Carolina has a lot to gain from these developments. While our average tax burden is near the national median, our tax code is among the worst in the United States in its treatment of investment and entrepreneurs. This is because we now have one of the highest marginal tax rates in the country on high-value entrepreneurs (8.25 percent), no lower rate for capital gains (the correct, neutral rate is zero), and a relatively high corporate income tax at 6.9 percent. Layered on top of the federal rates, our tax system guarantees that when all other factors are equivalent, investors seeking the highest after-tax rate of return will choose to put their money — and themselves — in Virginia, Georgia, Florida, Texas, etc.
Given the talk around Raleigh about budget deficits and tax “reform,” which ain’t, the prospects of our own politicians addressing North Carolina’s investment deficit seem dim. The good news is that any federal changes to the income-tax base in 2003 will turn into a bill before the state legislature to “conform.” As was the case last year, we might see hundreds of millions of dollars in needed tax relief submitted pretty much automatically to state leaders for an up or down vote. It should be a clarifying moment.