As shoppers head out in droves today to exchange ugly ties for power tools, socks for underwear, underwear for socks, duplicative toys for redundant ones, and so on, it would seem a perfect time to review plans underway to change North Carolina’s sales tax.
Right now, all but a handful of local jurisdictions apply a combined 7 percent in state and local sales tax on the retail purchase of non-food goods. Several years ago, the state legislature removed non-prepared foods from the sales tax base, reversing a decision made in the early 1960s by then-Gov. Terry Sanford to tax groceries to fund school improvements. Now the Easley administration is considering a plan to broaden the sales tax again to include at least some services, which may stabilize the tax base and allow for a reduction of the sales-tax rate.
The first thing to realize about our sales tax is that while it is advertised as a “retail” sales tax, it really isn’t. A retail sales tax would apply only to goods and/or services purchased by end users. Our tax, however, is imposed on a variety of inputs purchased by businesses to produce retail goods and services. For example, we impose a 1 percent tax on manufacturing machinery (those ignorant of tax policy assume this is some kind of gift to manufacturers, when really the correct sales tax on such items, themselves used to produce taxable goods, should be zero).
By the way, this flaw in our code is why a often-cited problem in the sales tax isn’t what it appears to be. You’ve heard it – in fact, I’ve said it before, though with an apparently ill-fated attempt to make sure people didn’t misinterpret my point. If you buy a lawn mower at the store to do your own yard work, you pay sales tax. If you hire a service to do your yard work, you don’t pay sales tax. Because upper-income households tends to hire out rather than do their own services, the effect is to make the sales tax regressive, imposing a higher proportional burden on lower-income households. Yes, in theory. But in practice in North Carolina, we actually charge sales tax on the machinery and supplies that many businesses, including lawn services, use. So while it doesn’t appear that consumers of services pay a sales tax, there is an implicit sales tax embedded in the price they pay to the provider.
It would be better if consumers paid such taxes up-front, and businesses were allowed buy their inputs free of sales tax, using a card-based system. Unfortunately, such arrangements can be prone to abuse and attempts at household evasion (suddenly, everyone has a home-based “business” that requires the purchase of bleach, pet food, and batteries, you see). This is yet another reason why I remain opposed to “reforms” of the sales tax that attempt to broaden its base and lower its rate.
Let me be clear. In theory, this makes sense. It would reduce distortions in the tax code and make it roughly proportional, rather than either regressive or progressive. In practice, though, I see too many problems with reforming the sales tax to include services and exclude wholesale purchases and inputs. Among other things, I’d be worried that expanding the base, even if made revenue-neutral in the short run through rate reduction, would set taxpayers up for more costly tax increases in the future.
A better solution, and one that would not require inventing a new tax-collection system, would be to phase out our sales tax entirely over time – the Internet makes this an attractive option, anyway – in favor of reforming our income tax so that it taxes only consumption. That is, every year a household would tally up net income from all sources, then subtract net savings – the amount the household added to its bank accounts or investments minus what was taken out. The result, by definition, would represent the retail purchase of all goods and services that year. Apply a single, flat-rate tax to that, and you have a roughly proportional, easy-to-understand tax system that grows with the economy and allows for state taxes paid to be deducted from your federal income tax (something a reformed sales tax would not allow). Get ready to hear a lot of debate about North Carolina’s sales tax in the coming months. My present position is: end it, don’t mend it. Let me know if you disagree.