Opinion: Daily Journal

Reform That Doesn’t Sell

RALEIGH – For as long as I have been in the state-policy mix in North Carolina, the political class has been arguing for sales-tax reform.

Back in 1990-91, when it was evident to then-Gov. Jim Martin and legislative leaders that the state budget was moving into the red, some lawmakers began pitching the notion of expanding the scope of the sales tax to include services. Little has happened since, despite years of jawboning, editorializing, commissioning studies, commissioning commissions, and repeated increases in the sales-tax rate.

The fact of the matter is that the political appetite is entirely lacking for any major increase in the sales-tax base to include the fast-growing sectors of the economy such as health care, education, or high-dollar personal services. All the legislature seems to be able to muster any enthusiasm for is picking off industries with the least political power – by sticking it to barbers, auto mechanics, masseuses, and interior designers, as well as their customers (the real incidence of sales taxes is borne by both ends of the transactions to varying degrees).

The obsession of North Carolina’s political class with sales-tax reform is hardly unique. As Governing reports in its April edition, taxing services is a cause championed by lawmakers and activists in dozens of state capitals. A few states, such as Hawaii and New Mexico, have a pretty broad sales-tax base already. A few others have already extended the sales tax to more services than we have in North Carolina. In general, however, the history of sales-tax debates outside our state is similar to our own: lotsa talk, little action.

There is a long list of reasons why sales-tax reform tends to run aground. Some are silly. Some are legitimate. Some are, in my mind, utterly persuasive, which is why I abandoned the idea long ago.

Governing explains one of the most important, and technical, flaws with simplistic sales-tax reforms this way:

Taxing services raises the danger of what’s known in the tax world as “pyramiding.” A food-processing plant, for example, might have to pay a sales tax for the accountant who handles its books, the mechanic who fixes its machines and the exterminator who kills its bugs. These levies add up, creating a “pyramid” of hidden taxes that raise the cost of doing business for industries that rely on service-intensive processes for their production.

Pyramiding can have all sorts of unintended consequences. For example, a state starts imposing a tax on legal services. Businesses would then have an incentive to keep lawyers on their staffs to avoid paying the tax, rather than hiring outside help. The fear is that these sorts of incentives will lead to businesses being structured to avoid taxes, not to operate as efficiently as possible. “Every public finance expert in the world,” says David Brunori, a law professor at George Washington University who studies state tax policy, “will say you should not impose taxes on business purchases.”

Every “expert” in the world, that is, except certain left-wing activists who don’t seem to understand why it is not only reasonable to exclude North Carolina businesses from paying sales tax on their purchases, but is actually required by basic principles of tax fairness and efficiency.

My own view is that North Carolina should, indeed, rely on a simple, broad-based consumption tax to pay for most government services. However, I don’t think we need to do that through the existing sales tax imposed on retail transactions. Instead of trying to rescue and expand that tax, which is threatened by the proliferation of online sales among other trends, my preference would be for North Carolina to phase out its retail sales tax in favor of a reformed tax on consumed income.

Currently, North Carolina’s income tax hitchhikes on the flawed federal income tax, while applying multiple rates based on income thresholds. What we should do is impose a flat marginal tax rate on all income above a personal or family exemption, after first allowing taxpayers to subtract their net savings and charitable contributions for the year. Any income a taxpayer doesn’t save or donate is, by definition, consumed, so the tax base of a consumed-income tax is precisely the same as that of a broad-based retail sales tax – only the former is actually easier to administer.

That’s the system North Carolina should adopt. Instead, our politicians will continue to talk up a sales-tax reform that we not only aren’t going to adopt but shouldn’t.

Hood is president of the John Locke Foundation.