Republican state senators want to make North Carolina’s income tax system more progressive.
Let me rephrase that statement, since senators have said little about progressivity when touting their tax plan. It’s more accurate to say that, regardless of intent, the Senate GOP’s proposed income tax changes would create a more progressive system. And that’s not a bad thing.
The most significant change in North Carolina’s income tax rate within the state’s larger 2013 tax reform package involved replacement of a three-tiered “progressive” income tax with a single flat tax rate. For those who spend little time with tax terminology, a short explanation might prove helpful.
A progressive tax does not take its name from its primarily left-of-center supporters. Instead the term “progressive” refers to the fact that as income levels rise, a progressively higher tax is applied to the income. At the federal level, the rate starts at 10 percent for married couples who earn up to $18,450 in 2015 and climbs to 39.6 percent for those who earn more than $457,600. Those in the highest income category pay seven different tax rates on different portions of their income. Only the amount earned above that highest threshold faces the highest rate. That rate is known in tax lingo as the “top marginal rate.”
North Carolina’s old system started with a 6 percent rate and topped out at 7.75 percent. Because most state taxpayers are also federal taxpayers, North Carolinians faced progressively higher tax bills from both Raleigh and Washington at higher income levels.
The 2013 state tax reform package did away with the state income tax tiers. Based on a desire for increased simplicity, and relying on evidence that lowering top marginal rates leads to stronger economic growth, legislators decided to institute a flat tax rate of 5.8 percent for 2014 and 5.75 percent for 2015.
Note that the new flat rate was lower than the lowest rate in the old progressive system. That reform created a lower income tax rate for all taxpayers. (That did not mean a lower tax bill for everyone. Along with lowering rates, legislators ended some exemptions and credits. Ongoing budget discussions this year involve tax tweaks that could restore exemptions for items such as medical expenses.)
Critics of a flat tax often complain that “the rich” — usually meaning “high-income earners,” a term that is not exactly synonymous with “rich” — should pay more. Those critics imply that all taxpayers pay the same amount of tax under a flat tax system. Since those with lower incomes have less money to spend, their tax burden is heavier.
That’s misleading. Under a flat tax, all taxpayers face the same rate — not the same amount of taxation. Without any credits or exemptions, the person who earns $300,000 pays 10 times as much in taxes as the person who earns $30,000. At a 6 percent rate, that’s $18,000 versus $1,800.
Even though the high-income taxpayer pays more — much more — than the taxpayer who earns less, the flat tax rate acts very differently than a progressive system. Each taxpayer surrenders to the tax man the exact same portion of his income.
Except that he doesn’t.
The simple example above omits all credits and exemptions. But that’s overly simplistic. The tax code builds in multiple ways to remove income from taxation. Since conservative reformers started working on tax reform in 2013, they’ve tried to eliminate many credits and exemptions that had favored or penalized particular types of behavior, just because some previous set of lawmakers favored or disliked that behavior.
Even with those changes, broad-based exemptions remain. Some have expanded along with the recent reduction in top marginal rates. For instance, lawmakers expanded the standard deduction. This is the amount of income excluded from any calculation of state taxes.
Those who support a higher standard deduction believe that taxpayers with the least amount of income should not have to pay the same rate as those with more income. In tax lingo, lawmakers are setting a “zero tax bracket.” One could describe the zero tax bracket as a way to build in progressivity without raising top marginal rates. Rather than raising rates on high-income earners, a higher zero tax bracket lowers rates on earners with the lowest incomes.
As the General Assembly lowered income tax rates in 2013, they also repealed a previously existing personal exemption while raising the standard deduction. For joint tax filers, the standard deduction jumped from $6,000 to $15,000. For heads of household, the number jumped from $4,400 to $12,000. For single filers, the number climbed from $3,000 to $7,500.
Let’s return to our example of the taxpayers earning $300,000 and $30,000. In this case, let’s consider two families of four. Once again, we omit consideration of all other credits and exemptions. For 2014, neither family paid any tax on the first $15,000 of income. The 5.8 percent rate kicked in for the next dollar. This means the family with $30,000 of income pays $870. That’s an effective tax rate of 2.9 percent. (Sorry for the additional tax jargon: The “effective” tax rate involves the simple calculation of the amount of taxes paid divided by income.)
The family with $300,000 of income pays $16,530. That’s an effective tax rate of 5.5 percent. Note also that the family earning 10 times as much income pays 19 times as much tax. Even with a flat-rate tax, the higher-income earner faces a much larger tax bill.
Once again, the example is simplified. Both families might take advantage of other credits and exemptions. In fact, our example of a family of four could mean tax credits for two children in both households. Based on another change conservative lawmakers enacted in 2013, an existing child care credit climbed from $100 to $125, but only for those joint filers making up to $40,000. In other words, our $30,000 family would get an additional $50 in tax breaks not available to the family with $300,000 of income.
That’s how the situation stands now. Under the Senate’s latest tax plan, the flat income tax rate would drop again to 5.5 percent in 2016. Senators also would raise the standard deduction gradually. By 2020, joint filers would pay no state income tax on their first $18,500 of income.
How would those changes affect our two families? Setting aside all other credits and exemptions, the $30,000 family would pay $632.50 in 2020, yielding an effective tax rate of 2.1 percent. The $300,000 family would pay $15,482.50, an effective tax rate just under 5.2 percent.
Note that that the higher-income family, earning 10 times as much income, pays 24 times as much state income tax. Even with a lower rate, the end result would be a more progressive tax distribution.
An astute observer might note that the higher-income family has a greater likelihood of taking advantage of other existing credits and exemptions than the lower-income family, so the gap between the two families’ tax bills might not be as large as presented in the examples above.
That might be true, but it’s not an argument against a flat tax rate. It’s an argument instead for ridding the tax code of as many targeted credits and exemptions as possible. For as the math shows, combining an economic growth-enhancing lower top marginal tax rate with a generous standard deduction yields a lot more progressive tax system than most people, even flat tax supporters, expect.
Mitch Kokai is Director of Communications for the John Locke Foundation.