RALEIGH – During the past couple of years of recessionary budgets, revenue collections have repeatedly fallen short of projections. For North Carolina lawmakers and budget officials trying to avoid major reductions in spending that would anger their constituencies, one of the few bright spots in the revenue picture was a series of surprising gains in corporate-tax receipts that somewhat offset other losses.
The new revenue didn’t come in because of upswings in profits. Rather, the state Department of Revenue implemented changes in how it computed and collected corporate taxes, including the handy tool of a special penalty on firms that, in the department’s view, had deliberately rearranged their finances to evade their tax liability.
The state used the prospect of the fine to “encourage” corporations in tax disputes to settle their cases. Think of Guido spelling the flower in his lapel before expressing his heartfelt concern about your continued safety in his neighborhood, and perhaps you’ll get a clearer picture of how the process worked in practice.
North Carolina business leaders had been complaining about the Perdue administration’s tactics for months leading up to the start of the 2010 legislative session. While taxpayers with unmistakable liabilities obviously have a responsibility to pay them, and other measures to increase tax compliance received widespread support, the corporate income-tax code is complex enough that there are honest differences of opinion about what particular firms owe the state.
To allow Revenue officials to levy penalties on the basis of their own impressions of the intent of corporate officers was unjust. I like the way Sen. Dan Clodfelter, a Mecklenburg Democrat, explained the problem. “We don’t do that to any other taxpayer,” he said. “That would be the equivalent of saying to somebody, ‘I’m going to really fine you a stiff fine for speeding, but I’m not going to post the speed limits.’”
The truth is that any officer of a corporation that fails to structure his business under the law to maximize profits and minimize tax liabilities is in violation of his legal and ethical responsibility to his shareholders. The power to distinguish between sound financial management and defrauding the state of taxes legally owed is not a power that the Department of Revenue should enjoy, given its clear financial incentive to see bad faith.
Furthermore, state officials have no grounds for complaining about people making business decisions in response to incentives created by the tax code. That’s what state officials want businesses to do. In fact, every year the General Assembly enacts or amends its tax laws with the express intention of tipping corporate decisions one way or the other. Lawmakers create tax breaks for favored activities and levy punitive taxes on activities they want to discourage. They try to steer firms into distressed counties or influence investment in new jobs, plants, or research and development.
Going into the 2010 session, then, the battle lines were drawn. Business lobbyists wanted the Department of Revenue to lose its asserted authority to levy special tax penalties. Revenue wanted to keep it. At the end of the session, lawmakers split the difference. They agreed to codify the use of the penalties – but only after the department publishes a guide for corporations telling them in detail how to comply with North Carolina’s corporate-income tax.
Was the irony lost on state tax officials? Probably. That’s what makes it so revealing.
The best long-term solution is to get North Carolina out of the business of levying a separate and inherently complicated tax on corporate income. There is nothing magical about income passing through an incorporated business. Just like any other form of income, it has no value until it reaches an actual person. States will always create biases and perverse incentives as long as they tax income at the corporate level and then tax it again when it is received as wages, dividends, or capital gains.
Fundamental tax reform is the only final solution to the problem. In the meantime, at least, North Carolina businesses will no longer be punished for failure to comply with rules the state neglects to publish.
Kafka, call your office.
Hood is president of the John Locke Foundation.