North Carolina’s franchise tax is a punitive and opaque tax levied on businesses organized under one of the usual corporate forms, primarily C-Corps and S-Corps. It is inconsistent with both good economics and good government. Most of the problems associated with the corporate income tax are also present in the franchise tax. But it goes a step further by taxing what tax analysts generally agree should be exempt from taxation and as a result it double taxes business assets. At present, only 16 states, mostly in the Southeast, still have a franchise tax.  Ideally, North Carolina should follow the lead of most other states and abolish the tax.

Conceptually the franchise tax is quite simple. It is a tax on the net value or worth of corporations with operations in the state. Net worth is defined as a business’s total assets minus its total liabilities. The rate of taxation for C-Corporations is $1.50 per $1,000 of net value with a floor of $200 that no corporation, no matter how small, can escape. For S-Corps it is $200 on the first million in net value and then $1.50 for each thousand after that. (See NCDOR) The tax is capped at $150,000 or $1,000,000 in valuation.

What North Carolina calls a “franchise tax” is, in fact, a corporate tax placed on top of the existing corporate income tax. The difference is that it is not levied on business income but on the value of its assets, that is, how much it is worth and not how much it earns. What this implies is that expenditures that are deductible from the corporation’s income, ultimately end up being subject to taxation under the franchise tax.

A standard principle of taxation is that expenditures made on plant and equipment meant to generate income should be fully deductible from corporate and other business income, and, in fact, they are.  The franchise tax is a back-door method allowing the state to tax the value of these purchases after the fact.

Imagine that a construction company purchases a bulldozer. When the company goes to pay its income tax, this bulldozer is a deductible expense. But once the purchase is made, the bulldozer becomes part of the company’s stock of capital equipment and therefore part of its asset base. When it is purchased, the value of the bulldozer is deducted under the corporate tax. But once the firm owns it, that same value does get taxed year after year under the franchise tax. This is not only bad economic policy but an underhanded way of taxing something that shouldn’t be taxed at all.  It is also a way of decoupling a business’ tax liability from how well it performs economically. Even in bad years, when the company might be losing money, the state will still require it to pay this tax on its previous asset purchases.

Viewed in conjunction with the corporate income tax, this is clearly a case of double taxation. It makes no difference that the revenue that went into purchasing the asset is fully deductible under the corporate income tax. The value of the asset (the bulldozer in our example) to the company comes from the fact that it generates future income, and this will be reflected in the assessed valuation of that asset at any given point. That income will be taxed as part of the corporate income tax.

As such, the corporate income tax reduces, i.e., taxes the value of the asset. So, to tax both the asset and the income that it generates is, in fact, double taxation. The value of the asset is reduced twice. The franchise tax not only discourages investment in the accumulation of assets, it is also punitive. As the Tax Foundation notes in their critique, “taxing a company based on its net worth disincentivizes the accumulation of wealth, or capital, which can distort the size of firms and lead to harmful economic effects.”

If North Carolina eliminated its franchise tax, or what the Tax Foundation calls its “capital stock tax,” its ranking in the Tax Foundation’s “state business tax climate index” would improve from 12th in the nation to 11th and in their sub-ranking for property and wealth taxes the state would move from 33rd to 16th.

Maybe the most pernicious aspect of NC’s franchise tax is its implications for honest and transparent government. It is a hidden tax whose burden is not borne by the businesses upon which it is levied but instead by its customers, employees, and shareholders.

As I have noted in several previous analyses, legal entities like corporations don’t pay taxes. People do. The franchise tax, like all taxes, must come out of the pocket of real people. When the franchise tax is levied, who pays it? Certainly, it is not paid by the legal entity known as the corporation. Rather, customers will pay in the form of higher prices, employees will pay in the form of lower wages, and shareholders will pay in the form of smaller returns. But none of these people actually see a bill labeled “franchise tax.” It is a completely non-transparent tax and is therefore inconsistent with principles of good government.

For citizens to know what government is costing them, they must be made keenly aware of how much they are paying in taxes. Obfuscating these costs by using forms of taxation like the franchise tax and the corporate income tax works well for politicians who want constituents to believe that they are getting something for nothing. On the other hand, it is a great disservice to the residents of the state who, as voters, need to be as informed as possible.