In 2013 the state of North Carolina passed and began implementing a program of sweeping tax reform meant to remove barriers to economic growth that were embedded in the state’s burdensome tax code. The reforms included instituting a broad-based flat-rate tax that resulted in a lower tax rate for every income group, some changes to the sales tax, elimination of the estate tax, and dramatic reductions in the state’s corporate income tax.
While these reforms made sense from an economic perspective and were likely to stimulate economic growth, there was some risk. Namely that, at least in the short run, they would also bring about unanticipated reductions in revenue to the state treasury, which would impinge upon the state’s spending priorities.
There was particular concern when it came to possible revenue shortfalls associated with proposed cuts in North Carolina’s corporate income tax, which at the time stood at 6.9 percent, by far the highest in the Southeast.
With the understanding that North Carolina’s corporate income tax, which in addition to its high rate was riddled with loopholes and special exemptions, needed a dramatic overhaul, the legislature came up with a way to deal with the revenue-related uncertainties. The ultimate goal was to reduce the rate to 3 percent, but because of the uncertainties regarding the revenues it was decided to put contingencies in place in the form of revenue triggers.
There would be an initial rate cut from 6.9 percent to 5 percent over the first two years, but additional cuts to 4 percent and then ultimately to 3 percent would be contingent on the state meeting certain revenue targets. The corporate rate would fall below 5 percent only if total revenues reached $20.2 billion in 2015 and $20.975 billion in 2016. After reaching that first target or “trigger,” the tax rate declined to 4 percent for this calendar year. The N.C. Department of Revenue announced last month that the state had met the second target or trigger, so the rate will fall to 3 percent in 2017.
At the state level sound tax reform, that is reform that will enhance economic growth, almost always involves some risk on the revenue side of the equation, particularly in the short run. In the longer run there may be a reasonable expectation that the reforms, if done properly, could actually enhance tax revenues because of expansions in the tax base brought about by increased economic growth.
Revenue triggers are being recognized as a way of smoothing the transition, allowing more certainty for lawmakers in the planning process. As the Tax Foundation has pointed out:
Well-designed triggers limit the volatility and unpredictability associated with any change to revenue codes and can be a valuable tool for states seeking to balance the economic impetus for tax reform with a governmental need for revenue predictability.
North Carolina is just one of many states that have decided to use triggers when making tax policy changes, each with their own particular approach, depending on the specific legislative goals. In fact, the Tax Foundation reports that over the last several years 11 states plus the District of Columbia have all implemented or are in the process of implementing tax policy changes that have, to one degree or another, depend on revenue triggers.
North Carolina should continue to look to this approach when considering future reform measures. In particular, an obvious next step for the state would be to reduce or eventually eliminate the capital gains tax, which penalizes investment and hinders small business expansion. Since reducing the capital gains tax will, like reducing the corporate income tax, lead to short-term reductions in state revenue, up to $500 million with complete repeal, a phase-in period based on revenue triggers would be a sensible approach.
Dr. Roy Cordato (@RoyCordato) is vice president for research and resident scholar at the John Locke Foundation.