Waiting for the progressives’ cheers
The word “progressive” takes on different meanings when applied to politics and taxation.
Still, those who label themselves progressive politically are more likely than their conservative counterparts to support progressive taxation.
That’s why it has been somewhat disappointing that progressives have remained relatively mute about one of the most striking aspects of North Carolina’s recent tax reforms. It’s a reform that builds more progressivity into the state’s income tax.
The adoption of a flat personal income tax rate represents one of the most significant reforms in recent N.C. political history. The General Assembly and then-Gov. Pat McCrory agreed in 2013 to replace a three-tiered income tax system with a single flat rate.
Yes, it’s a flat tax.
The state replaced a “progressive” tax system — labeled that way because of its progressively higher tax rates at higher income levels — with one rate. Moreover, the new rate (5.8 percent) was lower than the lowest rate (6 percent) in the old progressive system.
Taxpayers at every income level saw a cut in their personal income tax rates.
Conservatives typically praised the reform. They noted the obvious benefits for individual taxpayers, along with the academic research that suggested a likely positive impact for North Carolina’s economic growth.
Yet the idea met with widespread criticism from political progressives. They lamented the end of a system that ratcheted up tax rates as people earned higher incomes.
Buried by the debate about the merits of a flat tax rate was another tax reform that could have generated at least reluctant praise from progressives. Along with the lower flat rate, policymakers also exempted more income from taxation. They accomplished this goal by raising the standard deduction. This is otherwise known as raising the “zero tax bracket.”
Before the 2013 tax reform package, married couples filing jointly could deduct the first $6,000 of their income from the first tax rate that kicked in at 6 percent. A head of household removed $4,400 of income from taxation, while a single taxpayer saw a standard deduction of $3,000.
The tax reform package more than doubled those numbers. By 2016, married couples faced a standard deduction of $15,500. The numbers stood at $12,400 and $7,750 for heads of household and single filers respectively.
The deduction grew again this year, to $17,500, $14,000, and $8,750 for the three categories of personal income taxpayers.
And state senators want to exempt even more income from the tax. Their Billion Dollar Middle Class Tax Cut Act would place another $2,500 of a married couple’s income out of the hands of the tax man, with a standard deduction of $20,000. The deductions for heads of household would climb to $15,000, while a single taxpayer would enjoy a standard deduction of $10,000.
These changes are taking place as the single flat tax rate falls. Since the initial decision to scrap the three-tier tax system, the rate has fallen from 5.8 percent to 5.75 percent to 5.499 percent for this tax year. The Senate plan would lower the rate again to 5.35 percent.
I’ve thrown a lot of numbers at you and at least a couple of moving parts: the shrinking tax rate and the growing size of the standard deduction. An example might help explain how these changes end up making the tax system more progressive.
Let’s apply a flat 5.8 percent tax rate to income from married couples earning $40,000 and $400,000 of annual income. (To avoid even more complication in this column, we’ll set aside for a moment all other deductions and credits, including the additional benefits the state tax code provides lower-earning families with children.)
With no standard deduction, the first couple would pay $2,320 in taxes. The second couple would pay $23,200 — 10 times as much. Both couples would face an effective tax rate of 5.8 percent.
Now let’s keep the tax rate constant but add in the current standard deduction of $17,500. The first couple now sees its tax bill lowered to $1,305, while the second couple now pays $22,185. Notice that the effective tax rates drop to less than 3.3 percent for the first couple and 5.5 percent for the second couple. The second couple also pays 17 times as much state income tax as the first couple, despite earning 10 times as much income.
What would happen if the Senate plan moves forward and the deduction grows again? The first couple would pay $1,160 and face an effective tax rate of 2.9 percent. The second couple would pay $22,040 with an effective tax rate of 5.5 percent, just a touch smaller than the rate the couple faces under current state law. The second couple would pay 19 times as much tax as the first.
Repeat this exercise with the proposed 5.35 percent tax rate in the Senate plan. With no standard deduction, our hypothetical couples pay $2,140 and $21,400. Once again, the higher-earning couple pays 10 times as much, and the couples have the same effective tax rate.
With the current standard deduction, our two couples pay $1,203.75 (3 percent effective tax rate) and $20,463.75 (5.1 percent). The second couple again pays 17 times as much in state income tax. Under the Senate plan, the couples would pay $1,070 (less than 2.7 percent effective tax rate) and $20,330 (less than 5.1 percent). The second couple would pay 19 times as much in actual taxes.
It’s clear that the higher standard deduction leads to benefits for both couples, but the effective tax rate falls to a much greater degree for the family with less income. As the standard deduction grows, the difference in tax bills between the two couples widens to the lower-earning couple’s benefit.
Without introducing higher marginal tax rates that discourage investment, the state still ensures that higher earners pay a larger share of their income in taxes. In other words, increasing the standard deduction boosts the progressive nature of the state tax code.
It’s a pity political progressives say so little about it.
Mitch Kokai is senior political analyst for the John Locke Foundation.