Tax Reform Is About More Than Modernizing Outdated System

By Becki Gray, VP of John Locke Foundation and NC SPIN panelist, May 30, 2013

Tax reform has been discussed but not acted on for 20 years. This General Assembly and governor's office are committed to fixing a tax system that was set up the 1930s, when our economy was heavily dependent on agriculture and manufacturing. The tax code is outdated in a service-driven economy. In addition, over time we've seen carve-outs, exemptions, and special treatments resulting in an inequitable, confusing, and convoluted system that no longer works.

But cleaning up an outdated system is not the real reason we need tax reform. With the nation's fifth-highest unemployment rate (after California, Nevada, Mississippi, and Illinois) and high overall tax rates compared to our neighbors, we have fallen behind in competing for new businesses and expanding existing ones, resulting in an economy that is sluggish rather than robust. A more competitive, pro-growth tax system can spur economic growth and ensure long-term prosperity.

Senate leaders would broaden the state sales tax to more than 100 services not taxed previously while lowering the minimum statewide rate to 6.5 percent (from 6.75 percent). The Senate plan subjects virtually every consumer purchase to sales tax, including food and prescription drugs at the full rate. It lowers the personal income tax to a flat 4.5 percent (from top rate of 7.75 percent) and eliminates deductions such as the one for mortgage interest and the sales tax exemption for nonprofits. It phases down the corporate tax rate to 6 percent (from 6.9 percent). The Senate plan is a net tax cut of about $770 million over the first two years. But some families of low to moderate incomes, particularly those with several children, would pay higher rather than lower taxes under this plan.

House leaders would reduce the sales tax rate to 6.65 percent while also broadening the base -- but only to services sold by businesses that collect sales tax, such as retailers that sell both computers (taxable goods) and warranties (currently untaxed services). Like the Senate plan, the House plan flattens the income tax -- lowering the rate to 5.9 percent. It increases the per-child tax credit. It also caps rather than eliminates the mortgage-interest deduction. It caps the exemption for nonprofits at $5 million (affecting fewer than a dozen big hospitals and private colleges). The House cuts the corporate tax to 6.75 percent. The overall tax cut under the House plan would be about half that of the Senate plan over three years, and appears to be less weighted against moderate-income families.

Both plans lower the business franchise tax by 10 percent and abolish the state death tax.

Gov. Pat McCrory seems to be waiting to see what kind of compromise plan can be developed. Whatever the final tax reform looks like, it must have a few essential pieces. First, it should move toward taxing consumed income rather than total income (saved income should be taxed later, when it is spent on consumption). The plan should bring marginal tax rates down to spur economic growth.

Lawmakers don't have to abolish income-tax collection in order to move toward a consumption-based system. They can reduce the bias against savings and investment in other ways, such as offering unlimited, tax-free savings accounts, creating a lower tax rate for dividends and capital gains (as the federal tax code does), or further reducing corporate and franchise taxes.

Of course, tax reform is only one element of a long-term strategy for economic recovery in North Carolina. Reductions in spending, better delivery of services such as education, and less burdensome regulations must be part of the strategy, as well.