Is there a winner in the debate over taxes?

In discussing public policy, there’s few issues that create more debate than taxes. This is because taxes are linked to several complementary issues that are also controversial. When you talk about taxes, you don’t get one debate, but several debates. Among them are questions about fairness, income distribution, simplicity, economic growth, and funding of public programs. 

North Carolina is an ideal state to examine questions about taxes. With the divided government we’ve frequently had at the state level in recent years – meaning the General Assembly is controlled by one party with the Governor of the other party – debates about taxes are typical. So let me delve into the multiple issues tied to taxes and let you make the decisions about winners and losers.

The debate over fairness in the tax system is one of the most contentious. The fairness issue is most readily seen in the question about tax rates, especially tax rates on income. Should all households pay the same tax rate on a dollar of income, regardless of their total income? Those who agree would call this a “flat” or “fair” tax rate. Or should households with more income pay a higher tax rate than those with lower income. Supporters call this a “progressive” tax system. 

Currently, North Carolina has a flat personal income tax – meaning the same rate for all households regardless of their income. The federal government has a progressive income tax system, with higher tax rates applied to brackets of higher income. Of course, there’s continuous discussion of the range of the income brackets and the level of the tax rates.

There’s a direct link between the question of tax rates and the issue of income distribution. Some advocate using the tax system as a way of re-distributing income, that is, transferring income from higher-income households to lower-income households. One simple way of doing this is to tax the income of upper-income households at higher rates, and tax the income of lower-income households at lower rates. 

Automatically this makes higher-income households pay more tax per dollars of income than lower-income households. Advocates of spreading income more equally across households would applaud this tactic, while opponents counter the tactic punishes accomplishment.

The question of simplicity in the tax system is part of the discussion about tax rates. But there’s more to the issue, mainly revolving around the idea of deductions. Deductions are offsets to income occurring when taxpayer spend their money is a certain way.

For federal and North Carolina income taxes, all taxpaying households can take a “standard deduction” based on the number of people in the household.  But most other deductions, both for businesses and households, are based on specific kinds of spending. One of the largest household deductions is for the interest a homebuyer pays on their mortgage.  Renters receive nothing comparable. Another example is federal tax credit – which is worth more than a deduction – buyers of electric vehicles can take. 

These offsets to taxes have been questioned on two points. First, they complicate the tax system, often making taxes – especially income taxes – hard to understand. And if something is not easily understood, it can create attitudes that the system is manipulated to favor certain groups.

Second, the tax offsets can seem unfair, since they only come with the “catch” that the household or business spends money in a certain way.  The broader question is whether government should be giving tax favors to people who make certain kinds of expenditures. But in response, supporters of the deductions and credits say they are justified if people are motivated to make expenditures that help broader public purposes.

Economists have long recognized that taxes can impact the economic activities of both businesses and households. Taxes can hinder the economy by taking away funds that could be used for business expansion, investment in the private sector, or simply personal spending that can make households happy.  If tax rates are very high, they can also reduce the motivation for a person to work or a business to expand.

Yet at the same time, taxes are needed to fund the functions of government, such as public safety, transportation, international protection provided by the military, the court system, and others. There can be a healthy debate about the degree of need for these functions, but collecting tax revenues is the only alternative to borrowing if some level of government programs is to be provided.

Interestingly, economic research has long shown that higher tax rates are not necessarily the way to provide more funding for government programs. Research by some economists has  shown that raising tax rates may deter enough work and investment as to result in lower tax revenues. Reducing tax rates may do the opposite – encourage enough additional work and investment so as to increase growth in the economy and generate larger tax revenues. There are ongoing efforts by researchers to find the “best tax rate” that provides the most tax revenue.

Taxes are both controversial and complicated. Hopefully I’ve exposed and explained the areas of disagreement. And since I’ve addressed many issues, I’ve left you with multiple “you decides!

Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.