Tax reform needs a clear goal

While the North Carolina House and Senate continue to discuss how — or whether — to resolve their budget dispute and enact a new fiscal framework for the next two fiscal years, now is an excellent time for tax reformers in both chambers to spell out precisely what they hope to accomplish.

Some conservatives in the state capital and elsewhere want North Carolina to stop taxing personal income altogether. They point to the economic success of Florida, Texas, and other states that have never levied taxes on personal income. Since income taxes make up half of state revenues, how should North Carolina make up the difference? This faction advocates some combination of higher sales or excise taxes, greater local responsibility for education and other services (financed by higher property taxes), and lower state expenditures.

As I have previously argued, I don’t think it is realistic or necessary for North Carolina to abolish its personal-income tax altogether, although I strongly favor eliminating our much smaller but counterproductive tax on corporate income (it only generates about 5% of General Fund revenue, and does so rather inefficiently).

I agree that income taxes as currently structured are unfair and economically destructive. By taxing resources invested in productive capital multiple times — as personal income, as corporate income, and as dividends or capital gains received on investment principal that has already been taxed — the current system basically encourages us to eat our seed corn rather than planting it for a larger return in the future.

We should be taxing consumption, not total income. So, why don’t I favor replacing most or all of North Carolina’s income-tax revenue with sales-tax revenue? Because that’s not really going to happen, at least not with the tools available. State taxes on retail sales don’t actually apply to all consumption, to every good and service sold at retail. Large swaths of the services households purchase are not and will never be subject to sales tax. That’s borne out by decades of experience with sales-tax systems in other states.

Here’s another way to explain my point: our income-tax base is too broad, yes, but our sales-tax base is too narrow.

When households receive income, they can do one of three things with it: spend it, donate it, or save it for later (which funds investment in physical, financial, or human capital to produce future earnings for consumption or donation).

In 2023, total personal income in North Carolina was about $670 billion. Total spending on personal consumption was roughly $554 billion, of which $204 billion was spent on goods and $350 billion on services. Some of those services are, indeed, taxable. But purchases of medical care ($88 billion) and financial services ($40 billion) are mostly exempt from the sales tax, as are legal and other professional services that make up lots of spending but aren’t separately reported by the Bureau of Economic Analysis.

On the other hand, some business-to-business purchases are subject to North Carolina tax — and they shouldn’t be! A retail sales tax should be just that, a retail tax. Otherwise, you create market distortions and, on the margin, encourage horizontal and vertical integration of business enterprises that could function more efficiently as separate entities.

If I could be persuaded that the North Carolina General Assembly will do something no other state legislature has managed to do — expand its sales tax to encompass all goods and services sold at retail — I might well embrace an end to the income tax. Given the practical and political realities of the situation, however, I favor a different strategy.

Its underlying formula is a simple one: income equals consumption plus charitable giving plus net savings. To tax consumption, then, we can start with total income, subtract charitable giving and net savings, apply a standard deduction adjusted for family size, then tax what’s left — which is, by definition, consumption.

I recognize that’s easier said than done. But it’s still more realistic than taxing hospital bills, I promise.

John Hood is a John Locke Foundation board member. His books Mountain Folk, Forest Folk, and Water Folk combine epic fantasy and American history.