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Four options for reforming N.C.’s tax system

4 min readBy: Scott Drenkard, Joseph Bishop-Henchman

The following op-ed appeared in the News & Observer of Raleigh, NC on January 27, 2013

In our increasingly global economy, jobs and investment can go just about anywhere. As we exit the economic downturn, the smart states are asking an important question: What about our state attracts entrepreneurs and talented individuals to set up shop here?

North Carolina policymakers are poised to face that question this legislative session. TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform ranks high on the agenda, as the state ranks 44th in the Tax Foundation’s 2013 State Business Tax Climate Index, a comprehensive ranking of tax structures in the 50 states. Compared with other states, we find that North Carolina has high rates on narrow tax bases, meaning some favored activities get preferential treatment while everything else is subject to discouragingly high tax burdens.

Taxes are just one thing that drives individual and business location decisions, but a tax change can have immediate effects. Many states today have crafted their own “tax personality” that distinguishes them as attractive places to live and work. Florida and Texas taxpayers enjoy going without a personal income tax, while Delaware residents embrace tax-free retail sales. North Carolina policymakers and taxpayers will decide which plan is best for the Tar Heel State.

Today, the Tax Foundation and the Carolina Business Coalition will release a guide to North Carolina’s tax system, its strengths and weaknesses, and four major reform options. Each option raises the same amount of revenue as today while moving to a more neutral, simple approach with broad bases and low rates.

• “Option A” makes North Carolina the most pro-growth tax system in the country, simplifying the personal income tax at 6 percent, lowering the statewide sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. to 3.5 percent while expanding its base to services, and repealing the corporate income and franchise taxes.

• “Option B” keeps all the major taxes, but simplified and at low rates: a 5 percent income tax, 5 percent sales tax and 5 percent corporate tax. A similar positive reform was adopted in Utah, contributing to its economic success.

• “Option C” would eliminate taxes on individual and corporate income and broaden the sales tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. to services to make up the revenue. The total state sales tax rate would have to be raised to 8.75 percent to fully fund current levels of state spending, but the benefit of this option is that North Carolina would be one of the few states with no taxes on investment or job creation.

• “Option D” eliminates taxes on retail sales and corporate income, paying for these reductions with a single, simple tax on individual income at a flat 10 percent rate.

While these tax options look very different, each would move North Carolina to a more neutral tax treatment so the code is not picking winners and losers in the economy. For example, of the options that retain the sales tax, all expand the tax base to services and use the extra revenue to lower tax rates. This is a stark contrast to the current North Carolina sales tax system, which unfairly applies to sellers of goods but not sellers of services.

All plans also remove the antiquated franchise tax, a tax on business assets that strangles new investment. Business owners describe this tax as a “tax on breathing” because it is paid even if a business is unprofitable and discourages expansion and new equipment purchases.

Three of the options eliminate the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. entirely, thereby removing the tax most destructive to economic growth. While a corporation writes the corporate tax payment check, the real economic burden falls on consumers who must pay higher prices, workers who receive lower wages and shareholders who see lower dividends. Additionally, public finance experts list corporate income taxes as the most compliance-laden taxes, but despite all the paperwork, audits and legal fees, it raises only 4 percent of North Carolina’s state and local revenue.

Tax reform can be tough. But a fair, simple, pro-growth tax system is vital to creating new jobs and investment.

We hope that our report helps North Carolina build on its recent successes and make a great state even greater.

Scott Drenkard is an economist and Joseph Henchman is vice president for state projects at the Tax Foundation, a nonpartisan tax research group based in Washington.