Eleven states have enacted laws this year to reduce income 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. rates, in most cases paired with other structurally sound tax reforms. If North Carolina state senators get their way, their state will be the twelfth—and perhaps the most significant to date.
On June 10, 2021, the North Carolina Senate passed House Bill 334 with their own amendments. As amended, the bill would phase out 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. , reduce the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rate, increase the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and child deduction, and simplify the franchise 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. , among other changes. If enacted as-is, once the changes are fully implemented, North Carolina’s already competitive ranking on the State Business Climate Index—a measure of states’ tax structure—would improve from 10th to 5th overall, making it the best-ranked among states that levy an individual income tax.
Over the past decade, North Carolina’s tax structure has improved dramatically thanks to a series of tax reforms that began in 2013 and were built upon in subsequent years. To understand the significance of the reforms being considered this year, it is important to first put them into historical context.
North Carolina’s corporate income tax rate, once the highest in the Southeast, is now the lowest in the country at 2.5 percent. The corporate tax base, once riddled with carveouts, is now known for its relative neutrality after the paring back of incentives. The individual income tax was transformed into a competitive rate flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. , while franchise tax liability was reduced and the 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. base was modernized to apply to a wider range of consumer services. As a result, North Carolina saw the most dramatic improvement in Index ranking a state has ever seen, improving from 41st to 12th in just one year.
In the years to follow, North Carolina has seen notable improvement in economic growth. Previously, North Carolina lagged other states, seeing only 1.8 percent real GDP growth in the seven years prior to the reforms, much lower than the 5.6 percent national average at the time. In the seven years following the reforms, North Carolina’s GDP grew 9.5 percent, surpassing the 9 percent national average.
If further reforms to the corporate income tax, individual income tax, and franchise tax are made as established in HB 334, the state’s strong economic growth trajectory can be expected to continue.
Most notably, phasing out the state’s already lowest-in-the-nation corporate income tax—as HB 334 would do—would benefit North Carolina employees and consumers. Dollar-for-dollar, reducing and ultimately eliminating the corporate income tax is the one of the most pro-growth tax policy changes North Carolina policymakers could make, rivaled only by repealing the state’s aggressive franchise (capital stock) tax. While the legal incidence of the corporate income tax falls on corporations, the economic incidence falls on workers in the form of lower wages, shareholders who see lower returns on investment, and customers who face higher prices. Eliminating the corporate income tax would produce the opposite effect.
Under HB 334, the state’s 2.5 percent corporate income tax rate would be reduced by 0.5 percentage points per year, starting in 2024 and fully phasing out by 2028. In FY 2019, North Carolina’s corporate income tax generated $836 million, or less than 3 percent of the state’s general fund tax collections. Compared to most alternative revenue sources, the corporate income tax is not only more economically harmful, but it is also notoriously volatile, presenting challenges for state forecasters in anticipating how much revenue it will generate in any given year. Reducing and ultimately eliminating reliance on such a volatile revenue source would make state tax revenue more stable over time.
Some House Republicans have proposed prioritizing franchise tax reform over corporate income tax reform, however, and this could prove even more advantageous, as the franchise tax—discussed below—is imposed without regard to ability to pay, and specifically taxes in-state investment.
In addition to phasing out the corporate income tax, HB 334 would reduce the state’s individual income tax rate from 5.25 to 4.99 percent, effective January 1, 2022. This change would benefit all income taxpayers, since North Carolina is one of 9 states that levies a single-rate individual income tax on wage and salary income. A single-rate structure promotes neutrality by treating every dollar of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. equally, which is favorable compared to graduated-rate structures that reduce the payoff to work on the margin.
As of January 1, 2021, North Carolina’s individual income tax rate of 5.25 percent was lower than the top rates in all but 13 of the states that levy an individual income tax on wage income. However, with 10 states having enacted laws this year to reduce their individual income tax rates, the state tax landscape is rapidly growing more competitive. States that don’t respond risk falling behind.
In addition to reducing the individual income tax rate, HB 334 would make both the standard deduction and child deduction more generous. The standard deduction would increase from $10,750 to $12,750 for single filers and from $21,500 to $25,500 for joint filers, while the child deduction would increase by $500 per qualifying child, from $2,500 to $3,000. In addition to making the deduction more generous for those who already receive it, the bill would expand eligibility for the deduction by increasing the income threshold at which taxpayers can claim it (from $60,000 to $70,000 for single filers and from $120,000 to $140,000 for married couples filing jointly).
While the individual income tax rate reduction alone would benefit individual income taxpayers across the income spectrum, the proposed increases to the standard deduction and child deduction would remove additional income from the tax base entirely, providing additional relief to taxpayers at the lower end of the income spectrum.
Another notable reform in HB 334 is the simplification of the state’s franchise tax base. Currently, North Carolina is one of 16 states with a franchise tax, also known as a capital stock tax. Unlike corporate income taxes levied on the net income of a corporation, franchise taxes are levied on a business’s wealth, usually defined as net worth (with some adjustments). Capital stock taxes are essentially a tax on investing in a state, which makes them more economically harmful than many other tax types. By taxing businesses on their net worth, capital stock taxes discourage in-state investment and the accumulation of assets, favoring profit-taking over business investment and growth. Franchise taxes can be especially burdensome to new businesses, capital-intensive businesses, and struggling businesses because they are owed even when businesses post losses or barely break even. As a result, many businesses must reach into their valuable cash flow to pay the tax.
Under current law, North Carolina’s franchise tax is levied on the largest of three bases: (1) the company’s North Carolina-apportioned net worth; (2) 55 percent of the appraised value of all real and tangible personal property in the state; or (3) the business’s total investment in tangible property in the state. Under all three bases, the tax is levied at a rate of $1.50 for every $1,000 of the tax base, with a $200 minimum to ensure payment even by businesses with low net worth. HB 334 would reduce complexity by eliminating all but the first base option. This change would also reduce franchise tax liability for some businesses that have a significant amount of real and tangible personal property in North Carolina despite having a low net worth. A fiscal note for an earlier version of the bill estimates this change will reduce franchise tax collections by between $150 and $170 million per year.
In addition to these structural reforms, HB 334 would appropriate up to $1 billion in federal aid under the American Rescue Plan Act (ARPA) to issue grants to businesses that suffered economic harm because of the pandemic. Qualifying businesses would be eligible for grants of up to $18,750.
HB 334 would also allow pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es to elect to be taxed at the entity level to bypass the $10,000 federal state and local tax (SALT) deductionThe state and local tax (SALT) deduction permits taxpayers who itemize when filing federal taxes to deduct certain taxes paid to state and local governments. The Tax Cuts and Jobs Act (TCJA) capped it at ,000 per year, consisting of property taxes plus state income or sales taxes, but not both. cap that was adopted as part of the Tax Cuts and Jobs Act (TCJA)The Tax Cuts and Jobs Act in 2017 overhauled the federal tax code by reforming individual and business taxes. It was pro-growth reform, significantly lowering marginal tax rates and cost of capital. We estimated it reduced federal revenue by .47 trillion over 10 years before accounting for economic growth. of 2017. While intended to reduce taxes on noncorporate businesses, pass-through businesses were never meant to be taxed at the entity level; by definition, their business income was designed to “pass through” to owners’ individual income tax returns. An entity-level tax would introduce additional complexity and nonneutralities into the tax code, reversing some of the progress that has been made to simplify the tax code and make it more neutral.
Taken together, though, HB 334’s proposed reforms to the corporate income tax, individual income tax, and franchise tax would further solidify North Carolina’s position as a leader in sound tax policy and as a state whose tax code is among the most conducive to generating long-term economic growth.
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