North Carolina’s Vetoed Budget Includes Good Tax Provisions

July 18, 2019

House Bill 966, the budget passed by the North Carolina General Assembly on June 27, contained some promising tax provisions that would have perpetuated the Tar Heel State’s reputation as a leader in tax reform. However, Governor Roy Cooper (D) vetoed the budget on June 28, and a successful override is unlikely. The governor’s July 9th compromise proposal struck nearly all of the General Assembly’s tax reforms, and the budget conflict still appears far from resolution.

The most important proposed reform is a phasedown of the state’s outdated corporate franchise tax (also called a capital stock tax). The current franchise tax in North Carolina is 0.15 percent of either a company’s state-apportioned net worth, 55 percent of the appraised value of all real and tangible personal property in the state, or the business’s total investment in tangible property in the state, whichever is greatest.

Capital stock taxes are harmful to long-term economic growth. The Econ 101 adage is oft repeated and true: when you tax something, you get less of it. Taxing corporations on their capital stock disincentivizes the accumulation of capital, which hurts productivity. In economics, output is determined by two inputs: capital and labor. “Capital” is an aggregate term for all the stuff used to produce, such as machines, facilities, vehicles, etc. “Labor” is just an aggregate term for workers. Businesses need a balance of capital and labor to be productive. Labor makes capital useful, and capital makes labor more productive.

To illustrate, imagine two extreme situations. First, think of a chair factory with tons of woodworking machines but no workers. Clearly, no chairs will be produced because that capital isn’t useful without labor. Second, think of a different chair factory that’s fully staffed with workers but has almost no woodworking machines. The workers could make chairs with hammers, saws, and their bare hands–it would just take forever and be a miserable experience. Businesses are constantly trying to find the sweet spot in the middle of those two extremes where capital and labor are best balanced for productivity.

Capital stock taxes like the North Carolina franchise tax make it more difficult to find that balance because they prejudice the tax code against capital. Since labor is not included in calculating a corporation’s net worth, only capital is taxed by North Carolina’s franchise tax. Capital stock taxes put government’s thumb on the scale and harm businesses’ ability to be as productive as possible by distorting their incentives when making growth decisions and more heavily taxing capital-intensive businesses. That’s worse for workers, who will be less productive and have to work harder to produce the same amount of goods, and for consumers, who will have to pay higher prices for the same quality goods.

Many states have realized the harmful effects of capital stock taxes, and only 16 states continue to levy them. Two of those 16 (New York and Mississippi) are in the process of phasing them out. Four states (Kansas, Virginia, Rhode Island, and Pennsylvania) have eliminated their capital stock taxes within the last decade.

The budget that passed the North Carolina General Assembly would have reduced the franchise tax in three phases. For tax year 2020, nearly all C- and S-corporations would have paid the franchise tax at a rate of 0.129 percent. For tax year 2021, the rate would have been further reduced to 0.096 percent. Electric power companies were excluded from both of those rate reductions and would have continued to pay 0.15 percent. Then, for taxable year 2027, the rate would have been set at 0.096 percent for all corporations in North Carolina. These rate reductions were slightly more aggressive than those proposed in a separate bill earlier this year, which we wrote about in April. It also would have eliminated one of the three methods of valuation—the 55 percent of appraised value method—rendering the tax simpler. These are moves in the right direction for North Carolina, with the right destination being joining the majority of states and eliminating the franchise tax.

Source: North Carolina House Bill 966, Section 41.3.

Year Franchise Tax Rate Under General Assembly’s Budget
2019 0.15 percent for all corporations (status quo)
2020 0.129 percent for all corporations except electric power companies
2021 0.096 percent for all corporations except electric power companies
2027 0.096 percent for all corporations

Eliminating an entire tax of this size immediately represents too much of a budget hit, so gradually reducing reliance on this revenue stream by phasing out the tax makes sense. The franchise tax brought in $669.6 million in the fiscal year ending in 2018, which was 1.43 percent of the state’s total revenue that year. According to the Comprehensive Annual Fiscal Report (CAFR) from the Office of the State Controller, those collections were well above expectations and had been in 2017 as well. The CAFR goes on to credit previously enacted expansions of the franchise tax base for these unexpectedly high collections. But increasing reliance on the franchise tax is a step in the wrong direction.

There are many ways to raise a dollar of revenue, but some ways are more economically harmful than others, including franchise taxes. For the aforementioned reasons, phasedown with the goal of phaseout is an example of good tax policy.

The General Assembly’s budget also made other notable changes to the tax code. It instituted market-based sourcing for the apportionment of service income starting next year. Clarifying issues post-Wayfair, it directed marketplace facilitators to collect sales taxes. It also modestly increased the standard deduction from $10,000 to $10,500 beginning in tax year 2021. The governor’s compromise proposal kept these last two reforms and eschewed the rest.

Following the reforms of recent years, the franchise tax remains the least competitive aspect of an otherwise fairly efficient tax code. It will be interesting to see how negotiations play out between the governor and legislative leadership in the days to come.

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