North Carolina Builds on Tax Reform, Repealing Burdensome Local Privilege Taxes

Last Thursday, state lawmakers in North Carolina passed legislation building upon the comprehensive tax reform passed in the Tar Heel State last year, notably eliminating all municipal privilege taxes and reforming the treatment of net operating loss carryforwards in the corporate income tax code. Just hours after it was approved by the legislature, Governor Pat McCrory signed off on the changes.

In July of 2013, North Carolina adopted many of our recommendations for improving its tax code, passing sweeping and beneficial reform. In addition to lowering personal income and corporate taxes, the measure moderately broadened the sales tax base and eliminated the state’s estate tax – which will advance the state’s ranking from 44^th to as high as 17^th in our annual State Business Climate Index once the reforms fully phase in over the next few years.

So what are these new adjustments all about, and what will they mean for North Carolinians? Firstly, the law replaces the state’s net economic loss (NEL) deduction with a ‘State net loss’ deduction that is more comparable to the federal calculation of Net Operating Loss (NOL) – a recommendation that we made on page 30 of North Carolina Tax Reform Options: A Guide to Fair, Simple, Pro-Growth Reform. The change will strengthen the neutrality of corporate tax for businesses with profits that are particularly affected by business cycles.

The most controversial measure contained in the new law is the elimination of municipal authority to levy privilege license taxes on local businesses, which are paid in exchange for the "privilege" of doing business in a town or city. This repeal, which will take full effect on July 1, 2015, has generated significant pushback from some local governments and mayors, who claim that the collective $62 million in reduced revenue will have to be made up by another means.

Yet, it must be acknowledged that these privilege taxes – which are charged by 300 of North Carolina’s 540 cities – vary significantly across localities, creating considerable confusion and administrative costs. Some cities exact a flat rate from every business, while others levy a tax based on businesses’ gross revenue, number of employees, or size of capital. What’s more, municipalities have free reign to charge multiple privilege taxes simultaneously, or grant exceptions to certain trades. Such discrepancies inevitably lead to widely disparate liabilities between cities and industries. One reported hypothetical example detailing this problem involves a superstore earning $50 million in gross receipts: if located in the city of Dunn, NC, the superstore would owe just $30 in privilege taxes. If it were instead located in Durham, the same store would owe more than $25,000 in privilege taxes.

Another bewildering aspect of these taxes hinges upon the broad definition of what it means to be “doing business” in a locality, which does not necessarily require that a business or franchise be physically located within a city’s borders to be subject to the privilege tax. In fact, 25 percent of the businesses subject to Charlotte’s privilege tax are located outside of its official borders.

The privilege tax, which was originally instituted on the simple basis that it would allow the state government to identify every business that participates in the state's economy, was never meant to become a steady source of revenue for municipal governments. Nonetheless, larger cities such as Charlotte, Raleigh, and Greensboro have come to rely quite heavily on these "license" privilege taxes – a name which is slightly misleading, as these are usually not contingent upon meeting any additional certification standards. State lawmakers have promised to find a solution to the revenue gap in the next legislative session.

Just like any other tax that contains exemptions and different rates for different businesses, North Carolina’s patchwork of local privilege taxes violates the principle of neutrality that is essential for sound tax policy. The tax also fails the test of transparency, as it is largely hidden in the form of higher prices for goods and services for consumers.

Read more about the new tax on e-cigarettes here, and about other changes to the tax law here.

More on North Carolina here.