Remarks to the Shaftesbury Society Luncheon hosted by the John Locke Foundation, Raleigh, North Carolina

May 5, 2009

(Click here for video of this event.)

Good afternoon. Thank you for coming and for inviting us. North Carolina has been the state I’ve come to the most since I started working at the Tax Foundation because there is always something going on down here. (Laughter.) It’s always a pleasure to come down here and the see some good friends.

The purpose of the Tax Foundation’s state program is to provide data, research, and analysis from a disinterested national perspective to stakeholders and influential people like yourselves about tax policy. In this, we’re eager to work with everyone we can to provide the tools and information to make informed decisions, particularly about trends in other states and around the world, how you compare to other states, and where you can go from here.

Now we start from the assumption that you want wealth and jobs and productivity and entrepreneurship and rising standards of living. Now I understand not everybody shares those basic assumptions. (Laughter.) But assuming that, our argument is an important way of achieving that is having a tax system that exists to raise revenue without interfering in individual economic decisions, that doesn’t have politicians and bureaucrats picking winners and losers, and that provides opportunities for ideas to succeed or fail.

Now of course, other things than taxes matter. It’s pretty important that you have an educated population, that people who want a job can find one, that people have access to health care, and that you have good infrastructure. Our message at the Tax Foundation, though, is that tax policy is a part of this equation. Michigan has great universities, good public services, and decent infrastructure, but people flee the state because there are no jobs there. Michigan has designed a tax system that shifts resources from unpopular groups to popular ones. So they have a terrible business tax and all these transfers from existing businesses to favored ones-a credit for this, subsidies for that, and for all of it they have stagnation. They have no seen a year of net job creation since 2000; the recession is not new for Michigan.

Normally this is where I would talk about a success story to compare, but it’s pretty hard this year. State revenue is down and a lot of state budgets are hurting. North Carolina of course is included in this. I understand there is a protest today at the state capital over state workers being asked to not work without pay, as opposed to not working with pay. (Laughter.)

A big part of this state budget crisis is that when revenues were booming, spending boomed up with them, and so there were some states that thought double-digit growth in revenues would last forever and went ahead with double-digit spending increases. California, my home state, is the biggest example of this; again in the year 2000, that year capital gains tax collections made up 15% of their state budget, which is not sustainable in any long term growth. They relied on volatile revenue sources like capital gains, corporate income taxes, taxes on the high-income earners—very mobile people. Doing that makes your state budget much more likely to yo-yo sharply between bad and good times. We have a report on state budgets which you all have that goes over this.

Our message to legislators this year has been: yes, it’s a tough time, but it’s also an opportunity. These volatile revenue sources like capital gains taxes, corporate income taxes, and taxes on high-income earners—they are at their lowest ebb this year, with the state is getting almost nothing from them. It’s the perfect time to reduce or eliminate them and fix your state tax systems. States need to be looking for that edge Scott outlined. In New York and across the country, a lot of very smart and very young and very mobile people are thinking about what to do with their lives next. Where will they take their ideas and their entrepreneurship and their productivity?

Part of that is state spending. You can’t get taxes under control unless you get your spending under control. This year, state government spending growth nationwide is basically nil after accounting for inflation and this is years after years of exceeding inflation and population growth. If North Carolina is thinking about some modest reforms, there are lots of options. Colorado of course has it famous spending caps, the TABOR. There’s also New Hampshire with has a very limited government tradition.

A surprising one is Arkansas—one of the few states this year with a budget surplus—and this is not a red state thing. Democrats control both houses of the legislature by wide margins and the governorship, and yet they have a budget surplus this year. The reason they do is because they have mechanisms to requiring legislators to rank all their appropriations into “must have” and “nice to have” categories, and nothing in the “nice to have” category can be funded into the “must have” categories funded, and you can only fund the “nice to have” to the extent that revenues are available. Imagine that! (Laughter.)

And of course California has its Proposition 13 tax controls and they’re voting this month on some ambitious spending controls too. If Arkansas and California can tackle meaningful tax and spending reforms, there is no reason that North Carolina cannot. And of course other states that have emulated North Carolina’s excellent constitutional provision requiring tax legislation to be read three times, going through multiple readings in legislature. John mentioned the Heatherly lottery case which allowed me to become intimately familiar with the North Carolina Constitution. It’s an excellent document; I think you should be proud of it and proud that other states have looked to part of it as a model.

And as I said, part of how you attract and keep people depends on education, services and transportation. But taxes matter too. It’s a very hard sell to try to get somebody to open a new business in Hoboken or Pittsburgh or Detroit. But people say Raleigh or Charlotte or Durham or Winston-Salem and they don’t close their ears. Now you’ve got to think of how you can close that deal. What tax reform can you do that will one-up the other states and offer a simple, transparent, neutral, and stable tax system that will be a benefit to existing and new businesses alike, and will lay the groundwork for long-term economic growth after this recession?

Before we go into that, and before I offer my thoughts on the tax proposal swirling in the Legislature right now, let me talk about how you compare to your neighbors as a whole, neighbors and to the nation as a whole.

We have a couple different rankings that we do in the Tax Foundation. One is Tax Freedom Day, the day of the year in which Americans have earned enough to pay their taxes and start working for themselves. That arrived on April 9 in North Carolina, 4 days earlier than the national day but a bit below the regional average.

We have our Tax Burdens report, which evaluates how much North Carolinians pay in taxes. North Carolinians pay 9.8% of their income in taxes, higher than the U.S. average of 9.7%. Not bad, but not good.

North Carolina has the 11th highest top personal income tax rate in the country. Income tax collections are 13th highest in the country. Corporate tax collections are 21st highest in the country. Interestingly, your gas taxes are 14th highest in the country.

On the other hand your sales taxes and property taxes are lower than your average state. You don’t target cigarette smokers to fund all your state services, which is a good thing because it doesn’t create the situation where people demand more government because they’re making someone else pay for it. Although, I understand that in the legislature’s plan they are going to fix that problem. (Laughter.)

Each fall, the Tax Foundation digs into every state’s tax code and ranks them all on how business friendly they are. We weigh over a hundred variables in income, business, property, sales, and unemployment taxes, and apply the principles of sound tax policy to them. In our 2009 State Business Tax Climate Index, North Carolina ranked 39th best business climate out of 50, or in other words 12th worst business out of 50. That’s the worst in the south. You improved a bit over the previous year, thanks to that cut of your top individual income tax rate, but it’s still pretty high. To attract and keep entrepreneurs and companies, especially against neighbors that are more hungry for jobs and business than ever before, this may be a good time to tackle some real tax reform.

So I’ve outlined a few areas you might want to look at. Only you can decide what the end goal should look like, and there will probably be different ways to get there. Should you have a flat income tax with no sales tax? Should you have a broad sales tax with a low rate or none at all? Should you dump the corporate income tax? Should you tax capital gains at a lower rate? How much should state government spend each year, and on what? These are questions I hope North Carolinians will be able to debate and hash out, you should think big.

But allow me to suggest some things that you should stay away from. I’ve mentioned the dangers of taxes on capital gains, corporate income, and high-income earners. I’d also avoid taxes designed to punish certain activities or shift disproportionate tax burdens to unpopular or unrepresented groups, like smokers, or tourists like me, or car renters like Scott. (Laughter.) I’d also be very careful about franchise fees on LLCs: these are highly mobile businesses that have already paid taxes through the individual income tax code. Imposing a franchise tax on them is double taxation. They may just all go to Delaware. My roommate has a LLC in Delaware and it’s very easy to do: you just print out a form, fill it out, send it, they stamp it, they send it back to you and you have a Delaware LLC.

I’d also avoid keeping tax provisions designed to reward certain activities, like film tax credits and R&D tax credits and mortgage tax credits and new investment tax credits, and so forth. Studies have looked this and found that most of the activity would have occurred anyways. So it’s just a drain on state revenues at the expense of existing businesses who watch as their state rolls out the red carpet for new business while they end up having to pay and open the checkbook for everyone but them. I’m glad Scott mentioned Dell moving to Ireland and from Ireland to Poland because of course Dell has a history here in North Carolina. That incentive package they got, I don’t think you needed it, and I don’t know how many on this room will disagree with me on that, but is not the way to long term economic growth. Your governor and state legislators are smart people (laughter), well, maybe that’s debatable, but no one wants them playing venture capitalist with our money. It’s risky and the market should be deciding what business gets to succeed or fail, not a bureaucrat.

Sales tax reform is a little tougher. Sales taxes were first adopted during the Great Depression. North Carolina, for example, adopted hers in 1933 as property tax revenues plummeted and unemployment swelled. Back then, the 3% tax applied only to goods and not services, since services made up a small part of the total economy and it was hard to tax them. But as our goods-based economy has steadily transformed into a service-based economy, that the tax now covers a smaller and smaller share of total goods and services because it doesn’t tax most services. So the rate has had to go up every now and then, and today it’s somewhere between 6% and over 8% in some places. Your state line average it’s about 7%.

The ideal sales tax should tax all consumption once and only once. Services should be taxes just as much as goods. Business inputs, like raw materials or equipment, shouldn’t be subject to sales tax because consumers will pay the tax when they buy the finished product. Taxing it again at the production stage just leads to double taxation and disturbs the price, ends up encouraging businesses to consolidate for no reason other than to avoid double taxation. Washington State does that and it’s a mess there

In your sales tax, now you tax some of these inputs and for all the Legislature’s plan talks about it, it doesn’t address that problem. You will still be taxing manufacturing machinery and office equipment, while exempting those services like legal and medical services. You also exempt gasoline and groceries from the sales tax, which are huge parts of the taxable base. So you have a good opportunity here: you can get rid of those taxes on inputs, extend the tax to everything, and lower the rate dramatically.

Unfortunately, as you probably know, the plan doesn’t tax all services, just a bunch of politically unpopular ones. Maryland tried that. They started with this big long list of services and then the lobbyists picked it apart, and at the end, there was just one service left taxed: computer services. That was the one industry that didn’t have a lobbyist in Annapolis. They quickly hired four lobbyists and got that thrown out. (Laughter.) So you’ve really got to go for everything or that’ll happen.

I’m also kind of confused why are the rate reduction in the left plan it’s so small. Right now, North Carolina’s sales tax applies to only about 37% of your goods and services. If you got that up to just 60% of goods and services, you could slash the sales tax rate to 2.5%. So that this proposal cuts the sales tax to merely 4% to 5% is, well, yawn. Not going to cut it for interstate competitiveness.

2009 and 2010 present great opportunities. The tax system is in flux. Everyone agrees it’s on the table. Taxes matter and North Carolina already excels at some of the basics that many states have yet to achieve. One big oomph—slashing rates while eliminating distortions, or maybe even junking a whole tax altogether in this year when it raises little revenue anyway—can do wonders for laying the groundwork to ensure North Carolina enjoys long-term economic growth. You’re first in flight. Aim to be first in tax policy too. Thank you.

(Thanks to Maria José Toledo for transcribing the remarks.)



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