Download Tax Foundation Fiscal Fact No. 292: Recommendations for North Dakota’s Tax System
Tax Foundation Fiscal Fact No. 292
Introduction
At the request of the North Dakota Taxpayers Association, we offer a list of recommendations to improve North Dakota’s business 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. climate. The recommendations are derived from our State Business Tax Climate Index, which we produce annually to enable business leaders, government policymakers, and taxpayers to gauge how their states’ tax systems compare according to the economic principles of simplicity, neutrality, and broad tax bases with low tax rates.
The states that score best in the Index are those that embrace the established tax reform approach of broadening the tax bases and lowering the tax rates. Reforms along those lines can of course affect revenue totals. While we recommended specific base-broadening changes, we have not included any specific corresponding rate reductions in the analysis, for two reasons. First, state revenue officials are better positioned than we are to estimate revenue effects. Second, North Dakotans must decide for themselves whether they want tax reform to raise the same amount of revenue or reduce revenue.
All Index rank changes listed in this analysis represent what the effect would have been had North Dakota had the relevant change in effect on July 1, 2011, the first day of the standard state fiscal year and the snapshot date for the 2012 Index. If all of the changes listed below had been in effect on July 1, 2011, North Dakota would have ranked fifth overall in the FY2012 edition of the Index, instead of 29th.
The following changes would broaden the state’s tax bases and thus allow for lower tax rates without reducing tax revenue. These reduced tax rates (which are unspecified and therefore not reflected in the new rankings) could improve the state’s score further and provide more flexibility to choose among our other recommendations without necessarily changing the state’s final Index rank.
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.
• Provide for unlimited business net operating loss (NOL) carry-backs of up to three years. About a quarter of states allow NOL carry-backs, with the maximum generally three years. Of those that allow it, most do not limit the amount that can be carried back.
• Broaden the corporate 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. by eliminating tax preferences such as investment credits, job credits, and research and development (R&D) credits.
• Eliminate the throwback rule. About half of states have no throwback rule.
• Adjust tax bracketsA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. for inflation to avoid automatic real corporate tax increases due to inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. .
• Currently, North Dakota requires taxpayers to make an addition to income if foreign taxes were deducted from income at the federal level. North Dakota should eliminate this provision, effectively allowing the deduction for foreign taxes paid. Twenty-one states allow the federal deduction to flow through to the state tax calculation.
Without any rate changes, the above corporate base changes would have been enough to improve North Dakota’s rank to fourth, up from 21st place, in the corporate tax component of the Index had they been in effect on July 1, 2011. Reductions in corporate tax rates, potentially made revenue-neutral by the base-broadening mentioned, would further improve North Dakota’s score, as would moving to a flat rate structure.
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.
• Utah and Indiana ranked 10th and 11th respectively. Each has a flat, one-rate individual income tax. If North Dakota emulated this model-for example, moving to a single 3.99 percent rate with an increased 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 (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and personal exemption (to a combined level of $15,000 per spouse)–this would represent significant improvement. Had such a system been in effect on July 1, 2011, the state would have ranked 11th in the individual income tax Index component, up from 35th.
• Investment income is double taxed by the federal tax system, and states should avoid aggravating that distortion with further state taxes. If North Dakota eliminated income taxes on capital gains, interest, and dividend income, they would be the first state with an individual income tax to do so. This change, in addition to the rate change above, would have improved North Dakota’s rank to eighth for the individual income tax component (again, up from 35th).
North Dakota should also consider broadening the income tax base by eliminating special credits and deductions. While North Dakota currently adopts federal itemized deductions by starting their calculation with federal 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. , calculating state tax solely on the calculation of federal adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” (AGI) would greatly simplify the system, eliminate economic distortions, and allow the state to lower the statutory tax rate even further. Such a change would not directly impact the state’s Index score (the Index focuses on business taxes), but the broader base would allow for further rate reductions that would improve the state’s score.
Retail sales taxes are meant to tax consumption. Business-to-business transactions are not consumption; purchases by end-users are consumption. We recommend eliminating 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. on all business-to-business transactions and taxing all final retail sales to end-users, including services.
The above sales tax recommendations, if they had been in effect on July 1, 2011, would have improved the state’s rank to sixth best on the sales tax Index component, up from 15th, which would be the best of the states with a statewide sales tax. Expanding the sales tax base to consumer services would allow for a lower rate, which would improve the state’s score further.
Unemployment Insurance (UI) Tax:
• Reduce the time period for new businesses to qualify for an experience rating from three years to one year.
• Do not charge employers for UI claims for separations that were beyond the employer’s control (e.g. employee left voluntarily) or for employees who continue to work part-time.
• All state laws use a system of experience rating by which individual employers’ contribution rates vary by some measure of the historical risk of unemployment. North Dakota should consider changing to an experience rating formula for businesses that is based on statewide experience rather than the experience of each individual business. Unlike other formulas, a state experience formula (called a “benefit-wage-ratio formula” by U.S. Dept. of Labor) adjusts tax rates based on statewide conditions, rather than adjusting them based on each businesses’ employment history. This is desirable because it avoids the “shut-down effect” where struggling businesses face increasing UI tax rates, making it harder for the business to survive and potentially hastening its failure.
These UI changes, if they had been in effect on July 1, 2011, would have improved North Dakota’s rank on the unemployment insurance Index component to eighth place, up from 31st place.
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