State Tax Reform - Income Tax | Eastern North Carolina Now

    Publisher's note: The author of this post is Dr. Roy Cordato, who is a Analyst for the John Locke Foundation.

    North Carolina's state income tax penalizes people's income-generating activities by reducing the rewards to work, saving, investment, and entrepreneurship. In a market setting, these are all activities that lead to the production of goods and services, spur economic growth, and generate employment. The income tax discourages these activities relative to non-income generating activities — leisure and consumption. The negative effects of the income tax are due to its high and steeply progressive rate structure and its poorly defined base. Its rate structure drives a "wedge" between the rewards to work effort and the rewards to non-work activities; the higher the tax rate, the greater the wedge, i.e. the greater the penalty against additional work effort. The design of the tax base results in the returns to saving and investment being double taxed. The combination of the two reduces the state's economic growth potential and depresses job creation. It is possible, though, to restructure the state's tax code such that some of these biases are eliminated and others are at least ameliorated.

Key Facts

• North Carolina's top income tax rate is the highest in the Southeast and the 11th highest in the nation.
• The lowest rate in North Carolina is higher than or equal to the highest rate in all but one of the other southeastern states.
• When a tax is placed on income that is earned through work effort, that tax reduces the satisfaction that the individual would otherwise gain from spending it on goods and services. It also reduces all returns that could be gained from investments.
• When North Carolina taxes interest, dividends, and capital gains, it is "double taxing" saving and investment relative to consumption.
• While North Carolina's top marginal rate reduces the rewards to current consumption by 7.75 percent, it reduces investment returns by about 15 percent.
• The double taxation of investment returns not only reduces capital formation and economic growth in North Carolina, but also reduces employment opportunities and wage rates.
• Adding to this anti-productivity bias is North Carolina's steeply progressive rate structure, which penalizes increased productivity by taking a greater percentage of people's incomes as they earn more.

Recommendations

1. North Carolina should adopt a sweeping reform of its income tax.
2. The current rate structure should be collapsed into a single, low, flat rate in order to diminish the bias against work effort and self-improvement geared toward income advancement — referred to as human capital.
3. To eliminate the double taxation of saving and investment returns, the tax base should be adjusted to allow people to save and invest their income pre-tax. It should tax both the principle and the interest when it is removed from saving and spent. This would be similar to the way "individual retirement accounts" (IRAs) are treated under the tax code except there would be no age or other restrictions on withdrawal.