No, the N.C. Flat-Rate Income Tax is not Regressive | Eastern North Carolina Now

    Publisher's note: The author of this post is Mitch Kokai, who is senior political analyst for the Carolina Journal, John Hood Publisher.

    It's never fun to be ignored.

    True, longtime Raleigh News & Observer political columnist Rob Christensen might have written his latest piece before reading last week's Carolina Journal Daily Journal on recent progressive changes to North Carolina's personal income tax.

    But the N&O published Christensen's column three days after the Daily Journal. Since the two columns reach very different conclusions, Christensen's take on the income tax comes across as a rebuttal to Carolina Journal. As such, it deserves a response.

    First, a note about the legislation that inspired Christensen's column. Without opposing it outright, Christensen clearly offers concerns about Senate Bill 75. It would set a referendum on the ballot asking voters whether they want to lower North Carolina's existing state constitutional cap on the personal income tax rate from 10 percent to 5.5 percent.

    With a current rate of 5.499 percent, the change would have no immediate impact for state taxpayers. It would stop future legislatures from raising income tax rates, unless they submit their tax hike to voters with another constitutional amendment.

    The Senate approved the idea earlier this month. Two Democrats joined all but one Republican senator in a 36-13 vote. The idea sits now in the N.C. House Finance Committee.

    The John Locke Foundation has taken no formal position on S.B. 75. This column should not be mistaken as an endorsement of the proposed constitutional amendment.

    But it does take aim at one of Christensen's key arguments.

    The problem starts with the N&O print edition headline: "N.C. may lock in regressive tax code."

    A tax is regressive if the tax rate decreases as the amount of money subject to taxation increases. As the recent Daily Journal explains, North Carolina's income tax system does not do that.

    Christensen makes a passing reference to the "standard deduction," noting that raising that deduction can benefit "lower-income taxpayers." He admits that a Republican-led General Assembly has taken that step, then follows that admission with a line about the elimination of the state earned-income tax credit. Whether implied or not, a reader might infer that the latter action negates the benefits of the former.

    By failing to explore the impact of major changes in the standard deduction, Christensen misses a critical point: As lawmakers adopted one flat tax rate, they made such large-scale increases in the standard deduction that effective tax rates have become much more progressive than a flat tax would suggest.

    An example might help. Christensen references a "simple principle" that served as a motivating principle behind N.C. tax policy for most of the 20th century: "the bank president should pay at a higher rate than the bank teller."

    There's no source for this claim. It's also unclear whether the "simple" principle actually suggests that the higher-paid bank president should pay a higher tax rate, or that his tax bill should be proportionately larger than the teller's. In other words, if the bank president made 10 times as much income as the teller, would 10 times as large of a tax bill be sufficient? If not, how much larger should the president's tax bill be?

    Christensen does not answer these important questions. But we can address his argument without them.

    Federal data suggest that the average bank teller makes about $25,000 in annual income, and the average bank president makes about $120,000. That means the president earns 4.8 times more income than the teller.

    It is clear that North Carolina's old progressive-rate income tax would have generated higher rates for the bank president. Both the president and the teller would pay a 6 percent rate on the first $17,000 of taxable income and a 7 percent rate on additional dollars earned beyond that threshold. A 7.75 percent rate would have kicked in for the bank president for any taxable income above $80,000.

    Under a flat tax with no standard deduction, the difference in rates would disappear. Under the current rate of 5.499 percent, the teller would pay $1,374.75. The president would pay $6,598.80. Both would face an effective tax rate of 5.499 percent, and the president's tax bill would be 4.8 times as large as the teller's.

    (Yes, we are omitting all other deductions and credits for this example. If such credits and deductions reduce the bank president's tax bill to a larger extent than the teller's, that's a problem with the credits and deductions - not with the flat tax.)

    The computation above does not represent the end of the story. Under the original tax reform that instituted the flat tax, lawmakers more than doubled the standard deduction, also known as the "zero tax bracket." For a single taxpayer, the deduction originally jumped from $3,000 to $7,500.

    Lawmakers didn't stop there. In the past few years, that deduction has grown to $8,750. A current Senate proposal would raise that deduction again to $10,000 for a single taxpayer.

    How would these changes affect tax bills for our hypothetical bank employees? First, let's look at bills assuming a 5.499 percent flat tax rate and the pre-reform standard deduction of $3,000. The teller would pay $1,209.78, while the president would pay $6,433.83. The effective tax rate for the teller drops to 4.8 percent. The effective tax rate for the president drops below 5.4 percent. The president's tax bill is 5.3 times as large.

    Note that even without an increase in the standard deduction, the pre-reform deduction level leads the bank president to pay a higher rate and a larger bill. That's progressive taxation.

    Now, let's apply the $7,500 standard deduction incorporated in the original 2013 tax reform package. The teller pays $962.33 (3.8 percent effective tax rate), while the president pays $6,186.37 (5.2 percent). The president's tax bill is 6.4 times as large as the teller's. Boosting the standard deduction increased the flat tax's progressivity.

    At the current standard deduction of $8,750, the teller's tax bill drops again to $893.58 (3.6 percent). The president's bill drops to $6,117.63 (5.1 percent). The president's tax bill is 6.8 times as large as the teller's. Once again, the tax is more progressive.

    What if lawmakers go along with the current Senate plan to raise the standard deduction to $10,000? The teller would pay $824.85 (less than 3.3 percent). The president would pay $6,048.90 (slightly above 5 percent). The bank president, earning 4.8 times as much income as the teller, would face a tax bill 7.3 times as large as the teller's. The N.C. income tax would become even more progressive than it is today.

    Is that disparity large enough to meet Christensen's definition of the bank president paying more than the bank teller? If not, it's entirely possible to create an even more progressive tax system simply by continuing to raise the standard deduction.

    Plus addressing progressivity in this way avoids the economic problems created by an increase in the marginal tax rate. Once North Carolina's flat income tax rate kicks in, each additional dollar is taxed at the same rate. We don't have to worry that a higher tax rate at a given income threshold will discourage additional income-producing activity beyond that threshold.

    One additional caveat: Christensen notes that as lawmakers have lowered and flattened the income tax rate, they also have expanded the number of services subject to the sales tax. The sales tax is considered regressive. (It's a point Republican lawmakers made when fighting former Democratic Gov. Beverly Perdue in 2011 over her plans to preserve a temporary state sales tax.)

    Yet the mix between income and sales tax revenue, and its impact on progressive versus regressive taxation, is a topic for another day. Christensen specifically labels the current income tax system as regressive.

    It's one thing to argue against changing the existing constitutional cap on income tax rates. It's another to argue that such a change would lock in a "regressive tax code."

    The first argument has some merit. The second has none.
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