Three Key Points on Tax Reform | Eastern North Carolina Now

   Publisher's note: The article below appeared in John Hood's daily column in his publication, the Carolina Journal, which, because of Author / Publisher Hood, is inextricably linked to the John Locke Foundation.

    RALEIGH     As North Carolina lawmakers, lobbyists, and activists prepare for the Great Tax Reform Debate of 2013, there are a few things everyone ought to keep in mind.

    First, North Carolina's tax system is clearly broken. It is opaque, unevenly applied, and bad for economic growth. To improve the system, in other words, is to reverse these features - to make the cost of taxation more transparent to voters, to eliminate biases and preferences in the code, and to make North Carolina a more attractive place to live, work, save, invest, and create new jobs.

    Second, if you deny that tax rates affect economic decisions, you are essentially denying the prices affect economic decisions. You are, in a sense, denying the economic equivalent of the law of gravity.

    Admittedly, the interaction between the cost of taxes and the potential benefits of the government services they finance is a complex one. Much of my recent book explores the matter in depth. In brief, while the provision of truly valuable public services can, indeed, boost the economy more than the required taxes hamper the economy, there is a law of diminishing returns. Our state government is already past the point of diminishing returns in the overall expenditure of tax dollars. By redeploying them to higher-priority needs, and using competition and innovation to improve the quality of services, we can make North Carolina's economy better off while reforming and lowering taxes.

    Third, while there are several different paths to choose in state-level tax reform, the fundamental goals is the same: to tax consumed income rather than total income to pay for most state services.

    Total income consists of three things: consumption, savings, and charity. Savings, in turn, is simply deferred consumption. You save (and usually invest) your income today in expectation of consuming it tomorrow. Charity, in turn, is simply transferred consumption. You give your income away to others, without receiving tangible goods or services in return. The recipients then use it for their own consumption.

    Do you see why it makes sense to tax only current household consumption? Otherwise, government is penalizing households that save for future (taxable) consumption or give their income away to the needy whose consumption would otherwise likely be exempt from taxation anyway via exemptions (both in the income and sales tax codes, in the latter case consisting of policies such as exempting food from the tax base).

    The double-taxation of investment is the real explanation for why income taxes tend to hamper state economies more than sales taxes do. In both cases, income used for immediate consumption is taxed. In most cases, the problem is exacerbated by corporate-income taxes.

    There are three potential solutions to the problem:

   • Fair Tax - Levy a broad-based tax on the retail sales of all businesses, whether they market good or services. Exclude business-to-business transactions from the tax base.

   • Flat Tax - Levy a broad-based tax on all household income received as wages, net of personal exemptions and the costs of earning the income. Interest, dividends, and capital gains aren't taxable, because they are investment returns on income that has previously been taxed.

   • USA Tax - Levy a broad-based tax on all household income used for immediate consumption. Allow households to set up one or more unlimited savings accounts (USAs) in which all deposits are tax-deductible and withdrawals are taxable.

    Each of these solutions has pros and cons. The Fair Tax imposes the cost of tax compliance on businesses, and deprives households of transparent information about how much government costs them. The Flat Tax appears to give investors special treatment, because few remember that the original investment was taxed, and invites efforts at tax evasion by reclassifying wages as investment returns. The USA Tax requires some record-keeping and reporting on the part of financial institutions to ensure that the proper deduction is taken and that investors or their heirs ultimately pay tax on withdrawals.

    These are among the issues that will form the Great Tax Reform Debate of 2013.

    Hood is president of the John Locke Foundation and author of Our Best Foot Forward: An Investment Plan for North Carolina's Economic Recovery.