FAQs on State 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 you may know, the John Locke Foundation has just published a new book - First in Freedom: Transforming Ideas into Consequences for North Carolina - that proposes a new tax system for our state. It is called the USA Tax, which stands for unlimited savings allowance. Essentially, we propose that state government pay most of its bills with a broad-based, flat-rate tax on consumed income in the state.

    Ideally, the USA Tax would replace North Carolina's current retail sales tax, personal income tax, corporate income tax, and estate tax. That would require a USA Tax rate of 8.5 percent to raise the same amount of state revenue. If full replacement of all these taxes proves politically challenging, JLF offers a Plan B: adopt a 6 percent USA Tax to replace current income and estate taxes, and retain the retail sales tax at a somewhat-reduced rate of 4.5 percent.

    Plan A would generate a bigger economic benefit for North Carolina, according to an independent analysis conducted for JLF by economists at Suffolk University's Beacon Hill Institute in Boston. They estimate that replacing current state taxes with an 8.5 percent USA Tax would lead to the creation of more than 80,000 in the first full year of implementation, with thousands of additional jobs created in future years.

    But Plan B would be worth doing on its own terms. Adopting a 6 percent USA Tax and cutting the state's retail-sales tax would generate 10,000 jobs in the first full year of implementation, according to the study.

    Because consumed-income taxes may not be as familiar to readers as other tax-reform models are, I'm devoting the rest of today's column to answering frequently asked questions we have received while presenting our USA Tax plan to political, business, and civic leaders across the state.

   • How would the USA Tax work?

    Under the JLF system, the main source of state tax revenue would be a flat-rate tax on consumed income. It would operate within the current income-tax structure by following these simple steps:

    Step 1: All households liable for income taxes in North Carolina would be allowed to open one or more USA Accounts with any participating financial institution. At the end of each tax year, both account-holders and the state Department of Revenue would receive a simple inflow-outflow statement (similar to the current IRS Forms 5498 and 1099-R) reporting how much money was put into or taken out of each USA account during the tax year.

    Step 2: To file their state taxes, households would begin with federal Adjusted Gross Income (AGI), which automatically excludes taxpayer deposits into federal tax-deferred accounts such as IRA, 401(k)s, and HSAs.

    Step 3: Taxpayers would then deduct 40 percent of their federal personal exemptions.

    Step 4: Taxpayers would deduct net savings or add net withdrawals from their USA accounts.

    Step 5: Taxpayers would deduct any deposits into 529 college-savings plans, educational savings accounts, or other investment in education not already reported.

    Step 6: Taxpayers would deduct any contributions made to qualified charities.

    Step 7: Taxpayers would then pay a flat tax rate on the remaining consumed-income tax base.

   • What reporting requirements and other rules would apply to USA accounts?

    Although North Carolina would be the first state to authorize the creation of tax-deferred USA accounts, their design would hardly be unprecedented. USA accounts would operate very much like the IRAs and 401(k)s with which most of us are already familiar. Savers would have the freedom to choose whether and where to open USA accounts - just as banks, brokerages, mutual-fund companies, and other investment institutions would be free to chose whether to offer them. At the end of each tax year, all institutions that administer USA accounts would be required to send a standardized form to depositors and the state, reporting total inflows and outflows. This form would report only dollar amounts to the government, not individual assets or portfolio holdings - again, just as current IRA forms do. Still, if savers choose not to own any USA accounts, and thus forego the state tax deduction for net savings, they would remain free to do so.

    The main differences, then, between current tax-deferred savings options like IRAs and the new Carolina USA accounts would be 1) the latter would have no income caps for participation or dollar caps on deposits, 2) withdrawals would be subject to taxes but never to penalties, and 3) there would be no federal tax deduction for deposits into USA accounts, only a state tax deduction.

   • Why use federal AGI as the starting point for North Carolina's USA Tax?

    By starting with AGI, rather than federal taxable income, we broaden the tax base through the elimination of some unwise federal tax deductions. A broader base for the USA Tax translates into a lower marginal tax rate. Notice, however, that the new USA system includes its own set of personal exemptions, a charitable deduction, and an education deduction.

   • Why does the USA Tax system set the amount of state personal exemptions at 40 percent of federal personal exemptions?

    In any income-tax collection system, personal exemptions are used for two complementary purposes: to shield a core amount of living expenses from taxation altogether and to adjust the average tax burden for household size and income.

    It's important to recognize the distinction between the average tax burden and the marginal tax rate. The latter is what you pay for the next increment of the tax base - the next dollar you receive in income, for example, or the next dollar you spend on a taxable retail purchase. The average tax burden, however, is the total amount of tax you pay divided by your tax base. Imagine, for example, a simple income tax system with $25,000 in personal exemptions for a family of four and a 20 percent marginal tax rate for income above that amount. The average tax rate for a household with a $50,000 net income would be $5,000 divided by $50,000, or 10 percent.

    The distinction between marginal and average tax rates isn't really a complicated matter, but failure to grasp it has resulted in years of shoddy policy analysis, misleading journalism, and fruitless political debate. A flat-rate income tax of 20 percent, for example, has two marginal tax rates - zero percent up to the amount of personal exemptions and 20 percent above that level - but many different average tax rates depending on one's income and family structure.

    Under such a flat-tax environment, a middle-income household may pay the same marginal tax rate as a wealthy household for the next dollar of income, but the wealthy household still shoulders a higher average tax rate because a higher share of its total income is subjected to the 20 percent rate. In the above example, a household with $500,000 in income would have an average tax rate of 19 percent compared to the middle-income household's 10 percent average rate. But both have the same top marginal rate: 20 percent.

    Setting personal exemptions as a share of federal exemptions will serve to automatically adjust North Carolina's exemptions to inflation, which is part of the federal tax code. In our plan, we set state personal exemptions at 40 percent of the federal exemptions, yielding a revenue-neutral USA tax rate of 8.5 percent (after accounting for a positive feedback loop of some additional revenue from economic growth). If state policymakers wanted to make the average tax burden more progressive, they could do so by setting personal exemptions at 50 percent or 60 percent of the federal amounts, and then levying a somewhat-higher tax rate on the remaining tax base.

   • Why allow taxpayers to deduct money they invest in education?

    When we hear the term "investment," the image that often comes to mind is a mutual fund, a bond portfolio, or a money market account. But people save and invest in other ways, as well. To save is to forego spending your money for consumption today in expectation that spending that money on future consumption will be more valuable to you. To invest is to put your savings to work in the economy by loaning it or buying productive assets with it, in the expectation of interest, rent, dividends, or capital gains.

    One very effective way to invest your money, whether it be in yourself or in your children, is to purchase education or training. This increases the amount of human capital - the knowledge and skills required to perform work - just as investing in plants or equipment increases the amount of physical capital available to perform work. In both cases, it doesn't make sense to tax the amount of money invested if government is also going to tax the future income generated by those investments.

    Federal and state policymakers already treat household spending on education as a form of investment in some ways. States such as Louisiana, Iowa, and Indiana offer tax deductions or credits for household spending on education. The federal government offers a variety of tax credits and tax-preferred savings accounts for higher education. The federal tax code also recognizes two different savings vehicles for educational expenses: 529 plans and Coverdell education savings accounts (ESAs). North Carolina already allows taxpayers to take income-tax deductions for deposits of up to $2,500 per child into 529 plans, from which they can make tax-free withdrawals for college expenses. ESAs allow a broader choice of investment options to parents, who can use their accrued savings for elementary, secondary, or higher education expenses. Unfortunately, ESAs are more restrictive than 529 plans in other ways, such as caps on annual deposits and income limitations.

    For the purposes of our USA Tax proposal, we recommend that North Carolina continue to piggyback on these federally recognize options for educational investment, but to a greater extent. We should allow North Carolina taxpayers a deduction for the maximum deposits allowable for 529 plans and ESAs under current federal tax law. We should also retain the existing education tax relief for special-needs students, and consider additional policies to ensure that North Carolina households receive significant annual tax deductions for the money they spend or save for educational expenses such as tuition, tutoring, or textbooks.

   • Why allow taxpayers to deduct their charitable contributions?

    Some arguments for the tax deductibility of charitable giving and expenditures are better than others. For the purposes of the USA Tax, we think the most compelling argument for a tax deduction is that, at least for charities aimed at addressing the immediate needs of poor or disabled people, taxing gifts to these charities conflicts with the intent of personal exemptions. If a certain amount or share of every North Carolinian's consumption should be shielded from taxation through personal exemptions, and donations fund that consumption for disadvantaged recipients of charitable aid, then those donations to qualified charities ought not to be in the tax base.

   • North Carolina's current income-tax rates are 6 percent, 7 percent, and 7.75 percent. Why wouldn't an 8.5 percent USA Tax be considered a tax-rate increase?

    This is a case of comparing apples and oranges. Remember that under our Plan A, the USA Tax replaces four current state taxes: retail sales, personal income, corporate income, and estate. While the estate tax is relatively limited in scope and revenue, the other three taxes have to be considered in tandem if you want to compare the combined marginal tax rate of the current system to that of the USA Tax.

    For example, consider a North Carolina taxpayer of modest means whose household income is subject only to the lowest current income-tax rate of 6 percent. If that taxpayer buys a taxable good such as a pair of shoes or a DVD, the state charges another 4.75 percent on the money spent. Furthermore, because the actual burden of corporate income taxes is divided among shareholders, employees, and customers, at least some of the current 6.9 percent corporate income tax rate is passed along to the taxpayer in the form of lower wages or higher prices.

    So, depending on taxpayer income, how much of that income is spent on taxable goods, and the distribution of corporate-tax incidence, the current system imposes a combined marginal rate of 10 percent or more on every dollar received and spent. A USA Tax of 8.5 percent may have other disadvantages, but it would not raise the combined marginal rate on the income that North Carolina taxpayers spend. It would reduce that marginal rate in most cases. And it would substantially reduce the marginal rate on the income that is saved.

   • Why does the USA Tax levy a flat rate rather than multiple marginal tax rates?

    Governments should levy taxes to pay for public services - period. Taxes should not be used to redistribute income, punish politically unpopular behavior, or reward politically popular behavior. As such, North Carolina should seek neither a steeply progressive tax system nor a steeply regressive tax system. The goal for tax reform should be rough proportionality - if your standard of living is twice as much as mine, measured by either cash income or consumption, then your tax bill ought to be about twice as much as mine. This is a clear, logical rule that prevents the abuse of tax policy for social or political ends.

    Another reason to oppose multiple, progressive tax rates is that they create a disincentive to work, saving, and invest. The main reason to reform North Carolina's tax code is to increase the rate of economic growth and job creation. Multiple rates create a variety of such disincentive effects, particularly when combined with personal exemptions, marriage penalties, and other policies.

   • Is the USA Tax an income tax or a sales tax?

    This is a common and understandable question. Not to be too cheeky about it, the correct answer to the question is "yes."

    You see, taxing consumed income the way the John Locke Foundation proposes is essentially to borrow the best features of our two largest revenue sources, income tax and sales tax, while reducing or eliminating their worst features. The USA Tax operates within the existing income-tax structure. Rules regarding tax collection, withholding, profit or loss from businesses and farms, and payroll reporting would be largely unchanged. North Carolinians would use their federal income tax information to file their state USA taxes. Legally, in other words, the state would retain an income-tax system. No North Carolina businesses would be compelled to collect sales tax for the first time, or comply with any new business taxes.

    On the other hand, the base of the USA Tax is quite different from that of a traditional income tax. As we have discussed at great length in our new book and other supporting material, government should never tax total personal income, which is the current practice at both the federal and state level. The JLF plan would eliminate state taxes on total personal income.

    Personal income consists of three things: 1) money you spend on goods and services today, 2) money you save and invest to spend on goods and services in the future, and 3) money you give away to charities to finance someone else's consumption of goods and services. The current income tax levies a tax on virtually all of #1, some of #2, and virtually none of #3. In our view, the correct tax base to pay for general government services is #1 alone - household consumption.

    A properly structured sales tax - levying a tax on all goods and services sold at retail - would also tax only household consumption. So the USA Tax and a broadened sales tax have a similar tax base in theory. These two tax systems differ substantially, however, in the details and in how taxes are collected, remitted, and administered.

   • What makes the USA Tax better than the traditional income tax?

    Taxing total personal income, as the federal and state tax codes currently do, creates a bias against savings and investment. All income is ultimately consumed. Savings is a means of deferring that consumption to a future date, presumably when it will be more valuable to the saver or his heirs. If a state taxes both consumption and investment at the same current rate, it creates a bias in favor of spending income today rather than saving it to spend tomorrow.

    Here's an example to illustrate the problem. Let's say both Jim and Jane receive $1,000 pay raises from their employer. Jim decides to spend his raise immediately on a new big-screen TV. Jane decides to save her pay raise for five years at a 5 percent annual interest rate. In the absence of taxation, Jim acquires and enjoys a $1,000 TV set, and Jane acquires a nest egg that grows to 1,276 over five years.

    Now let's add a 20 percent income tax to the story. After subtracting the tax on his pay raise, Jim has $800 left to buy a somewhat-smaller TV. His purchasing power has been reduced by 20 percent. And after subtracting the tax on her pay raise, Jane has $800 left to save. That means that after five years, her nest egg will grow to $1,021 - also a 20 percent decrease from the $1,276 she would have had in the absence of the tax.

    But while the income tax system is finished touching Jim's TV expenditure, it's not finished touching Jane's savings account. If every year the interest she earns on her account is also subject to the 20 percent tax rate, Jane will end up with $973 at the end of five years - or 24 percent less than the $1,276 baseline. In effect, Jane's investment return has been taxed twice, first because the principal has been reduced from $1,000 to $800 and again because each year's interest on her account has been taxed.

    It gets worse if Jane's money is invested not in a bank account earning interest, but in the stock of a business subject to corporate income tax. Before Jane receives and pays personal taxes on her annual dividend, the corporation first makes a tax payment on the income it is about to send to Jane and other shareholders. (Corporations do not pay income taxes on money paid out in wages, which are deductible to the firm.) Or, if Jane receives her return at the end of the five years by selling the stock for a capital gain, the sale price will reflect the extent to which corporate taxes have reduced the company's retained earnings. (About half of all capital gains from stock involve corporations with substantial income-tax bills.) What's worse, some of the capital gain she receives may reflect general monetary inflation rather than a real increase in income. Thus corporate taxes represent a third layer of taxation that further widens the gap between the effective tax rates on Jim's consumption and Jane's investment.

    If you add a few zeros to the amounts in my example, and jack up the marginal tax rates to account for both federal and state taxes, you start to see how improperly structured income taxes can distort the decisions of households and businesses, creating biases toward spending rather than saving in personal finance and toward tax-deductible debt rather than taxable equity in business finance.

    This is the primary reason why taxes on total income - such as North Carolina's current personal income tax - tend to dampen economic growth. Regardless of whether you collect taxes via retail transactions or payroll deduction, the portion of income that is immediately consumed is going to be taxed. But the portion of your income that is saved fares very differently, depending on the structure of the tax code. By creating unlimited savings allowances, the USA Tax lets taxpayers save their money and earn returns on it without a current tax liability. They pay tax only when they remove the money to consume.