Assessing the Senate Tax Plan | 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     For months, North Carolina's political establishment has been lying in wait for the state's new Republican leaders to act on their long-promised initiative for tax reform. When Senate leader Phil Berger outlined his tax-reform proposal via website and video message on May 6, the establishment pounced.

    Some critics went after the lack of fine detail in the plan, since Berger presented a description but no bill. Everyone else went after the details Berger did release. Lobbyists for service industries attacked the Senate's idea to broaden North Carolina's retail-sales tax to more than 100 services currently exempt from it. Lobbyists for state spending interests attacked the Senate's idea to make tax reform a net tax cut of $1 billion (reportedly about $250 million in the first fiscal year). Left-of-center critics attacked the plan as tax cuts for the rich financed by tax hikes on the poor.

    In my view, some of the criticisms are valid. Some aren't. Let's start with what the Senate leaders' tax-reform plan gets right.

    First, the Senate is right to structure its tax-reform package as a net tax cut. To set a goal of revenue-neutrality is entirely legitimate when creating a theoretical model for tax reform. The political reality of tax reform is quite different, however. No matter what lawmakers do, the inevitable result of tax reform is that while most households and businesses gain, some lose. They lose a cherished deduction or credit. Or they shoulder increased compliance costs. As a discrete interest group, those who lose tend to know precisely how much they would lose and how best to lobby the legislature to avoid it. The majority of taxpayers who would gain are not similarly organized. In a revenue-neutral tax reform, their expected gain may not be large enough to motivate them to political action.

    By making any reform package a net tax cut, however, lawmakers can build and maintain a stronger political coalition to withstand the special-interest pleading.

    Second, the Senate is right to begin transitioning North Carolina's tax code from a heavy reliance on income-based taxation to a system based more on consumption taxes. Under the Senate outline, the state's personal-income tax would within three years become a flat tax of 4.5 percent, down from a top rate of 7.75 percent. The state's corporate-income tax would drop to 6 percent, down from 6.75 percent, along with a change in the tax base that would also reduce cost for many businesses.

    On the other hand, the Senate would increase revenue from the retail sales tax by adding billion of dollars of untaxed services to the tax base while pulling the rate down only slightly, to 6.5 percent from the current 6.75 percent. Essentially, the plan replaces some of the lost revenue from income-tax cuts by raising the sales tax burden on most North Carolinians.

    I agree with the goal of taxing consumption rather than total income. Despite strident claims to the contrary, there are many econometric studies demonstrating that taxing total income is harmful to economic growth, particularly when the proceeds are used for transfer programs such as Medicaid (where North Carolina is a particularly high spender by national standards). My 2012 book Our Best Foot Forward discusses the academic literature in great detail.

    Not only is consumption taxation better for the economy, but it is also fairer and more logical. Remember that annual income is simply consumption plus savings plus charitable giving. Because most people consume most of what they earn every year, the major difference between a sales tax and an income tax is that the latter taxes investment returns such as interest, dividends, and capital gains.

    But the money people save and invest today is money that they or their heirs will use for taxable consumption in the future. That stream of income ought to be taxed once and only once. Instead, its value is reduced multiple times - when the money is originally saved, when it earns a return and is spent, and again if that return is in the form of dividends or capital gains subject to corporate income tax. Although IRAs and other savings vehicles reduce the problem somewhat, they are subject to various limitations.

    There are two possible solutions. One is to abolish income taxes altogether and tax consumption directly, via a broadened sales tax. Another is to retain the personal income tax, exempt savings from its base, and either abolish corporate taxes or make corporate dividends and capital gains deductible. The second option taxes consumption, as well, but indirectly. Along both tracks, policymakers can move their tax codes towards the ultimate solution in stages.

    Senate leaders would like to abolish the income tax. Their proposal moves North Carolina a bit in that direction. My preference, however, is for the second option. I'd make only modest changes to the sales tax, the viability of which will be increasingly undercut by the online sales of goods and services, anyway. Instead, I'd pull the personal-income tax rate down to a flat rate of about 6 percent and either introduce tax-free state savings accounts or set a lower marginal tax rate on dividends and capital gains. South Carolina, for example, is one of several states that exempt some investment returns from double-taxation. Its effective tax rate on capital gains is 3.9 percent, about half of North Carolina's top effective tax rate.

    Because the Senate plan seeks to replace income-tax revenue with a broadened sales tax, it picks unnecessary fights with dozens of industry groups who dislike the idea of becoming unpaid tax collectors for government. The plan also increases the state tax burden on households of low to moderate incomes. What makes more sense to me is to retain the income-tax structure, which avoids new regulatory burdens on business, while using generous personal exemptions to ensure that the overall system doesn't become more regressive.

    I understand what Berger and other Senate leaders are trying to accomplish, but conservatives shouldn't be in the business of raising taxes on families making $35,000 a year. Instead, they should unite behind a reform package that moves incrementally towards a consumption tax without imperiling their credibility on taxes or their electoral coalition for accomplishing other important conservative goals.