North Carolina’s Tax Reform: A Model for the Nation?

August 9, 2013 — 1 Comment

As Washington lawmakers struggle to make any progress on tax reform, North Carolina passed a major overhaul of its tax code – the first in 80 years.

The legislation is based mainly on Republican ideals – a flat tax, simplified code, fewer deductions, and less revenue.  It will change the state’s tax system from one that was on par with national averages to one that is “fairly radical in relation to other states,” according to Kathleen Thies, senior state tax analyst for the tax publisher CCH.  Specifically, the plan:

  • Nascar: 1, Tax Reform: 2, Education:3?

    Nascar: 1, Tax Reform: 2, Education:3?

    Drops the top individual income tax rate of 7.75% to a flat rate of 5.75% for all income levels – the largest state tax cut this year

  • Cuts the corporate tax rate from 6.9% to 5% (with room to drop the rate as low as 3% by 2017)
  • Increases the standard deduction to $7,500 (for single filers)
  • Increases the state sales tax and expands it to certain services
  • Allows full deductibility of charitable contributions
  • Fully exempts social security payments from income tax
  • Repeals the estate tax
  • Retains full sales tax refund for nonprofits
  • Caps property taxes and mortgage interest payments at $20K
  • Caps the gasoline tax

On the revenue side, the changes will cost the state around $600 million per year.  North Carolina is not exactly thriving right now, either: Nearly half of counties reported unemployment figures above 10% in June, and over 80% saw increased rates from the previous month.  North Carolina already has one of the lowest periods for state unemployment compensation (20 weeks) and recently became the only state to cut access to federal Emergency Unemployment Compensation.

The poor and unemployed will also be hurt by a rise in the state sales tax; because lower income people spend more of their disposable income on consumption goods, they are disproportionately effected by sales and other excise taxes.

With less revenue, critics of the plan are wary of what cuts will come next.  Some are pointing to education – this year’s budget already neglected to follow through on a promised pay-rise to teachers, new caps on teacher pay ensured class sizes will go up, and other ‘spending woes’ are being extended to extracurriculars and school supplies (Source: Kelly Phillips, Forbes.com).

The hope, though, is that new economic activity generated by a new tax system will be enough to compensate for the lost revenue.  It remains to be seen whether this “pro-growth” model of taxation will work, but it will undeniably make the state more attractive to businesses.  The state’s business tax climate index ranked 44th worst in the nation prior to the reforms, but is expected to rise to 17th once the changes take effect.

“Small businesses and large companies across North Carolina are going to see a significant increase in their job-creating capacity,” said Patrick Gleason, director of state affairs at Americans for Tax Reform. “It’s a big step in the right direction. This final deal represents a huge improvement over the current tax code.”

Not surprisingly, the plan is receiving praise by Republican leaders and being touted as a model for other states and the country; Democrat leaders, meanwhile, are less impressed.

Another camp sees the changes as on the whole, underwhelming.  For starters, the plan isn’t really for a pure flat tax system.  Many deductions will still be allowed, and investment income will still be taxed as ordinary income.  And while a 25% drop in the individual rate is significant, total revenue collected by the state will only fall by around 3% – suggesting the legislation does a lot of tax shifting i.e., dropping individual rates and replacing them with less obvious forms of revenue collection.

For the most “radical” tax reform bill passed this year, and for a state with a Republican-controlled congress, it’s not really the one-eighty many tax protestors hoped for.

On the other hand, since it’s unlikely Washington will strike a deal on tax reform anytime soon, it will be interesting to see how North Carolina’s tax system plays out.  In the upcoming years it could serve as a model for lawmakers to build off; it could also become the poster child for what not to do.

Tell us what you think in the comments section below!

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  1. The West is Best for Business « The Joy of Tax Law - October 15, 2013

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