John Hood: Stay the Course on Tax Reform

RALEIGH — Over the past decade, North Carolina’s tax code has undergone a dramatic transformation. Once rated by the Tax Foundation as having one of the nation’s worst business-tax climates, our state now has one of the best. Our top marginal tax rate on personal income, once the highest in the Southeast at 7.75%, is now 4.99%. Our corporate tax rate, also once the region’s highest at 6.9%, is now 2.5%. 

Because lawmakers didn’t just cut tax rates but reformed the system itself — broadening some tax bases while restructuring others — North Carolina has continued to experience healthy revenue growth. Indeed, despite repeated and panicky predictions of shortfalls by progressives, the state’s revenue has generally exceeded its (wisely conservative) revenue forecasts, giving it the capacity to fund core services while shoring up its savings reserves to guard against future budget crises. 

So far, so good. But what should policymakers do next? There’s a range of possible answers.  

Under the state budget plan enacted last year and signed by Gov. Roy Cooper, North Carolina’s personal income tax rate will drop to 3.99% by 2027 and its corporate rate will phase out entirely by 2029. Some Republican lawmakers want to speed up those rate reductions. Others want to get rid of the personal income tax entirely, while still others want to do the same with North Carolina’s franchise tax, an outdated system that taxes firms doing business in the state based not on their net income but on their net worth. To offset expected revenue losses from these tax reductions, there is talk of ridding the income tax code of most remaining credits and carve-outs, or of expanding the sales tax to additional services sold at retail such as accounting, legal advice, and medical care. 

On the Democratic side, Gov. Roy Cooper and his legislative allies would roll back most of the tax cuts of the last decade if they could. In particular, Cooper would dearly love to save the corporate tax — and, indeed, to raise its rate substantially on most businesses while retaining the ability to offer generous incentives to politically favored companies. Unless something very surprising happens this November, however, these Democratic fantasies will remain just that. 

Speaking of political realities, North Carolina made a fateful decision long ago to fund public schools and roads primarily with state taxes rather than local ones. So what most other Americans pay for with their property taxes, North Carolinians pay for with income, sales, and gas taxes. Republicans need to keep that in mind as they fashion their tax-reform priorities. 

North Carolina’s personal income tax is projected to raise $14.3 billion during the fiscal year that ends this June. The state sales tax is projected to raise $9.6 billion, the corporate tax $1.1 billion, and the franchise tax $840 million.  

Given continued spending discipline and even moderate revenue growth, we can do away with the corporate tax as scheduled, or even accelerate the phase-out, without imperiling core services. Pursuing other ambitious reforms, however, will require tough choices. 

For North Carolina to join the likes of Florida, Tennessee, and Texas in abolishing income taxes altogether, for example, we’d either have to more than double our sales tax collections (likely by taxing many services at high rates), require local governments to raise property or sales taxes drastically to take on new funding responsibilities, or some combination of the two. 

Well, okay, I omitted two more options. One is to assume that the economic growth induced by abolishing our income tax would producing offsetting sales taxes at current rates. That’s mathematically impossible. The other is to cut General Fund spending in half. That’s politically impossible. 

I’m in favor of additional pro-growth tax cuts such as slashing capital-gains taxes and pulling business-to-business transactions out of the retail sales tax (they were never retail sales in the first place). Still, our highest priority should be to protect the tax cuts already enacted and scheduled. Not very exciting, perhaps, but prudent.

John Hood is a John Locke Foundation board member and author of the new novel Mountain Folk, a historical fantasy set during the American Revolution (MountainFolkBook.com).