Reforming the Tax Code

On July 23, 2013, Governor McCrory signed into law landmark legislation that cuts income tax rates for all North Carolina’s taxpayers — and replaces the existing complicated system with a single Flat Tax. With the already lower state sales tax rates passed last session, it’s estimated that this year’s tax reform efforts will save North Carolina taxpayers $4.75 billion over the next five years.

North Carolina’s outdated and burdensome tax code has long been a drag on our state’s potential for economic growth. Our unemployment rate is the fifth-highest in the nation, and state income taxes are higher than in any other surrounding state. The General Assembly believes that a simpler tax code with lower rates will help us be more competitive in the service-based economy of the 21st century. Our current state tax code dates from the Depression-era 1930s, when agriculture and manufacturing were North Carolina’s primary industries.

Tax Reform is a significant piece of a bold economic revitalization program which the legislature began last session, when it enacted a historic $1 billion tax cut. Its work continued this year by tackling the state’s massive Unemployment Insurance Debt and passing a far-reaching Regulatory Reform law. These efforts, among many others, are designed to free up capital and spur job creation.

The landmark Tax Reform law accomplishes several big things, and starting next year, the existing tax code will change in some very important ways.

Personal Taxes

The new Tax Reform Law replaces the old tiered system of personal income tax rates (of 6.0%, 7.0% or 7.75%) with a Flat Tax, lowering the rate for everyone to 5.75% next year. The new law continues to protect our most vulnerable citizens by retaining for them an effective personal income tax rate of 0% and increasing the child credit $25 for families with incomes below $40,000. The new law also more than doubles the size of the standard deduction, aimed at helping lower and middle income earners. For instance, for a married couple filing jointly, this will exempt the first $15,000 of income from their tax bill; for someone filing as the head of a household, the first $12,000 of income will be exempt from tax. And for single filers, the first $7,500 of their income will be exempt.

Currently, personal income is taxed starting with the very first dollar earned.

The new law continues to allow taxpayers to deduct local property taxes, mortgage interest payments and charitable contributions — but caps the mortgage interest and property tax deductions to at a combined $20,000. There remains no cap on the charitable contributions that North Carolina’s taxpayers may deduct.

Broadens the base

Tax reform efforts have reduced the overall sales tax rate and the new law expands the tax base. This is accomplished by adding a limited number of transactions that would now be subject to the sales tax, including warranties, service contracts, the delivery, installation or repair of tangible personal goods (e.g. dishwashers or lawn mowers), and as you may have heard about, movie tickets. The limited expansion in sales tax would apply only to certain industries already set up to collect these taxes. The new law protects senior citizens and working families by keeping existing exemptions for food, Social Security and medication.

Business Taxes

The new tax law reduces the Corporate Income Tax from the current rate of 6.9% to 6% in 2014. It’s reduced then again to 5% in 2015, and the Corporate Income Tax may fall as low as even 3% by 2017 — that is, if the state achieves its specified revenue targets. Although the new law does not change the Franchise Tax yet next year, it was referred to the Revenue Laws Committee for further study. (A franchise tax is not a tax on income — it is an additional tax on any corporation that conducts business). North Carolina’s corporate income tax rate peaked in 1991 at 7.75%, and from 1997 to 2000, the rate was successively reduced to the present rate of 6.9%. A decrease in the corporate tax rate will help make our state more competitive for economic development, increase business investment in the state, and stimulate an increase in job opportunities.

Corporations have the ability to shift their tax burden to other groups: shareholders, in the form of reduced dividends; employees, in the form of lower wages for fewer employees; and customers, in the form of higher prices and diminished choice. It can also amount to double taxation for individuals already paying taxes on their own personal incomes as well.

Another problem that states with high corporate tax rates encounter is that multi-state corporations are able to shift their income sources to affiliates in other states with lower rates, resulting in a loss of vital revenue to fund important state programs, like education.

Some might say that the lowering of the corporate tax rate results in a loss of revenue, forcing the state to look for other sources to make up the difference. But tax reform sponsors counter that this is based on a static economic model that does not account for the changes in behavior induced by a change in taxation structures.

A more dynamic model takes into account the “growth dividend” by including the positive side-effects that always accompany a lower tax environment. “People and businesses make decisions and move assets and resources based on their ability to thrive and profit over the long term,” said Rep. Tim Moffitt, another of the primary co-sponsors of the Tax Reform law this year. “Lowering the tax rate will help to stem out-migration of businesses to neighboring states and encourage a greater in-migration of businesses looking for a more business-friendly and profitable economic environment,” he said. “Lowering these rates is also very encouraging to existing businesses that wish to further expand and thrive.”

The benefits to the overall economic health of the state do not happen overnight, and the short-term losses in revenues must be considered carefully. “It has to be done in a methodical, maybe multiyear process so that we do not destabilize what … still continues to be a fragile economy,” observed Speaker Thom Tillis. The tax reductions in the current bill are seen as a prudent short-term step on the path to greater economic freedom in our state. The long-term goal is to reduce both corporate and individual income taxes to zero and is part of a “broaden the base and lower the rate” strategy.

The Tax Reform Plan is a major step in transitioning North Carolina from a reliance on the unstable Income Tax to a consumption-based revenue generating system — and state government will collect taxes when money is spent and not when it is earned.