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Senate Tax Plan To Raise Taxes $1.7 Billion While Offering Numerous Changes

Brian Balfour  |  April 28, 2009

The Senate Finance Committee’s tax “reform” plan would result in a substantial tax increase on North Carolinians. By the committee’s own estimates, state and local tax hikes would total $1.7 billion over two years.

Labeled the “21st Century Tax Rate Reduction and Modernization Plan,” the Senate’s proposal includes perhaps the most drastic changes to North Carolina’s tax structure in 70 years. While many of the specific alterations are worthy of praise, the significant net increase in North Carolina’s tax burden is troubling.

Tax increases suppress economic growth, and are especially harmful during recessionary periods. As UNC-Chapel Hill economist James Smith noted in 2001 after North Carolina increased taxes during that recession, “It’s one of the all-time stupidest things done by a legislature anywhere. You don’t raise taxes in a recession, or even in a dismal economic environment.”

Increase Sin Taxes
While stopping well short of Gov. Purdue’s proposed tax hikes on tobacco and alcohol, the Senate tax plan nevertheless targets these items for rate increases.

• The tax on cigarettes would increase by 15 cents per pack while other tobacco products would see their excise tax rise by 3 percent
• Similarly, the alcohol excise tax would increase based on a sliding scale – the higher the alcohol content, the sharper the tax increase
• All told, these sin taxes would amount to a tax increase of $123 million per year
• This is much lower than Purdue’s sin tax proposals that would have increased these taxes by more than $650 million

Raising Sin Taxes Hurts the Poor Disproportionately, Stunts Economic Growth

• Sin taxes impose a “regressive” form of taxes upon North Carolina citizens; i.e. a tax that consumes a greater portion of the income of the poor than the wealthy
  
  • Research further shows that a greater portion of low-income people smoke compared to middle- and upper-income people
• Raising these taxes will cut jobs involved in those industries including tobacco farmers and manufacturers, alcohol distributors, bars, restaurants and convenience stores in this state
• North Carolina’s overall economy would be harmed by sin-tax increases as well. Those who pay the higher taxes for tobacco and alcohol products subsequently have less money remaining to purchase other goods and services

Business Tax Changes – A Mixed Bag
Several changes are proposed for taxing businesses in North Carolina with the stated intent of making North Carolina “more competitive” for business investment and job creation. There are some sensible reforms to the tax treatment of big businesses in the Senate plan, but the treatment of small businesses is highly questionable. The end result, however, is a net increase on businesses – both big and small – in North Carolina.

• North Carolina’s corporate tax rate would be reduced from 6.9 percent to 4.5 percent in two years, while eliminating many targeted tax credits
  
  • This would take North Carolina’s corporate tax rate from being the highest in the region to effectively the lowest among the 45 states in the nation that have a corporate tax
  • Tens of millions worth of ineffective targeted tax credits will be eliminated, helping to finance the reduced corporate tax rate. This move promotes a more equal tax treatment of business, and inspires more fair and healthy market competition (although some credits remain)
• The state and local privilege license taxes will be repealed, but the state franchise tax will be applied to all businesses organized as limited liability corporations
  
  • Overall, this trade nets a tax increase on businesses
    
    • While businesses such as attorneys, architects and home inspectors would no longer need to pay the privilege license taxes, they would become subject to the franchise tax that currently exempts businesses organized as limited liability corporations
    • This trade-off would result in a $38 million increase on the overall tax burden placed on the effected businesses for 2010-11
• The Senate plan would change the tax treatment of business inputs. Manufacturing and farm equipment, and other depreciable property would be exempt from the current 1 percent tax levied on them. Other supplies and accessories purchased by businesses, however, would be taxed at the general sales tax rate (a combined 6 percent in the Senate’s plan – see more below)
  
  • While designed to encourage business investment in productive capital goods, the net result of this change is a tax increase on businesses. The change may encourage companies to purchase more equipment and machinery, but overlooks the expense of accessories and complementary goods required for their upkeep. Given the net result is a tax increase, in the long term this tax change may do more harm than good
• The Public School Building Capital Fund is eliminated. This means that a share of the corporate tax revenue no longer will go to local governments to finance new school construction – an amount estimated at $65 million for 2010-11. The broadening of the sales tax base, however, would generate an increase of $177 million for local governments in 2010-11

State Personal Income Taxes Simplified – But Increased Overall
The Senate tax plan seeks to simplify state taxes, broaden the state income tax base and lower marginal rates. The end result, unfortunately, would be an overall increase in the income tax burden of more than $340 million annually by 2011-12.

• State income for taxable purposes would follow the federal adjusted gross income guidelines. By this standard, significantly more income would be subject to the state income tax. This higher taxable income would then be offset by a number of changes in order to bring the taxpayer’s burden back down close to the current level:
  
  • The current marginal rates of 6 percent, 7 percent and 7.75 percent would be reduced to 5.25 percent, 6.5 percent and 7.5 percent
  • A new “zero bracket” would be created: the first $10,000 (for Married filing jointly) of income would be exempt from taxation
  • Many of the current state exemptions and deductions would be converted to tax credits
• In the end, the Senate tax plan would result in an overall net increase in the state income tax burden, but with roughly 90 percent of taxpayers experiencing a decrease in their income taxes. The increase would be shouldered by the top 10 percent of income earners, which includes a large number of unincorporated small businesses.

Sales Tax Extended to Many Services, Rate Lowered
Several services that have never before been taxed would be subject to a sales tax under the Senate tax plan. The intent of the sales tax changes proposed by the Senate is to broaden the tax base (i.e. tax more transactions than before) while lowering the tax rate.

The plan would lower the total sales tax rate (state plus local) in North Carolina to 6 percent (except for Mecklenburg County, which adds another half cent), but the broadening of the base would result in a net increase in the state and local sales tax burden totaling $345 million by 2011-12.

• The state sales tax rate would drop from 4.75 percent to 4 percent. The local sales tax rate of 2 percent would remain
• Many services not currently subject to the sales tax would be taxed. Several items such as software downloads, recreation, building repairs, moving and other personal services would then also be taxed at the new, lower, tax rate (a more detailed list of services to be taxed is being developed)
• One policy likely to receive ample controversy would be the recommendation to cap the sales tax refund to nonprofits at $5 million. This move is clearly aimed at nonprofit hospitals currently entitled to unlimited sales tax exemptions. The new cap would cost such entities close to $100 million annually by 2011-12 – a cost likely to be passed along to health care consumers

Conclusion
The North Carolina Senate plan to “modernize” the state’s tax structure includes some positive reforms, but overall misses the mark. The net increase in North Carolina’s tax burden means less money available in the private sector to drive the state’s economic recovery and growth. The substantial decrease in the corporate tax rate will make the state more competitive in the eyes of larger businesses. The effect, however, on small businesses – the overwhelming majority of businesses in the state – will be negative due to both the “franchise for privilege” tax swap (resulting in a net tax hike) and the increased income tax burden placed on many unincorporated small businesses.

Finally, the Senate’s tax proposal may merely serve as a distraction from the kind of reform really needed in Raleigh: spending reform. Without a healthy dose of fiscal restraint by North Carolina lawmakers, any such “tax reform” will be meaningless as growing budgets will demand an ever growing financial sacrifice from taxpayers.

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