Fixing North Carolina’s Tax System

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North Carolina’s economy and population have changed dramatically, yet our financial systems have not kept pace.  As a result, we have a tax structure that is unfair, that collapses when the economy turns sour, and that isn’t able
to provide us with the roads and classrooms that we need.

North Carolina’s must create
a tax system that is competitive, stable, adequate and fair if we are to prosper in the 21st Century economy. To do that we will have to address problems at the state and local level.                                      Evolution of Composition of NC Tax Revenues, 1970-2005. More

Problem: Our tax revenues drop sharply in a recession, requiring painful budget cuts and higher tax rates.

North Carolina’s tax revenues drop sharply in a recession for two important reasons: a lack of balance among tax sources and a severe erosion of the sales tax base.

Lack of balance: States should get their get tax revenues from diverse sources, such as the personal income tax, the corporate income tax, and the sales tax.  Unlike other states, North Carolina has come to depend heavily on income taxes, which are very volatile.

We would have a more stable tax base if we reduce the share of state revenues coming from the income tax and increase the share provided by the sales tax and other sources.  In future downturns, the state will not face such a sudden and steep a drop in revenues.

   Sources of State Revenues as a percentage
   of all revenues, 2006. More

Erosion of the sales tax base: Like many states, North Carolina’s sales tax system was designed for an economy where most spending was on tangible things, like cars and clothing.  We now spend our money on services, most of which are not subject to the sales tax, such as car repairs, doctors visits, and live entertainment. 

As a result, we tax fewer items in our household budget, but at much higher tax rates than in the past,        U.S. Sales Tax Base as Percentage of Personal Income. More
which is not fair to producers
and consumers of these products.

Solution:  Reduce dependence on the income tax by applying the sales tax to services while lowering the sales tax rate.

Expanding the sales tax base to include services would bring a variety of important benefits.

It would provide a more stable source of tax revenue;
It would make the tax system fairer by no longer discriminating against producers of goods;
Growth in revenues would better match the growth in the economy; and
An expanded sales tax base could allow for substantial reductions in the sales tax rate.

Problems at the Local Level

Problem:  Local governments lack sufficient revenues to provide the services that residents demand.

The division of revenues and responsibilities between state and local governments have become blurred, with counties and cities increasingly required to shoulder burdens for which they have inadequate resources.

Solution:  Broaden the sales tax base and provide other local options

Local governments share in sales tax revenues, so a broader sales tax base that included services could also yield greater revenues for local governments.  Additional local revenue options, enjoyed by some jurisdictions but not others, should be made available to all.

A Comprehensive Solution
The broad outline of reform is simple, even if the details are always contentious.  North Carolina needs to rebalance its revenues so as to depend less on the income tax, and to do that it must expand the sales tax to include services. 

Modernizing our tax system in this manner will reduce our vulnerability to sharp reductions in tax revenues in the next economic downturn and provide the foundation for a tax system that is pro-growth, competitive, stable, adequate, and fair. 

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