Economic Outlook - November 2006

State should press the sales tax into services

The state tax system hasn’t changed much since the 1930s, and some say it needs an overhaul. It worked well enough for the manufacturing economy of the 20th century, but services dominate the state’s economy now. The Institute for Emerging Issues, a Raleigh-based think tank chaired by former Gov. Jim Hunt, hopes to have recommendations ready when a new governor takes office in 2009. Roland Stephen is assistant director for research and policy.

BNC: North Carolina has a $2.4 billion surplus, yet you say we’re in trouble.

Stephen: That was made up largely of nonrecurring funds. About 45% of our revenue is from the income tax, and the income tax is volatile. In good years, when people are paying on their capital gains, getting bonuses or those sorts of things, that yields a windfall, and you ought not to enter into spending commitments that assume it will continue. More fundamentally, we have a tax system that will not grow as the economy grows. But we can be sure that our spending obligations will grow as the economy grows. In fact, they’re likely to outstrip it.

What are the top expenditures?

Education is the biggest, but Medicaid will grow faster. Medicaid pays for long-term care of the elderly if they are below a certain income level. That represents about a third of Medicaid dollars. Medicaid also pays a lot for people who are on disability, and that’s a big-ticket item. So, as our population gets older and sicker, the cost of Medicaid is going to grow more rapidly than our economy.

What else is wrong with our income tax?

The top rate is high compared with other states — in particular, other Southeastern states. Do people leave North Carolina because of it? I don’t know. But it is a bad signal. In a noisy environment where CEOs and others are making investment decisions about where to locate firms, they’re looking for cues about the business climate.

Where does our overall tax burden rank?

Somewhere in the middle of the pack. We have high personal-income taxes, but we have low property taxes.

How can we fix our problems?

The sales tax in North Carolina, as in many states, rests on the sale of goods. Services have not been taxed in most states, yet in the United States we’re moving to a service economy. So sales tax rests on a continuously shrinking piece of the economic base.

And heavy purchasers of services, who tend to be wealthy, get a free ride?

Exactly. If I’m living a quiet life and go buy a lawn mower, I pay a sales tax on that. If I live in my McMansion and I have a fancy lawn service, I don’t pay a sales tax on that. Some people don’t like the sales tax because they think it’s not very progressive. Expanding the base would improve that while keeping rates the same or even lowering rates. And it would allow you to lower rates on the income-tax side. That is a formula that will help the economy grow.

About 35% of sales tax comes from business-to-business sales. Is that a problem?

It causes tax cascading, which means a product is taxed at several stages of production. It is a significant problem, and it would be good to get rid of that. There are measurement problems. What is a business and what is not a business? And if you exempt all businesses, does everyone rush off and turn themselves into a business? If you shifted our sales tax to an authentic consumption tax — so the sales to consumers were taxed and intermediate exchanges from business to business were exempted — that would help our economy.

You’d have to broaden your tax base to compensate.

Exactly. You might even have to consider something as significant as health care, both prescriptions and health services, because health care is going to represent a very large part of the economy in the next 25 years.

That would be politically sensitive.

Yes, but when we get rich, health care is something we buy a lot of. Rich people spend a lot more of their disposable income on health care than poor people. So that’s a way of making a sales tax more progressive.

Who would a tax overhaul favor?

Each person might lose in one area and gain in another. Let’s take a financial-services firm in North Carolina. It’s the kind of business we want to recruit. That business will probably pay a sales tax on services it provides in North Carolina, where now it doesn’t. On the other hand, the people it hires would pay lower rates of income tax. Maybe the corporation might have a lower corporate-tax rate. And that rate might have been simplified, which made calculating state income tax simple and required fewer lawyers and accountants.

What needs to happen?

We need to engage and mobilize leaders and opinion makers in communities across the state. We think that the best way to wrestle with this issue is to go to commun- ities, find out what they’re saying, have a good informed debate about that and then make the connections between that and the challenges facing the state as a whole.