Time for a change

The state's tax system, mired in the past, no longer works. But bringing it into the 21st century will take a lot of guts.
By Jack Betts

There’s a structural flaw in state government that virtually every study commission since the fall of the Berlin Wall has come to the same general conclusion on how to fix, one that has the support of former governors from both parties, legislative leaders and the man many think most likely to be the next governor, as well as top Tar Heel business leaders. With all that behind it, you’d think it would be an easy fix. But this issue is radioactive: In the last decade, every good-faith effort to reform North Carolina’s aging, dysfunctional, inadequate tax system has fallen apart for a host of reasons, few having to do with wanting to preserve a relic of the Great Depression that has been tinkered with ever since.

North Carolina’s tax rates are too high. Sales tax is 4.75%. Corporate-income tax: 6.9%. Personal-income tax: 7.75% on the highest incomes. Yet the sales-tax base is too narrow, and the system is vulnerable to economic ups and downs and, based as it is on the state’s 1930s textiles-tobacco-furniture economy, inadequate. Still another report, this one drafted in January, concludes: “North Carolina’s tax system is based on an economy of a bygone era and will not generate sufficient revenue to support the state budget even when the economy recovers.” The solution sounds simple: Broaden the sales tax, now applied mostly to retail sales, to include services and cut tax rates. Eliminate the state corporate-income tax, perhaps replacing it with a restructured business-franchise tax, and enjoy relief from the constant demand for incentives that reduce corporate income-tax liability.

Here’s why there is resistance to change and why reform keeps getting derailed: Any time you want to expand the tax base — such as by taxing more services — someone’s going to complain that this is a tax hike or, worse, a new tax entirely. But leaders in both parties keep trying. Democrats, who controlled both chambers of the General Assembly with rare exceptions for more than a century, came close a time or two. Republicans, who captured the House and Senate two years ago, say their plan, similar in some respects to that of the Democrats, will gain traction in the session that convenes May 16 and could pass as early as 2013. “We’re laying the groundwork this year,” says Thom Tillis, speaker of the House (cover story, April). Bob Rucho, another Republican from Mecklenburg County who co-chairs the Senate Finance Committee, has been working for more than a year on a four-part state economic plan that includes initiatives in education, transportation, energy and taxation. “I don’t want to put a Band-Aid on a bleeding artery,” he says. “The current system is not functioning on all cylinders. It just requires a bold change. We want to be on the cutting edge.”

The bold system he, Tillis and GOP gubernatorial candidate Pat McCrory have been talking about goes further than what Democrats contemplated. Not only do they want to abolish the corporate-income tax but see if the state could derive enough revenue from offshore and onshore energy exploration to slash — or even eliminate — the personal-income tax. “If we broaden the base and eliminate or lower the taxes, then we will have a system that will welcome business to come to the state,” Rucho says. “We want to grow our existing businesses, too. And if we do this right, it would allow for expansion of the tax base, which means you don’t have to raise taxes to meet needs.” It also would make the state more competitive in recruiting business. Endorsing reform, Senate leader Phil Berger told The [Shelby] Star in February, “We have to have tax revenues to provide certain government services, but we need to find a way to make sure we are competitive with other states in terms of how we tax and the level that we tax.”

“I wish them good luck at it,” Secretary of Revenue David Hoyle says. As a businessman and longtime legislative rainmaker, the Gastonia Democrat participated in a number of studies on tax modernization. He’s a believer in expanding the tax base, reducing rates and simply eliminating the corporate- income tax. If that could be dropped, he believes, there would be no need for the state’s costly and largely ineffective practice — at least in terms of creating lasting jobs — of offering financial incentives to attract businesses. “Everybody believes it’s the right thing to do, but the problem is getting the political courage to do it. Everybody is worried about someone’s ox getting gored.”

More than 20 years ago, the Economic Future Study Commission recommended reform to make the tax system “more responsive to the future growth of income and consumption in North Carolina.” Without it, the commission warned, the General Assembly would have to resort to “ad hoc measures to increase revenues or control spending.” That observation was prophetic. The legislature has raised a variety of rates over the years, including those on corporate and personal income and sales. For example, the sales tax has been increased five times since 1991, a recent study notes, but the proportion of state revenue from it has declined from 31% in the 1970-71 fiscal year to just under 28% in 2008-09. That derived from corporate income tax, slightly more than 12% of tax revenue four decades ago, brings in about 5%.

Who makes up the difference? Individuals. Personal-income tax, which brought in about a third of the state’s operating revenue in 1970-71, generates more than 56% of the money to pay school teachers, maintain state parks, recruit businesses, protect the environment, support a 17-campus university system and 58 community colleges and provide a long list of other services. This shift shadows that of the state’s economy from its old manufacturing base to one built on services. In 1970, a new study by legislative staff notes, manufacturing accounted for more than 35% of jobs and now 11%. Back then, services accounted for less than 15%; now, it’s nearly 40%. Other sectors, including government employment, are about what they were 40 years ago.

“The economic change has been remarkable,” says a report by the North Carolina Network of Grantmakers, a group of private foundations and donors that has assessed how the state will meet its most pressing needs. “North Carolina’s tax code, last reformed in the aftermath of the Great Depression by creating a sales tax, was largely based on an economy of products. That made sense 75 years ago, maybe even 25 years ago. Now that we are increasingly consumers of services, the limitations in our tax code no longer make sense. This revenue structure will prevent North Carolina from prospering in the future.”

Such criticism is not new. The Governor’s Commission to Modernize State Finances, chaired by former Judge Tom Ross (now president of the UNC system), recommended in 2002 that the state consider expanding the sales-tax base to include more services. North Carolina taxes fewer of them than most states, and the commission found that the state could double the sales-tax base and that the rates “could be reduced markedly if all goods and services were taxed at the same rate.” Those were not the only benefits of such a change, the report noted. The current system, it added, “contributes to the discrepancies and inconsistencies in the sales-tax code,” another reason for simplifying the revenue system by getting rid of caps on certain products and special exemptions from the tax.

Roland Stephen, former assistant director of the Institute for Emerging Issues at N.C. State University, helped advance legislative leaders’ thinking on tax reform for years and has consulted with the new Republican majority in the legislature. “They understand that North Carolina has a crazy system for collecting taxes — the narrow base, the relatively high rates,” he says. “For businesses, it’s not that high, but it is terribly confusing in ways that it doesn’t need to be. And on the sales-tax side, we certainly tax consumption far too little.” He believes that the corporate income-tax is especially wrongheaded — “stupid, ineffective,” he says. One problem is its tax code, riddled with concessions, credits and conflicting language. But Stephen does think that business activity ought to be taxed to help pay for needed state services. “That’s the only way you can get away from high personal income-tax rates in North Carolina.”

The Institute for Emerging Issues effort resulted in the formation of the bipartisan Business Committee on Financing the Future, headed by John McNairy, president of Tidewater Transit Co. in Kinston, Jack Cecil, president of Biltmore Farms LLC in Asheville, and former Charlotte Mayor Richard Vinroot, a partner in the law firm Robinson, Bradshaw & Hinson PA who was the GOP nominee for governor in 2000. “Everyone wins if we can broaden the base and lower the rates,” McNairy says. The group has endorsed specific changes, including extending the sales tax to “many services and previously exempted tangible items but not medical services and prescription drugs. The committee supports a compensation mechanism for low-income taxpayers if the sales tax is broadened to include food.” The point of extending the sales tax would be to reduce income-tax rates, the committee says, but the overall goal is to build a revenue system that is “stable, fair and adequate to needs of future generations.”

There are reasons to be optimistic about the possibility of significant tax reform in the near future. For one thing, the Republican majority is in many respects more disciplined than the Democrats who controlled the legislature. For another, the leadership — in both the House and Senate, for a change — appears to be committed to amending the tax system. And McCrory says he’s determined to do it if he becomes governor in January. “The income tax and the corporate tax have become liabilities in North Carolina. They are high, and we are not competitive with our next-door neighbors in Virginia and South Carolina.” He sees structural tax reform as one step in developing a sustainable, consistent economic policy. Moving to a tax on consumption and potential levies on energy production would be two key instruments in a new revenue system, he says.

That would be a remarkable change. While departing Democratic Gov. Bev Perdue said in 2009 that tax reform was a “huge must-do for me,” she never threw herself behind systemic change, instead backing a number of incremental changes. She proposed lowering the corporate rate to 4.9% and keeping three-quarters of a temporary 1-cent sales tax that was due to expire, among other things. The legislature declined. Democratic candidates angling to succeed her have not embraced comprehensive tax reform, either, though several say they support policies designed to help small businesses grow and protect low-income citizens from having to pay more sales taxes. So leadership on the issue evidently will come from Republicans this session and next year, when they could have even stronger legislative majorities. And therein lies a danger: If the Republicans keep control of both houses as well as win the governorship, they may be inclined to believe they can do anything. But if they muscle through a partisan version of tax reform that conservative and moderate Democrats can’t support, they might unwittingly tee up revisions if and when Democrats regain control.

That may be a while, Raleigh political analyst John Davis notes. “North Carolina Democrats are learning the hard way that there is great wisdom in the old adage, ‘If you live by the redistricting sword, you die by the redistricting sword.’ In redrawing the state legislative boundaries, North Carolina Republicans simply lowered themselves to the standard for fairness set by Democrats over many decades. The result is that with critical policy matters such as tax reform, Democrats will have to suffer the insult of being ignored just as they ignored the Republican minority for most of the past 100 years.”

“State Sen. Dan Clodfelter knows the difficulties of trying to shepherd tax-reform proposals through the legislature of a state sharply divided on key political issues. After serving on major tax-modernization panels over the past decade and working to build legislative support for a revenue overhaul, the Mecklenburg County Democrat has learned three important lessons: “To succeed, tax reform has to be bipartisan, it has to be bicameral, and the governor has to lead.” He and his allies worked to make the effort bipartisan with mixed success.

In last year’s session, Johnathan Rhyne, then a Republican member of the House from Lincoln County, proposed a Tax Modernization Study Commission to evaluate the tax structure and recommend revenue-neutral changes. Clodfelter and Sen. Fletcher Hartsell, a Republican from Cabarrus County, sponsored a comprehensive tax-reform plan to, among other things, give legislators something to study and launch the debate. He also hoped to make it clear that to bring about lasting tax reform, everyone had to buy in to the idea. “The way I put it is, you have to go in with a commitment — and you have to mean it — that nobody’s ox is going to get gored, but everybody’s ox is going to get a scratch. Everything has to be on the table.”

Neither bill went anywhere in a difficult session dominated by deep cuts to state spending and fractious debate over social issues. Those debates have left bruises, and they may make bipartisan consensus even harder this year and next. Rucho says he is aware of the difficulties that lie ahead. “Is this going to be easy? No way. But we are willing to make a bold change.”

Veteran political writer Jack Betts lives in Meadows of Dan, Va.