Income Taxes Hold Back NC’s Economy

A similar version of this article originally appeared in the Charlotte Business Journal

“The power to tax is the power to destroy.” That is an oft-repeated paraphrase of a quote from former U.S. Chief Justice John Marshall in an 1819 court decision. Indeed taxes do destroy: incentives, productivity, businesses, and opportunity.

But taxes are a necessary evil to fund government, and we all know government isn’t going away anytime soon.

It’s no secret that North Carolina legislators will take a serious crack at reforming the state’s tax code in 2013. Which leads us to the question: What tax structure will impose the least destruction on North Carolina’s economy, and enable it to once again become competitive?

Economists have provided abundant research on the topic, and have largely formed a consensus: Income taxes are the most harmful to a state’s economic growth, while the sales tax has the least negative impact.

For instance, in a book published by the American Legislative Exchange Council titled Rich States, Poor States, former Reagan economic advisor Arthur Laffer declares: “States that wish to increase growth would best do so by eliminating or lowering their corporate and personal income tax rates.”

Included in the book is research on the 11 states that have enacted a personal income tax in the last 50 years. The findings? Without exception, all of the states’ economies now have a smaller share of the nation’s economy than they possessed in the years prior to the enactment of an income tax.

The list of expert analysis confirming this thesis is abundant. To pick just one example, University of Colorado economist Barry Paulson ran a regression analysis of state economic performance and concluded that “the analysis underscores the negative impact of income taxes on economic growth in the states” and that states relying on income taxes for revenue experienced slower economic growth than states relying on other taxes for revenue.

In a 2001 paper, Ohio University economist Richard Vedder compared the economic performance of states between 1957 and 1997 and found a “strong negative relationship between income taxes and economic growth,” and “sales taxes are clearly less harmful than income taxes.”

And for those who insist that corporations must “pay their fair share” of taxes? You may want to consider where that tax burden actually falls.

Upon examining a regression analysis of state data from 1977 to 2005 for a recent paper, a Federal Reserve economist concluded, “In the case of the state corporate income tax, labor bears a significant burden from the tax in the form of lower wages.”

Moreover, in this highly globalized world, North Carolina not only needs to worry about competing with neighboring states for domestic businesses, but also competing for investments from foreign-based companies. Foreign direct investment (FDI) constitutes a significant and growing share of the U.S. economy.

State lawmakers should take note of this finding from a 2001 paper written by University of Michigan economists: “[F]or foreign investors, the corporate tax rate is the most relevant tax in their investment decision.” The economists conclude: “We find FDI to be quite sensitive to states’ corporate tax rates.”

Still other research finds that states relying more heavily on its sales tax experience less volatile revenue collections. For instance, Laffer found that: “Revenue generated from sales taxes is the least affected by the boom and bust cycle – in fact sales tax revenue changes by only half as much as revenue from personal and corporate income taxes do.”

It is no coincidence that North Carolina, with its over-reliance on personal and corporate income taxes, is suffering from the fifth-highest unemployment rate in the nation, and has seen its per capita income drop below national and regional averages over the past decade. Our tax structure is set up exactly opposite to what theory and evidence tells us we should do.

Reforming the tax code by eliminating the personal and corporate income taxes would be the boldest, and wisest, moves to make North Carolina competitive once again. Imagine every worker receiving a raise in take-home pay, and businesses small and large no longer burdened with punishing tax bills.

To replace the lost revenue, North Carolina could expand the sales tax to include services, and would likely need to raise the rate slightly. The modern economy is much more service-oriented, and this new tax code would better reflect that reality.

The bottom line: Such a reform would promote job and income growth, and provide a more stable source of revenue to state government.

Tax reform is likely coming to North Carolina. Here’s hoping lawmakers listen to sound theory and evidence and implement a tax structure that promotes economic growth, rather than continues to destroy opportunity.

Brian Balfour is Director of Policy at the Civitas Institute in Raleigh (www.nccivitas.org)