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Do tax rates matter? Not much

In North Carolina, a singular focus on comparing the state’s income tax rates to other states was used to justify massive rate reductions in the 2013 tax plan.  But do tax rates determine whether a state is competitive?

It turns out that income tax rates do not indicate competitiveness of a state’s tax code for two reasons:

  1. The vast majority of people and business make decisions based on other factors
  2. Tax credits and deductions mean that few pay the full income tax rate.

How much do tax rates impact taxpayer decisions? Not Much

Tax rates really aren’t a driving or primary force behind taxpayer decision making —whether individual or business.

A review of available research finds that tax cuts impact on labor supply is not conclusive. The Congressional Budget Office in 2007 reviewed various tax changes and found that the impacts vary across the income distribution: some of the greatest impacts from reductions in marginal rates, for example, would be for low-income workers and secondary wage earners, those who [1]would not be affected by lowering top rates.

Income taxes play a negligible role in people’s decisions about where to locate, according to several recent studies on interstate migration. This new research confirms North Carolina’s experience: the Budget and Tax Center found that the number of wealthy households into North Carolina increased significantly [2]after the state added a new top income-tax bracket in 2001.

Finally, the personal income tax does not significantly affect job-creation decisions [3], according to research. This is primarily because a tiny portion of the households that receive the income tax cut are in a position to create jobs.  Nearly half of the businesses filing personal income taxes are sole proprietors, and 9 out 10 of those do not have any employees.

Additionally, the impact of tax cuts on business investment is not only be small but requires years to fully take effect [4]. Evidence has generally found that a 10 percent reduction in total state and local taxes paid by businesses is likely to boost economic output and jobs by only about 2 percent.

How much do people really pay in taxes? Hint: It’s not the income tax rate

Very few taxpayers pay the actual income tax rate because of deductions and credits.

A taxpayer’s marginal tax rate is the tax rate imposed on his or her last dollar of income. In a progressive personal income tax system such as what North Carolina had in place prior to 2014, the tax rate applied to higher levels of income is higher than the rate applied to lower levels of income. For example, in North Carolina, the first $21,250 of any taxpayer’s taxable income is taxed at 6 percent, the next $78,750 is taxed at a 7 percent, and any taxable income they earn over $100,000 is taxed at a top marginal rate of 7.75%. It is fundamental to remember that only income over the marginal tax bracket, or income level, is taxed at the next higher rate. Put differently, this means that no taxpayer actually pays the top marginal tax rate (currently 7.75%) of their entire taxable income in state personal income taxes.

The taxpayer’s effective tax rate, which is the share of total income that he or she pays in taxes, are usually much lower than their marginal rates.  In a recent analysis of a separate matter, the Fiscal Research Division came to the not surprising conclusion that taxpayers’ effective tax rate under the old tax code was more like 4.75% – nowhere near the lowest marginal rate of 6% and certainly nowhere close to 7.75% [5].  The tax plan passed in 2013 cuts the personal income tax rate to 5.8 percent in 2014 and again to 5.75 percent in 2015.  Both of these rates are still higher than the effective tax rate that Fiscal Research has calculated for what North Carolina taxpayers actually paid on average under the old tax code.

And that is just personal income taxes. On the corporate income tax side, similar loopholes and deductions mean that very few profitable corporations pay the now 6 percent tax rate on corporate income.  In fact, recent analysis shows that between 2008 and 2012, nine corporations headquartered in North Carolina paid an average overall corporate income tax rate of just 3.7 percent [6], well below the state’s 6.9 percent statutory rate at the time, on more than $51 billion in combined profits.

The reality is that statutory tax rates tell us very little about the amount of income taxes individuals and corporations actually pay. Even more concerning is that policymakers have made decisions to lower tax rates without monitoring the consequences for taxpayers as the combined effect of rates, deductions and credits impact taxpayers in different ways.  The overall impact of the push to lower tax rates is unlikely to achieve improved economic outcomes and, in North Carolina, will result in some taxpayers paying more.