NC Budget and Tax Center

Tax swap likely to create more problems than solutions

State leaders are on a relentless pursuit to radically change the state’s tax system to rely more and more on the sales tax, while working to eliminate the income tax. This tax swap is necessary, they say, to address the volatile nature of the income tax. What it means is that there will be a heavier tax load for middle and low income North Carolinians.

This is an approach to taxation that will likely create more problems than solutions.

Volatility refers to how the level of revenue collections is affected by what’s going on in the economy. Good economic times mean higher levels of overall tax revenue, while economic downturns typically result in state revenues plummeting. The strength of revenue collections, however, can be a product of both the business cycle and the design of the tax system. North Carolina’s current tax code is underperforming historic growth rates (see Gov.’s FY17 budget, Page 33), which could be a result of tax changes passed in recent years that have resulted in a flat income tax, for example.

A report by the Center on Budget & Policy Priorities highlights reasons that a tax swap—greater reliance on sales tax and less on income tax—will not only fail to address volatility concerns but also can generate additional problems.

  • Virtually all state taxes are volatile, albeit to varying degrees. Most major state taxes, including the sales tax, are subject to ups and downs with the economy. Indeed, under some circumstances, sales taxes can decline faster in recessions than income taxes.
  • While income taxes typically fall more steeply than sales taxes when the economy enters a recession, the reverse is also true:  income taxes rise more rapidly than sales taxes during periods of economic growth. Taking both periods of growth and decline together, only income taxes increase enough to fund normal expenditure growth and meet the evolving needs of residents and businesses. Sales taxes do not.
  • Eliminating the income tax won’t protect North Carolina from revenue losses in downturns. States without income taxes—Florida and Nevada for example—were among the hardest hit in the Great Recession. Most experts recommend a balance across various sources of revenue to offset the competing sensitivities and contributions that each can make to a revenue system seeking to achieve stability, equity and long-term adequacy.

Most fundamentally, North Carolina Senators proposal to eliminate the income tax would require policymakers to find other sources for more than half of the revenue that the state currently collects. A proposal that will likely lead to further erosion in the state’s commitment to public investments that help families, seniors and communities thrive.

Moreover, it is a solution that is unnecessary given the better tool of a Rainy Day Fund to address volatility—one that state leaders have committed to aggressively.  And while the timing and pace of state leaders’ contribution to the Rainy Day Fund now raises concern, it is clear that a responsible Rainy Day Fund policy, relying on a mix of state taxes that include an income tax and not restricting tools to generate revenue at the local level, are ways that can help address and manage volatility.

Shifting to greater reliance on the sales tax and eliminating the income tax will not give North Carolina the flexibility it needs to change with the ebb and flow of the economy. It will only shift the tax load and undercut the state’s tax code’s ability to achieve a core responsibility of funding the services that support thriving communities.

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