Four reasons 2013 tax plan likely main driver of revenue shortfall

It hasn’t taken long for the costly tax plan passed last year to replace grandiose promises with an unfortunate reality. State officials recently confirmed that the 2013 tax plan passed by state policymakers will cost at least $200 million more each year than initially projected, with a price tag of at least $5.3 billion over the next five years. Our own estimates point to the potential for the total revenue loss to reach $1.1 billion by 2016.

As the prolonged negotiated budget for fiscal year 2015 highlights, North Carolina’s revenue challenge hampers our ability to invest in public education, healthcare services, and other public investments that serve as the foundation of economic growth.

The General Assembly’s Fiscal Research Division (FRD) was charged with assessing the fiscal impact of the tax plan and confirms that the personal income tax rate reduction is having a greater immediate impact on revenue collections. FRD attributes the larger-than-expected eventual revenue shortfall to slower wage growth. But it’s difficult to imagine that the income tax cuts are not driving the greater revenue losses given what we know about who benefits from the tax changes and slower wage growth suggests that the tax changes should cost less, not more. Moreover, slow wage growth raises additional concerns about the reality of a Carolina Comeback.

Failure to connect the costly tax cuts to the state’s revenue challenge disregards the skewed nature of the economic recovery. In the first three years of the economic recovery, the top 1 percent of income earners captured 95 percent of the income gains nationally. North Carolina has experienced a similar trend. During the recovery, income for the top 1 percent of income earners in the state grew by 6.2 percent from 2009 to 2011 while the bottom 99 percent saw their income decline by 2.9 percent. The income tax cuts in the tax plan largely benefit the wealthiest taxpayers; therefore, the cost of the tax plan will increase as this group captures more and more of the economic gains.

The original cost estimates for the tax plan is based on assumptions and income data reflective of an economic downturn, not an economic recovery. Federal income tax data available at the time the tax plan was crafted represented an economy at its worst – federal income tax data for tax year 2010 was the most current information available. Incomes from all sources (salaries, wages, capital gains, etc.) at all income levels took a hit. Federal income tax statistics recently released for 2012 provide insight into how the economic recovery has played out across income groups.

Here are four reasons why the income tax cuts in the 2013 tax plan are likely the major driver of the larger-than-expected revenue shortfall reported by FRD.

1. The huge income tax cuts in the tax plans largely benefits the wealthy and this group has captured a disproportionate share of economic gains during recovery. For tax year 2012, tax returns with adjusted gross income (AGI) of $1 million or more represented just 0.2 percent (2 out of every 1,000 tax returns) of all tax returns in North Carolina. This group captured 31 percent of the total AGI growth for the state.

2. Low and middle-income North Carolina taxpayers have seen little growth in their income during the economic recovery. Salaries and wages for North Carolina taxpayers with AGI of $100,000 or less (88 percent of all North Carolina tax returns for tax year 2012) grew a dismal 1.9 percent for 2012 compared to 2010. This outcome further confirms the uneven nature of the economic recovery, in which low- and middle-income North Carolinians are not participating in the productivity and economic gains during the recovery.

3. Income growth from capital gains has grown substantially and flowed overwhelmingly to the wealthy in North Carolina. Growth in capital gains income generated from owning various assets and commercial interests – stocks and bonds, for example – have flowed to a small group of wealthy individuals. Total income from net capital gains in North Carolina grew 86 percent for 2012 tax year compared to 2010 tax year. Nearly 71 percent of this income was captured by North Carolina taxpayers with AGI of $1 million or more.

4. Changes to itemized deductions claimed by North Carolina taxpayers likely to drive up cost of tax plan. The 2013 tax plan limited the amount of itemized deductions for mortgage interest and property taxes that can be claimed to a combined $20,000 and allows unlimited deductions for charitable contributions for taxpayers who itemize expenses rather than take a standard deduction allowance. For North Carolina, the total value of itemized expenses grew only 0.6 percent for 2012 compared to 2010. However, a deeper assessment reveals that itemized dedications for charitable contributions increased 12 percent while itemized deductions for home mortgage interest and real estate taxes decreased 11 percent. Accordingly, with charitable contributions remaining uncapped under the new tax changes, growth in itemized deductions for this category will increase the cost of the tax plan, as this deduction reduces the amount of income subject to state income taxes.

What becomes clear from analyzing federal income tax data for North Carolina is that the economic recovery has been very uneven. The wealthiest income earners in the state have fared particularly well while low- and middle-income families and individuals have yet to experience an economic recovery.

This is the reality that is driving the larger-than-expected cost of the tax plan passed last year. The income tax cuts in the tax plan serve as an additional benefit to a small group that has captured a disproportionate share of the economic gains. Stopping the next round of income tax rate cuts set to go into effect on January 1, 2015 is a good first step to effectively addressing the state’s revenue challenge and putting us on a path towards economic prosperity for all North Carolinians.

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