In 2013, North Carolina instituted sweeping tax reforms, making its tax system more efficient. It created a single-rate system, bringing both the top rate of 7.75 percent and the bottom rate of 6 percent down to a flat rate of 5.75 percent.
In addition, lawmakers broadened the base of the tax, eliminating many special privileges in the code, and reduced the corporate income tax. They also used the tax reform process to reduce the overall tax burden on North Carolinians, allowing taxpayers from all income groups to keep more of their earned income.
Bias Against Entrepreneurship
All these reforms are good for the economy. In addition to transferring more money from political control to the private sector, meaning from less-efficient to more-efficient uses, the changes in the rates and the base reduce the tax system’s bias against saving, investment, and entrepreneurship.
However, one important area of the state’s tax code was left unreformed: the treatment of capital gains. Doing so would be a logical next step in North Carolina’s movement toward a truly efficient tax system, one without special penalties for investment and entrepreneurship, such as those in the current code.
Capital gains taxes, like all taxes on investment returns, impose a second layer of taxation on investment, and therefore entrepreneurship. Capital gains are the increase in value of an equity investment.
This kind of investment includes anything from stocks and bonds to a plot of land or one’s home or business. For example, if a person invests in stock costing $5,000, and 10 years later he sells that stock for $10,000, his capital gain would be $5,000.
Currently, the $5,000 gain would be taxed at the same rate as regular income. At the federal level and in other states, however, capital gains are taxed at a lower rate or not at all.
The reason for such tax treatment is what happens when both an initial investment and the return on that investment, in this case the capital gain, are taxed. Let’s assume that, in our example, the $5,000 used to invest stocks began as $5,555 in pre-tax income and $555 in taxes.
Without the tax, the investor could have made a $5,555 investment. After the tax, however, the investment was reduced to $5,000. The value of the stock the individual could purchase was thus reduced by 10 percent. Everything else equal, thereturn that could be generated from that investment was also reduced by 10 percent.
To tax the gain is to reduce the investment return a second time. Taxing capital gains is a form of double taxation: once when the initial investment is taxed, and again when the gain on that investment is taxed.
The most straightforward way to eliminate this double taxation is to completely eliminate the tax on capital gains. Although there are no U.S. states that do this, a number of other places do, including Belgium, New Zealand, and, not surprisingly, the leading world financial hub of Hong Kong.
Baby Steps, If Not Leaps
If eliminating double taxation entirely is too politically difficult or poses fiscal concerns, lawmakers can at least to reduce the size of the problem by following the national government’s approach and taxing capital gains less than ordinary income.
The national government taxes capital gains at about half the rate applied to regular income. Using this as a model, North Carolina could have a capital gains tax of about 2.9 percent.
An alternative approach used by a number of states is to exempt a certain amount of capital gains from taxation. For example, South Carolina allows taxpayers to exempt 44 percent of their capital gains from taxation, and Wisconsin excludes 30 percent.
Whatever the North Carolina legislature does in this regard, it must do something. The current approach is a relic from the state’s old tax system and is inconsistent with North Carolina’s new and economically more sensible approach to tax policy.
Roy Cordato, Ph.D. ([email protected]) is vice president for research and a resident scholar at the John Locke Foundation, based in Raleigh, North Carolina.
“North Carolina’s Capital Gains Tax: It’s Time to Consider a Change,” Roy Cordato, John Locke Foundation: http://heartland.org/policy-documents/north-carolinas-capital-gains-tax-its-time-consider-change