Financing the Future: Fiscal Modernization in North Carolina

Roby B. Sawyers, CPA, Ph.D.

College of Management

2

Background

North Carolina’s tax system was largely set in place in the 1920s and 1930s.

While it was a model tax system then, it is not sufficient for North Carolina today or in the future

North Carolina is changing - we are growing, growing older, and becoming more diverse.

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North Carolina in the Year 2030

The population of North Carolina is growing rapidly

Population of North Carolina

5,000,000

9,000,000

13,000,000

2000 2005 2010 2015 2020 2025 2030

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North Carolina in the Year 2030

Yet population growth is not evenly distributed across the state.

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North Carolina in the Year 2030

012345678

2005 2010 2015 2020 2025 2030

Mill

ion

s

65+School AgeWorking Age

And the population is aging, especially in rural areas.

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Major Expenditure Trends

Medicaid expenditures have risen rapidly and will continue to rise as the population ages.

Past Medicaid Expenditures

$-

$1,000,000,000

$2,000,000,000

$3,000,000,000

$4,000,000,000

$5,000,000,000

$6,000,000,000

$7,000,000,000

$8,000,000,000

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Major Expenditure Trends

6.0

10.0

14.0

2005 2010 2015 2030

Bill

ion

s o

f $

K12Higher

The cost of higher education will rise. The cost of new schools will be concentrated

in rapidly growing urban areas.

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Major Expenditure Trends

2.4 million new residential housing units by 2030.

$30-$60 billion financial gap for new infrastructure.

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State and Local Responsibilities

There are state responsibilities where shortfalls occur (adequate funding for roads & schools).

There are local responsibilities that are inappropriate (Medicaid).

There are local responsibilities that might be appropriate (roads in urban areas) but lack a source of revenue.

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The Revenue Outlook

These demographic changes, expenditure trends and changes in the NC economy have resulted in a projected “structural deficit” - tax revenues are not able to keep up with a growing economy and basic expenditures.

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Local Government Revenue Outlook Local governments struggle to pay for

needed services as more responsibilities are mandated without corresponding new sources of revenue.

Local governments are not able to provide uniform levels of services across the state.

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State Revenue Outlook

Over the last twenty or so years, state lawmakers have enacted a series of temporary? sales tax and income tax rate increases to deal with budget shortfalls.

While we may have a surplus this year, Much of that excess is non-recurring and Growth in revenue is volatile

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State Revenue Growth

-4

-2

02

4

6

810

12

14

1975 1980 1985 1990 1995 2000 2005

%

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The Facts: NC is not necessarily a high tax state although our tax burden is high compared to other SE states

Taxes as a % of Income - 10% (Ranked 28th in nation)

GA: 9.8%

SC: 9.7%

VA: 9.7%

FL: 9.2%

TN: 8.3%

Source: Prof. Michael Walden, NC State

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NC Taxes as a % of Income and National Rank

9.2

9.3

9.4

9.5

9.6

9.7

9.8

9.9

10

10.1

10.2

%

0

5

10

15

20

25

30

35

40

%

Rank

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2005 RESULTS: TAXES PER CAPITA

$3268 per person

Ranked 30th highest in nation

Lower than VA, GA, FL

Higher than SC & TN

Source: Prof. Michael Walden, NC State

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N.C. State and Local Taxes Per Capita, 2005$

20002200240026002800300032003400

1992 1997 2000 2004 2005

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N.C. FEES AND CHARGES - 2004

Per capita: $1038

Ranked 2nd highest in SE behind SC

% of income: 3.6%

Ranked 2nd highest in SE behind SC

Source: Prof. Michael Walden, NC State

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SPECIFIC TAXES – PER CAPITA

Tax Rank in SE (2004)

Property 5 Sales 5 Individual Income 2 Corporate Income 1

Source: Prof. Michael Walden, NC State

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SPECIFIC TAXES - % OF INCOME

Tax Rank in SE (2004) Property 5 Sales 5 Individual Income Tax 1 Corporate Income Tax 2

Source: Prof. Michael Walden, NC State

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BUT – TAXES CAN’T BE VIEWED IN ISOLATION

Studies show public spending on education, roads, and public safety can promote economic growth and counter impact of taxes

Source: Prof. Michael Walden, NC State

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NC IS A LEADER IN “CORE” SPENDING

Public spending on education, roads, and public safety as a % of own revenues

NC: 58%

National average: 53%

NC is 2nd in SESource: Prof. Michael Walden, NC State

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NC Core Spending as % of Total Own Spending

52535455565758

%

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Changes in Sources of Tax Revenue

Percent of Total NC State and Local Tax Revenue from Various Sources

1957 2002

Sales Taxes 41.4% 34.8%

Property Taxes 26.8% 24.0%

License Taxes 11.0% 4.0%

Individual Income Taxes

10.5% 32.2%

Corporate Income Taxes

9.1% 3.0%

Other Taxes 1.2% 2.0%

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NC Depends Heavily on the Income Tax

U.S.

General Sales & Gross

Receipts32.7%

Selective Sales14.9%

Licenses6.9%

Individual Income33.7%

Corp Net Income5.9%

Other Taxes4.0%

Property2.0%

North Carolina

General Sales & Gross

Receipts24.7%

Selective Sales16.2%

Licenses5.9%

Individual Income45.2%

Corp Net Income6.8%

Other Taxes1.2%

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Problems with the Income Tax

• Volatile• Depends on “bracket creep”• Uncompetitive rates: High rates, paid by

small businesses operating as proprietorships, owners of flow through entities as well as individuals

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Problems with the Sales Tax

• Discriminates against manufacturing (services are largely not subject to tax)

• Relies on a shrinking base

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The Sales Tax Base is Shrinking

38

40

42

44

46

48

50

52

54

79 84 89 94 99 04

Perc

en

t

The sales tax base is shrinking as percentage of the economy.

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Personal Consumption Expenditures 1979 and 2004

1979 2004 Percent Percent

Total Expenditure 100.0 100.0 Durable Goods Autos Furn & Household Other Durables

13.4 5.9 5.2 2.4

12.0 5.4 4.3 2.3

Nondurable Goods Food and Beverage Other Nondurables

39.1 20.3 18.8

28.8 13.8 15.0

Services 47.4 59.1

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Financing the Future

How should North Carolina go about financing its future?

That was the question posed by NC State’s Institute for Emerging Issues at its February 2006 Emerging Issues Forum.

Three themes surfaced from the forum: A sound tax system should be:Sufficient,Efficient, andEquitable.

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Financing the Future

Conclusions from IEI’s work

Tax reform must be comprehensive and should include base broadening and rate reductions.

Local governments need autonomy and flexibility to respond to their specific needs.

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Fiscal Modernization

Largely as a result of the IEI’s work, Governor Easley and the General Assembly created a State and Local Fiscal Modernization Study Commission in August 2006.

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Fiscal Modernization

The Commission’s charge is broad and includes:recommending ways to modernize and

restructure North Carolina’s tax code; examining and making recommendations

with respect to state and local government revenue sharing and taxing authority; and

examining and making recommendations with respect to the division of responsibilities between state and local governments.

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General Tax Recommendations

1. Tax reform must be comprehensive in order to be successful.

2. Income and sales tax bases should be broadened and tax rates should be reduced so that overall changes at the state level are revenue neutral.

3. To the extent that base broadening results in increased burdens for low-income taxpayers, the State should provide a mechanism to offset this increase.

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Recommendations: Income Tax

• Broaden the individual income tax base, reduce individual rates and eliminate tax filing and payment responsibilities for low income taxpayers

• Reduce the corporate income tax rate and adopt combined (unitary) reporting.

• Review the corporate franchise tax.• Eliminate the estate and gift tax.

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Recommendations: Sales Tax

• Broaden sales tax base to include services.• Lower the sales tax rate.• Eliminate special rates and exemptions. For

example, change the highway use tax rate to regular sales tax rate (funds dedicated to transportation infrastructure, 1% = $200 million).

• Convert excise taxes to ad valorum, set at the general state and local rate.

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Recommendations: Local Revenues and Responsibilities

• Medicaid should be assumed entirely by the state and paid for in a manner that is fair for both the state and the counties.

• The State should provide greater flexibility to local governments by allowing a menu of revenue options including occupancy taxes, Impact fees, Prepared Food, Vehicle Tag, Land Transfer Tax (Deed Stamp), Local sales tax option

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Recommendations: Local Revenues and Responsibilities

• The State should allow counties to reappraise real property more frequently, use annual indexing and provide targeted property tax relief.

• State and local governments must work together to solve the looming infrastructure needs of the state.

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Next Steps:

Commission will reconvene in September Staff to develop detailed proposal for fiscal

modernization Solicit public input through hearings across the

state Fine tune and draft legislative proposals by May

2008