Guest Opinion: Cut state tax on capital gains

Published 8:02 pm Monday, May 20, 2024

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By John Hood

RALEIGH — Over the past decade, the General Assembly has pursued a tax-reform strategy designed to foster growth and expand freedom in the Tar Heel State. North Carolina now has a flat-rate income tax. State taxes on both personal income and retail sales apply lower rates to broader bases. And lawmakers are in the process of phasing out state taxes on corporate income.

I support most of the tax policies enacted by the state legislature to date. But on one matter, I part company with some lawmakers. They seem to believe North Carolina can phase out not only corporate taxes but all income taxes while continuing to fund core public services.

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Unless they’re prepared to raise the state sales tax and broaden its base dramatically — applying it to health care, legal representation, banking and other professional services — the fiscal math here doesn’t add up.

Despite years of gradual rate reduction, the personal income tax will generate about half of all General Fund revenues this year. No reasonable projection of future economic growth or non-tax revenue can possibly replace all or even a substantial share of the revenue from personal income taxes. Nor do I think it likely future lawmakers will pick the political fights necessary to tax medical, legal or financial services sold at retail.

That having been said, I agree that North Carolina can and should do more to make our tax code friendlier to growth and investment. That means mending the way we define taxable income, not ending the system altogether.

Here’s a simple equation to keep in mind: total income equals what is spent today (consumption), what will be spent later (savings), and what is given away to someone else to spend (charity). When governments tax total income, they actually create a costly and counterproductive bias against savings and investment. That’s because consumed income is taxed only once (when we buy goods and services with after-tax dollars) while saved income is taxed multiple times (once before the principal is invested in an asset, again if it generates dividends or interest, yet again as a capital gains if the asset is sold, and still more if the asset in question is stock in a taxable corporation).

One solution to this problem is, indeed, to tax only annual consumption. Alas, no state in the country does this properly. Some tax more services than North Carolina does, but none taxes all goods and services sold at retail. In other words, the income-tax base is too broad but the sales-tax base is too narrow.

There is a more-practical solution, however: keep the personal-income tax mechanism in place but subtract net savings (and charitable gifts) from taxable income. One time-honored way of moving toward such a system is to exempt all or part of long-term capital gains from the tax base.

The federal tax code already contains a version of this idea. So do the tax codes of many industrialized countries. Indeed, the likes of Belgium, the Czech Republic, Luxembourg, Slovakia, Slovenia, Switzerland and Turkey don’t tax long-term capital gains at all.

Below the federal level, several states with income taxes distinguish between long-term capital gains and other forms of income. Consider the case of South Carolina. Although its top income tax of 6.3% for 2024 is much higher than our flat 4.5%, South Carolina excludes 44% of long-term capital gains, making its effective tax rate lower than ours. Other states that tax capital gains at a lower rate include Arkansas, Arizona, Wisconsin, North Dakota, Montana and New Mexico. Seven other states, including Tennessee and Florida, have no capital-gains tax (because they levy no income tax).

I recommend that North Carolina institute an exclusion similar to South Carolina’s, then expand it over time. Along with the already scheduled phase-out of corporate taxes, such a policy would make our state friendlier to savings and investment without creating fiscal imbalances or picking political fights with service industries that state lawmakers are unlikely to win.

John Hood is a John Locke Foundation board member.