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.

3 North Carolina in the Year 2030 The population of North Carolina is growing rapidly

4 North Carolina in the Year 2030 Yet population growth is not evenly distributed across the state.

5 North Carolina in the Year 2030 And the population is aging, especially in rural areas.

6 Major Expenditure Trends Medicaid expenditures have risen rapidly and will continue to rise as the population ages.

7 Major Expenditure Trends Billions of $ K12 Higher The cost of higher education will rise. The cost of new schools will be concentrated in rapidly growing urban areas.

8 Major Expenditure Trends 2.4 million new residential housing units by $30-$60 billion financial gap for new infrastructure.

9 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.

10 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.

11 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.

12 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

13 State Revenue Growth

14 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 28 th 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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RESULTS: TAXES PER CAPITA $3268 per person Ranked 30 th highest in nation Lower than VA, GA, FL Higher than SC & TN Source: Prof. Michael Walden, NC State

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18 N.C. FEES AND CHARGES Per capita: $1038 Ranked 2 nd highest in SE behind SC % of income: 3.6% Ranked 2 nd highest in SE behind SC Source: Prof. Michael Walden, NC State

19 SPECIFIC TAXES – PER CAPITA Tax Rank in SE (2004) Property 5 Sales 5 Individual Income 2 Corporate Income1 Source: Prof. Michael Walden, NC State

20 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

21 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

22 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 2 nd in SE Source: Prof. Michael Walden, NC State

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24 Changes in Sources of Tax Revenue Percent of Total NC State and Local Tax Revenue from Various Sources Sales Taxes41.4%34.8% Property Taxes26.8%24.0% License Taxes11.0%4.0% Individual Income Taxes 10.5%32.2% Corporate Income Taxes 9.1%3.0% Other Taxes1.2%2.0%

25 NC Depends Heavily on the Income Tax

26 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

27 Problems with the Sales Tax Discriminates against manufacturing (services are largely not subject to tax) Relies on a shrinking base

28 The Sales Tax Base is Shrinking The sales tax base is shrinking as percentage of the economy.

29 Personal Consumption Expenditures 1979 and 2004

30 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, and Equitable.

31 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.

32 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.

33 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.

34 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.

35 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.

36 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.

37 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

38 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.

39 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