More Jobs, Bigger Paychecks

DECEMBER 2012

MORE JOBS,

BIGGER

PAYCHECKS A Pro-Growth Tax Reform for North Carolina

EXECUTIVE SUMMARY North Carolina competes with every other state for tomorrow’s growth industries.

Although North Carolina was once a growth leader, this is no longer the case.

Policymakers in Raleigh can reverse this trend. Among the many state policies that are important in fostering strong economic growth, a pro-growth state tax policy is crucial. But, North Carolina’s tax system fails the pro-growth criteria.

North Carolina’s tax system suffers from:

• An exceptionally high personal income tax rate;

• An uncompetitive corporate income tax compared to other states in its region; and,

• An overall tax burden that has gone from generally below the national average to generally above the national average—the 17th highest in the nation, and the highest tax burden compared to all of its neighboring states.

Progressive Income Taxes More Harmful to Growth For any economic decision (i.e., work effort, saving, or investing) the marginal tax rate on the next dollar earned is crucial. To see why the marginal tax rate matters, imagine the work or investing incentives a person would face if the marginal tax rate on the next dollar earned was 100 percent. Under this scenario, every extra dollar a person earns would go straight to the government. Regardless if the tax rate on the previous dollar earned was zero, there is very little incentive for anyone to work, save or invest under such a punitive tax rate. Now imagine the work or investing incentives a person would face if the marginal tax rate on the next dollar earned was zero. Under this scenario, the investor or worker would get to keep the full value of the income or return that they earn. Obviously, the second scenario is more favorable to the worker or investor than the first.

Any tax reform in North Carolina should increase the after-tax income for the next dollar earned and raise the reward to work. Tax policies that increase the incentive to produce, invest and innovate attract industries and entrepreneurs. Increased economic growth, income and employment follow. Tax reform should reduce the More Jobs, BIGGER Paychecks | A Pro-Growth Tax Reform for North Carolina

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penalty from additional work, savings, and investment and subsequently encourage increased work effort, increased wages, increased savings, and greater investments (and subsequently, greater capital accumulation).

Real world illustrations of this theory can be seen in the relative economic performance of those states without a corporate income tax compared to all of the other states; and, the relative performance of those states without a personal income tax compared to all of the other states: • The average annual growth rates for those states without a corporate income tax exceeded the growth rate of all other states by 0.7 percentage points per year between 1992 and 2001, and by 1.0 percentage points between 2002 and 2011; and, • The average annual growth rates for those states without a personal income tax exceeded the growth rate of all other states by 0.7 percentage points per year between 1992 and 2001, and by 0.5 percentage points between 2002 and 2011.

In other words, over the last 20 years those states that did not tax income (either corporate or personal) gained a growth advantage vis-à-vis all other states. Alternatively, those states without a sales tax did not outperform the states with a sales tax.

Benefits to North Carolina from Income Tax Elimination: Our Findings A proposed consumption-based tax system currently being discussed by state legislative leaders leverages these insights to improve the overall economic incentives in North Carolina by transforming the state’s current high marginal income tax system into a broad-based flat tax on consumption, thereby producing increased incentives to work and produce in the state. Based on our analysis,

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a consumption-based tax reform can increase North Carolina’s average annual rate of personal income growth by 0.38 percent to 0.66 percenti. To understand the significance of an accelerated rate of growth this size, we can examine North Carolina’s economic performance from 2000 to 2011.

North Carolina’s relative personal income growth ranking fell from the 4th fastest in the U.S. between 1981 and 1999 to the 26th fastest in the nation between 2000 and 2011. However, had a consumption-based tax reform been implemented in 2000, and based on the estimated increase in North Carolina’s average annual rate of personal income growth, North Carolina’s expected average personal income growth would have increased to between 4.4 percent and 4.7 percent, increasing North Carolina’s relative growth rank to between the 18th fastest and the 14th fastest over this time period. In dollar terms, personal income would be between $14.4 billion and $25.0 billion higher in 2011 than the actual 2011 personal income of $347.9 billion without a consumption-based tax reform– an income level 4 to 7 percent higher.

Additionally, the accelerated income growth would have created additional job growth. Based on the connection between income growth and employment growth, total employment in 2011 would have been higher by an additional 217 thousand to 378 thousand jobs. Figure ES1 summarizes the beneficial economic impacts from a consumption-based tax reform.

A growing literature examining the impact of income taxes on economic performance supports the findings of this study–high personal and corporate income tax rates have a large and negative impact on economic growth.

Because high income tax rates have a larger negative impact on economic growth than consumption-based taxes, eliminating North Carolina’s uncompetitive personal income tax and corporate income tax systems is a pro-

FIGURE ES1: Potential Additional Economic Growth Impacts in North Carolina Difference between Actual 2011 Values and Estimated Values Under Consumption-based Tax Reform Growth in Personal Income

Percentage Increase in Total Employment 7.18%

Billions

$25.0

4.13%

$14.4

Low Growth Estimate

High Growth Estimate

growth tax reform that will increase the state’s rate of economic growth while providing the state government with the same amount of revenues on a static basis.

Implementing a Consumption-based Tax Reform A proposal to transform North Carolina’s current tax system into primarily a consumption-based tax system is under consideration. The scope of this study is to evaluate the plan, as it is being proposed as of December 2012. The reform is designed to be statically revenue neutral – without accounting for any increase in North Carolina’s rate of economic growth (the entire purpose of the reform), the state will raise the same amount of revenues both prior to and following the tax reform. The proposed tax reform would repeal North Carolina’s personal income tax, corporate income tax, and franchise tax due to the larger negative economic impact these taxes impose on

Low Growth Estimate

High Growth Estimate

the economy and replace these revenues with the following tax system: • Expand the current sales tax base to include all services currently taxed in at least one state • Expand the current sales tax base to close current loopholes (e.g. preferential rates for certain goods) • Expand the real estate conveyance fee • Implement a business license fee levied on all businesses with a base equal to assets minus liabilities minus retained earnings, determined in accordance with Generally Accepted Accounting Principles

Setting the Tax Rates to be Revenue Neutral The primary purpose of any state tax system is to raise sufficient revenues for the state government to operate. In

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FY2011-12, total state tax revenues were $18.5 billionii.

Of these, the personal income tax, corporate income tax, and the franchise tax raised $12.0 billion or approximately 65 percent of North Carolina’s total tax revenues.

Adding the $5.3 billion in state sales tax revenue brings the total for these revenue sources to $17.3 billion.

The business license fee is designed to statutorily incorporate business entities into the tax base. The base for calculating the business license fee is the amount of capital stock surplus, and undivided profit apportioned to North Carolina, excluding retained earnings. The business license fee as currently being considered is designed to raise $4 billion, which according to the Fiscal Research Division, is achieved with a 1.05 percent business license fee including a $500 minimum payment for smaller businesses. Incorporating the expected revenues from the business license fee still leaves $8 billion in revenues that need to be replaced.

The new real estate conveyance tax would add a 1 percent tax on all commercial and residential real estate transactions in North Carolina. According to the Fiscal Research Division, a 1 percent tax on the total value of real estate transactions in North Carolina would generate $390 million, leaving $7.6 billion in revenues that need to be replaced.

The remainder of these revenues would be replaced by expanding the current state sales tax base to include the following categories: • Repealing current exemptions, preferential rates, and refunds • Expanding the tax base to include services taxed in at least one state according to the Federation of Tax Administrators (FTA) • The expanded sales tax base would not include capitalized goods or services purchased by businesses • Incorporating insurance premiums, residential leases, lottery ticket sales, and out of pocket medical expenses into the tax base According to the Fiscal Research Division, this tax base expansion will broaden North Carolina’s sales tax base from the current estimated $115.2 billion to $193.6 billion or a 68.0 percent expansion of the state sales tax base, see Table ES1 for a detailed breakdown of the sales tax base expansion. Based on a $193.6 billion sales tax base and $7.6 billion in necessary additional sales tax revenues, the static revenue neutral state sales tax rate under the proposed tax reform would be 6.53 percent. Local governments also impose sales taxes. However, due to

TABLE ES1: Estimated Expansion of North Carolina’s State Sales Tax Baseiv Repealing Current Exemptions, Preferential Rates, and Refunds Capital Outlay Exclusion Expand Tax Base to FTA Services Insurance Premiums Residential Leases

$83.83 ($19.88) $44.20 $13.30 $0.79

Lottery Ticket Sales Out of Pocket Medical Expenses Leakage Allowance

$1.46 $0.08 ($45.41)

Total Sales Tax Base Expansion

$78.37

TOTAL NEW SALES TAX BASE 4

$193.60

the expanded sales tax base, the local sales tax rate could be lowered without costing the local governments any revenues. Based on a 68.0 percent expansion of the sales tax base, current local revenues (on a static basis) could be raised via a 1.52 percent local sales taxiii. Combining the sales tax rates together, the revenue neutral state and local sales tax rates would be 8.05 percent.

Putting the components together, the proposed tax reform would raise a projected revenue-neutral $17.3 billion from the following revenue sources: • $4.0 billion through the new business license fee; • $0.4 billion through the real estate conveyance tax; and, • $12.9 billion through the expanded sales tax base (including $7.6 billion in new revenues).

Regressivity Concerns Static analyses criticize consumption-based tax systems based on the claim the consumption taxes are regressive.

The criticisms, which are true as far as they go, argue that lower-income individuals spend more of their income on products that are subject to consumption taxes. Therefore, these analyses conclude, that the burden from a consumption tax is larger on lower income individuals than higher income individuals.

Regressivity concerns, however, do not account for the beneficial impacts to all residents created by the accelerated rate of economic growth. Additionally, the static regressivity concerns can be alleviated through modifications to the sales tax system.

Increasing North Carolina’s average rate of economic growth is the whole purpose of implementing a consumption-based tax reform. Greater economic growth leads to more jobs in North Carolina, increases economic prosper-

ity, and empowers people to better provide for themselves and their families. Simply put, increasing people’s economic opportunity is the best way to help lower-income families.

Moreover, most attempts to measure regressivity fail to account for the value of government transfer payments and government services received by low-income households, which is a major shortcoming. To illustrate this, Figure ES2 below, which is provided by Pennsylvania’s Secretary of Public Welfare, shows household’s income plus the cash value of federal and state government welfare programs (this example illustrates a household with a single parent and two children). The graphic clearly shows that the consumption levels of low-income, middle-income and upper-middle income households are quite similar once income tax burdens and government benefits are taken into account. While this is a measure examining Pennsylvania residents, there is little doubt that such a chart constructed for North Carolina would show very similar results.

Along with the dynamic benefits that will increase the welfare of lower-income and higher-income residents, static concerns with respect to the consumption tax can be directly addressed as well. Sales taxes are generally designed to tax goods. Over the past 30 years, goods as a share of transactions has been declining as the U.S. economy has become oriented toward services. Like many state sales tax systems, North Carolina’s has not kept up with these transitions. Consequently, North Carolina’s sales tax base has become inefficiently narrowed. Expanding the sales tax base to include services becomes an important component of an effective tax reform.

From a regressivity perspective, the expansion of the sales tax base incorporates purchases made, to a larger extent, by higher income individuals. Broadening the sales tax base to purchases skewed toward higher income individuals helps reduce the static regressivity concerns.

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FIGURE ES2: Income plus the Cash Value of Federal and State Government Welfare Programs: Various Income Groups In Pennsylvania

Alternatively, the static regressivity concerns can be alleviated through greater exemptions of the items that account for a greater share of lower-income individual’s budget. For instance, removing food and out of pocket medical expenses from the tax base eases the tax burden across the board but especially for lower income individuals. Thus, the static regressivity concerns would be lessened. Narrowing the tax base comes with a cost. In this case, the tax base would fall from the estimated $193.3 billion to an estimated $180.4 billion. The necessary state sales tax rate under this option would be 7.03 percent (thus increasing the combined state/local sales tax rate to 8.55 percent).

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To the extent that other measures to address regressivity are desired, sales tax refunds or greater sales tax exemptions on goods that consume a larger portion of lowerincome households can be implemented. However, these programs also come with a cost – they require a higher sales tax rate in order to maintain revenue neutrality on a static basis.

Stability Benefits Another major tax reform concern is the stability of tax revenues over the business cycle. Instability of tax rev-

enues causes serious problems. During economic downturns personal income, capital gains, and corporate income tax revenues decline by more than the actual decline in economic activity. North Carolina’s expected revenues from such revenue sources can fall far below forecasted revenues and create severe pressure to raise revenues from other sources, cut spending or borrow. Unfortunately, such pressures often result in tax increases at the worst possible time – a recession.

and lowering income taxes while widening the sales tax base. Such a move would make completing the transition function more smooth, and provide a tax structure more pro-growth than the current structure in the meantime.

Specific details of any phase-in transition period would need to be determined by lawmakers and is beyond the scope of this paper, which is to evaluate the final stage of the proposed tax reform plan.

During periods of economic expansion, capital gains and corporate income tax revenues rise much faster than economic growth. During these times actual tax revenues exceed forecasted revenues. Often the state under such conditions will easily meet or exceed balanced budget requirements. A false impression that these good times are “here to stay” can take hold. Given the inevitable pressure to increase spending to garner votes, much of the new revenue bounty can lead to an excessive increase in government spending. When normal or slower economic conditions take hold it becomes difficult to cut back on the new spending. The revenue volatility has, consequently, led to a pro-spending bias over the business cycle. To stem the revenue volatility problem over the business cycle, more stable sources of revenue should be emphasized while the reliance on more volatile revenue sources should be reduced. This is another benefit gained from eliminating the personal income and corporate income taxes, as these have been found to be much more volatile sources of state revenue than sales taxes.

Concluding Thoughts

Implementation Such a transformation of North Carolina’s tax code would be significant. Transitioning to full implementation of this plan may take some time, perhaps under a phase-in period over a pre-determined number of years.

Should this be the case, the phase-in period should be clearly detailed and would be best if it included flattening

Pro-growth tax reforms generate increased economic activity and job growth. The longer a pro-growth tax system is in place, the greater these gains and the more prosperous a state’s economy becomes. During prosperous times, when economic growth is greater, there is the added benefit of falling demand for government social spending programs (e.g., unemployment, welfare, etc.) that further benefits a state’s budget. It also creates greater opportunity for all residents of North Carolina. The tax reform plan currently being proposed by state lawmakers represents an opportunity to break from North Carolina’s past and addresses the current weaknesses in the state’s tax system. Such a pro-growth tax reform will make North Carolina more competitive than all of its neighbors and help the state reclaim the designation of one of the premier growth states in the country.

The range of estimates is based on the estimated equation based on the first differences (lower estimate) and levels (higher estimate).

The values are calculated using the estimated income coefficients from both equations and North Carolina’s estimated marginal income tax rates based on the first differences and based on the levels. ii “2012 Annotated Conference Committee Report on the Continuation, Expansion, and Capital Budgets” Fiscal Research Division, North Carolina General Assembly. iii “Tax Modernization Working Group, Senate Appropriations Meeting”, Fiscal Research Division, North Carolina General Assembly, October 17, 2012. iv “Tax Modernization Working Group, Senate Appropriations Meeting”, Fiscal Research Division, North Carolina General Assembly, October 17, 2012. i

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Introduction: The Need to Reform North Carolina’s Taxes

N

orth Carolina was once a growth champion of the national economy. Between 1981 and 1999, North Carolina’s average personal income growth was the 4th fastest in the nation. Since 2000, however, North Carolina’s personal income growth premium relative to the national average has significantly slowed. Average personal income growth has been the 26th fastest in the nation between 2000 and 2011. And, the change in North Carolina’s economic fortunes is visible across many different economic measures.

Figure 1 illustrates this trend for overall state economic activity, or state GDP.1 In 1981 economic activity in North

Carolina accounted for 2.1 percent of total economic activity in the U.S. By 1999, due to the substantially faster pace of economic growth in North Carolina, economic activity in North Carolina accounted for 2.8 percent of total economic activity in the U.S. Like personal income growth, North Carolina’s accelerated rate of economic growth did not persist into the 2000s. As of 2011, economic activity in North Carolina was 2.9 percent of total U.S. economic activity – only slightly larger than the share in 1999. And, while the GDP data are not directly comparable pre- and

post-1997, the trend of a growing share of the U.S. economy (the dotted line in Figure 1), had it continued, would have led to a significantly larger amount of economic output in North Carolina by 2011.

Figure 2 illustrates that the same pattern holds for North Carolina’s share of total U.S. employment—jobs were created in North Carolina at a faster rate than the nation overall in the 1980s and 1990s, but during the 2000s a significant relative slowdown in North Carolina job creation also occurred. Had North Carolina’s share of total U.S. employment continued on its 1981 through 1999 trend line (dotted line in Figure 2) by 2011 there would have been an additional 402 thousand jobs in the state.

Figure 3 illustrates that a similar dynamic also occurred with respect to median household income. In 1984, North Carolina’s median household income of $20,569 was only around 92 percent of the national median household income of $22,415. Median household income grew faster in the 1990s in North Carolina relative to the U.S. until 1996 when it was actually slightly larger than the U.S.

FIGURE 1: North Carolina GDP as a Share of Total U.S. GDP 1981–20112 Ratio: NC/US (SIC)

Ratio: NC/US (NAICS)

1981–1997 Trend

3.0%

2.5%

2.0%

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

1.5%

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FIGURE 2: North Carolina Employment as a Share of Total U.S. Employment 1981–20113 NC Emp. Share U.S. Emp.

Trendline 1981–1999

3.3%

3.1%

2.9%

2.7%

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

2.5%

FIGURE 3: North Carolina’s Median Income Relative to U.S. Median Income 1984 - 20114 110.0% 100.0% 90.0% 80.0% 70.0% 60.0%

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

50.0%

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median household income ($35,601 in North Carolina compared to $35,492 for the U.S. overall). Since 1996, median household income growth in North Carolina has lagged the nation such that by 2011 North Carolina’s median household income of $45,206 was 90.3 percent of the U.S. average of $50,054.

Since 1996, median household income growth in North Carolina has lagged the nation Figures 1 through 3 illustrate a disappointing trend for North Carolina: the state is no longer growing significantly faster than the national economy—in fact it is lagging in some measures— and the slower growth premium has been persisting for more than a decade. The cost in lost employment opportunities, lost income, and lost wealth is tremendous.

North Carolina’s prolonged economic growth slowdown is a multi-faceted problem. For instance, several major sectors of North Carolina’s economy—non-durable goods manufacturing, real estate, and construction, which

together accounted for nearly a quarter of North Carolina’s total economic output as of 2011—underperformed the national growth trends in these sectors. While non-durable goods manufacturing in the U.S. increased 47.0 percent between 2000 and 2011, it only grew 20.8 percent in North Carolina. Similarly, the construction industry and real estate industries have created greater volatility in North Carolina than average, and due to weaker than average growth since the financial crisis, are currently depressing North Carolina’s economic growth relative to the country.

However, the impact from policy cannot be ignored either.

North Carolina’s tax policy is an important contributing factor to the state’s economic slowdown. Taxes in the Tar Heel state have never been optimal, but have worsened over time. For instance, Figure 4 presents North Carolina’s state tax burden relative to the average state and local tax burden.

As Figure 4 illustrates, during the 1980s and 1990s when North Carolina’s economic growth rate was substantially faster than the nation’s its tax burden was less than the nation’s. The reverse is true during the 2000s.

FIGURE 4: North Carolina’s Tax Burden Compared to the U.S. Average State Tax Burden 1984 - 20105 NC

US

10.5% 10.0% 9.5% 9.0% 8.5%

1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

8.0%

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Implementing a pro-growth tax reform can help reinvigorate North Carolina’s substantial growth premium once again

consistent and predictable. Taxpayers should be well aware of the tax burden in place and revenue estimates should be fully explained in a public manner.

Implementing a pro-growth tax reform can help reinvigorate North Carolina’s substantial growth premium once again.

There are many pro-growth tax reforms that would benefit North Carolina. Any proposed alternative tax reform proposal should be judged against the criteria of the optimal tax system. An optimal tax system is one that is:

• Simple – The state tax code should be easily understood by taxpayers. Compliance costs should be minimized, as should enforcement costs. A more simple tax code increases voluntary compliance and limits the incentives to engage in tax-avoidance activities.

• Growth Enhancing – Tax policy should be one most conducive to economic growth, job creation, opportunity and increased financial prosperity for all North Carolinians. Such a policy would encourage capital investment and make North Carolina more competitive at attracting existing businesses into the state, encouraging more new domestic businesses, as well as expansion of existing businesses.

Arduin, Laffer & Moore Econometrics has been asked to evaluate the economic benefits from a consumption-based tax system being proposed by North Carolina legislative leaders, with the following major provisions:

• Economically Neutral – North Carolina’s tax structure should minimize distortions to economic decisions made by households and businesses. The tax system should not favor certain industries, activities or products. As such, North Carolina’s economy will be able to adapt and diversify in concert with an ever-changing, dynamic marketplace rather than being heavily concentrated and tied down to specific industries favored by a biased tax code.

• Stable – The tax structure should be designed in a way to limit fluctuations of revenue during economic booms and busts and thus provide a more predictable source of funding for state government.

Such stability will help budget writers avoid future tax rate increases and significant changes in state agency appropriations.

• Transparent – Tax structures should be clear,

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1) Repeal the personal income tax, corporate income tax, and franchise tax 2) Expand the current sales tax base to include all services currently taxed in at least one state 3) Expand the current sales tax base to close current loopholes (e.g. preferential rates for certain goods) 4) Expand the real estate conveyance fee 5) Implement a business license fee levied on all businesses with a base equal to assets minus liabilities minus retained earnings, determined in accordance with Generally Accepted Accounting Principles This consumption based tax system fits all of the criteria listed above: • Growth Enhancing – As demonstrated below, income taxes have a larger negative impact on growth than consumption taxes.

• Economically Neutral – Because the consumption tax base is significantly expanded, the tax system reduces the distortions between alternative consumption decisions.

• Stable – As demonstrated below, consumption is a more stable tax base than income.

• Transparent – The tax rates are visible and can be broken out on the receipts such that both the consumer and producer are fully informed regarding the taxes charged.

• Simple – The consumption tax is a simple flat rate charged against a known base. Vagaries regarding “what is the tax base” are significantly reduced.

This paper outlines the justifications and benefits for transforming North Carolina’s current anti-growth tax system into a pro-growth, consumption-based tax system.

The next section of the paper compares North Carolina’s tax system to its neighbors and the national average illustrating the competitive disadvantages North Carolina currently faces due to its tax system. Following this discussion, the theory behind a pro-growth consumption-based tax system is presented along with summaries of key economic studies that substantiate the findings of this paper – high progressive income tax systems (such as North Carolina’s) reduce a state’s potential rate of economic growth. Having presented the current competitive disadvantage created by

North Carolina’s tax system, the next section presents the proposed tax reform. Of course, the purpose of pursuing the tax reform is to increase economic growth – create dynamic impacts. The final section estimates the potential dynamic economic benefits that could be generated by the proposed reform.

North Carolina’s Regional Competitors: A Quick Overview As discussed above, North Carolina’s economy is no longer growing significantly faster than the national average. It is also significantly underperforming its neighbors in several key metrics. Figure 5 illustrates that North Carolina’s poverty rate is both significantly higher than the national average and North Carolina’s key competitors of Virginia and South Carolina.

Figure 6 compares the median household income in North Carolina compared to its neighbors and the U.S. average.

Amongst North Carolina’s neighbors, only Virginia’s median household income exceeds the national average. More

FIGURE 5: Poverty Rate: North Carolina Compared to U.S. and Neighbors 20116 20.0%

17.9%

18.3%

19.1%

15.9% 13.9%

15.0%

11.5% 10.0%

5.0%

0.0%

VA

SC

U.S.

NC

TN

GA

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FIGURE 6: Median Household Income: North Carolina Compared to U.S. and Neighbors 2011 (in dollars)7 20.0%

62,444 50,443

15.0%

47,003

45,741

45,210

GA

NC

41,044

10.0%

5.0%

0.0%

VA

U.S

SC

TN

troubling for North Carolina, compared to its relatively

North Carolina’s overall tax burden is the 17th highest in the

poor neighbors, North Carolina’s median household income

nation and it is the highest tax burden compared to all of its neighboring states.

is the second lowest. Consequently, both poverty and low average incomes continues to be a problem that must be addressed in North Carolina.

A review of how North Carolina’s tax system stacks up in its region and nationally illustrates that North Carolina’s tax competitiveness is a restraint to growth. The purpose of the tax reform is to remove this constraint helping to accelerate economic growth in North Carolina creating greater economic opportunity, jobs, income, and more stable tax revenues for the state. Perhaps more importantly, sustained economic growth is the greatest cure for poverty.

Rating North Carolina’s Tax System Starting with overall tax burdens, according to the Tax Foundation, total state and local taxes in North Carolina comprised 9.91% of total personal income in 2010, which is above the national average of 9.86 percent, see Figure 7.8

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Top Marginal Personal Income Tax Rate Compared to its neighbors, North Carolina has the highest top marginal income tax rate, which also exceeds the national average by nearly 1.8 percentage points. Alternatively stated, North Carolina’s top income tax rate requires people in North Carolina to pay an additional $17.90 for every $1,000 in taxable income they earn compared to the national average.

Top marginal income tax rates are not necessarily comparable, however. For instance, North Carolina’s top rate does not apply until an income of $60,000 ($100,000 for a couple), while Georgia’s top marginal income tax rate of 6.00% becomes effective at $7,000 ($10,000 for a couple). The top bracket is an important indicator, however. The top marginal tax rate determines the incentive to innovate for many of the most economically productive citizens and businesses in the state. On this measure, North Carolina scores poorly.

FIGURE 7: Total Tax Burden as a Percentage of Personal Income: North Carolina Compared to U.S. and Neighbors 20109 12.00% 10.00%

9.91%

9.25% 7.72%

8.00%

8.96%

8.37%

Average U.S. Tax Burden: 9.86%

6.00% 4.00% 2.00% 0.00%

NC

VA

TN

GA

SC

FIGURE 8: Top Marginal Personal Income Tax Rate: North Carolina Compared to U.S. and Neighbors 2012 9.00% 8.00%

7.75% 7.00%

7.00%

5.75%

6.00%

6.00%

5.00%

Average Top Marginal Income Tax Rate: 5.96%

4.00% 3.00% 2.00% 1.00% 0.00%

0.00% NC

VA

TN

GA

SC

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Ideally, states will tax the largest possible tax base at the lowest possible tax rate. Personal income tax codes often fall far short of this economic ideal. Despite the fact that both might generate a similar revenue stream, the tax structure of a state which imposes a low flat-rate tax on a broad range of personal income provides greater economic efficiency, growth incentives, and subsequently experiences greater economic performance than the tax structure of a state with a narrow, highly progressive personal income tax.

Sales Tax Rate and Burden Due to the differences in state sales tax bases and the complexity that local sales taxes add, we compare North Carolina’s sales tax burden using two different measures: average state and local sales tax rates and state and local sales tax revenues per $1,000 of personal income. Table 1 compares North Carolina’s state and local sales tax rate to its neighbors based on the average combined state and local sales tax rates.10

TABLE 1 State and Average Local Sales Tax Rates: North Carolina Compared to U.S. and Neighbors 2012 Minimum State & Local Sales Tax Rate Georgia North Carolina South Carolina Tennessee Virginia U.S. Average

6.87% 6.87% 7.12% 9.43% 5.00% 6.88%

When the average state and local sales tax rates are compared, North Carolina’s 6.87 percent rate is around the average U.S. rate of 6.88 percent, and is average compared to its neighbors – the neighbor that has a lower average state and local sales tax rate is Virginia. Total sales tax revenue per $1,000 of personal income provides a measure of the pervasiveness of the combined state and average local sales

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tax rates. Figure 9 compares the sales tax burden per $1,000 of personal income in North Carolina to its neighbors as well as the U.S. average.

Figure 9 illustrates that North Carolina imposes an average sales tax burden compared to the country as a whole; and, except for Tennessee, a slightly higher sales tax burden compared to its neighbors. While not a unique problem, North Carolina’s sales tax base is also becoming inefficiently narrow. Based on North Carolina’s 2010 state sales tax revenues and the state sales tax rate, a rough estimate of the state sales tax base is between 24.0 percent and 25.0 percent of the total value of goods and services produced in the economy.11 The 24.0 percent figure is calculated based on North Carolina’s 5.75 percent state sales tax rate (for 2010) that raised $5.9 billion.12 This implies a sales tax base of $102 billion. The 25.0 percent figure is based on an estimated sales tax base (including local) of $109 billion from the North Carolina Department of Revenue.13 Total state GDP in North Carolina was $424.6 billion in 2010.

Consequently, the estimated sales tax base was between 24.0 percent and 25.0 percent of total state GDP.

This continued narrowing of North Carolina’s state sales tax base is contrary to the requirements of a good tax source The sales tax base is less than one-half of North Carolina’s economy because the 21st Century economy is skewed toward services and other intangibles, while the state’s sales tax base is skewed towards tangible goods and only a sub-set of the economy’s services. Consequently, the state sales tax is not being collected on a growing percentage of sales of final goods and services in North Carolina’s economy. It is likely that the percentage of sales covered by the state sales tax will continue to decline in the future as 21st Century industries continue to outperform the growth in the tangible goods economy. This continued narrowing of North Carolina’s state sales tax base is contrary to the requirements of a good tax source.

FIGURE 9: State and Local Sales Tax Burden per $1,000 of Personal Income: North Carolina Compared to U.S. and Neighbors 2010 $50.00

$46.42

$45.00 $40.00 $35.00

$35.58

$30.00

$23.33

$25.00

$32.77

$30.43

GA

SC

Average Sales Tax Burden $35.03

$20.00 $15.00 $10.00 $5.00 $0.00

NC

VA

Combination Tax Rate The above review of the main state tax revenue sources – individual income taxes and sales taxes – does not provide an immediate answer with respect to which state has a more competitive tax system. In order to grasp this more fully we have constructed a “combination” tax index in Table 2. The combination tax index shows the marginal tax bite for the major tax systems (personal income taxes and sales taxes) combined.14 The combination tax would be appropriate for a wage earner or someone who is receiving income that does not pass through the North Carolina’s (or other states) corporate income tax system. In North Carolina, a person earning above $60,000 a year (or couple earning $100,000 a year) would confront a 7.75 percent top marginal income tax rate; and, when this after-tax income is consumed they would have to pay average state and local sales taxes of 6.87 percent on those goods and services subject to the sales tax. A median income household earning $45,210 would confront a 7.0 percent marginal income tax rate; and, when

TN

this after-tax income is consumed they would have to pay average state and local sales taxes of 6.87 percent on those goods and services subject to the sales tax.

Based on the income and sales tax rates for North Carolina, North Carolina’s neighbors and the U.S. average, we calculate the combination tax – the amount of money that the income and sales taxes take for every $100 of earnings in the respective states, assuming that the income earnings face the highest state marginal income tax rate and the rate faced by the state’s median income household. The average state and local sales tax rate is adjusted because not all income is spent on goods and services that pay a state and local sales tax – and this percentage varies by state. Total state sales tax rates are the average state sales tax revenues as a percentage of personal income.

The results of the personal combination tax are summarized in Table 2. In North Carolina, when a person facing the top state marginal income tax rate earns $100, he must pay the personal income tax of 7.75 percent, or $7.75 in

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TABLE 2 Top Combination Tax Rate: North Carolina Compared to U.S. and Neighbors 2012

North Carolina Georgia South Carolina Tennessee Virginia U.S. Average

Starting Personal Income $100.00 $100.00 $100.00 $100.00 $100.00 $100.00

Personal Income Personal Income Tax $92.25 $94.00 $93.00 $100.00 $94.25 $94.04

Personal Income Personal Income Tax - Sales Tax Burden $88.69 $90.72 $89.96 $95.36 $91.92 $90.54

Combination Tax Rate -11.31% -9.28% -10.04% -4.64% -8.08% -9.46%

Source: ALME Calculation

income taxes. This leaves the person with $92.25 of income (disregarding the effect of federal taxes). The average sales tax burden subtracts another $3.56, leaving $88.69 in after-tax income for the individual or an 11.31% combination tax rate.

North Carolina has the highest combination tax rate in the region taking 11.31-cents from each additional dollar earned through income and sales taxes, based on the combination tax rate. Perhaps more troubling, North Carolina’s combination tax is substantially higher than the U.S. average. And, the combination tax facing the median household in North Carolina is not much better. While the highest personal income tax applies to households earning the median state income in all of North Carolina’s neighbors, the median household income tax rate in North Carolina is 7.0 percent.

Based on the median household income, North Carolina’s combination tax is 10.56 percent. Under North Carolina’s current high income tax system, consequently, households earning the median income face a larger tax rate than the wealthiest families in all of North Carolina’s neighbors.

Entrepreneurs, as opposed to locating in North Carolina, could settle in Virginia or Tennessee where the combination marginal tax rate is significantly less than the tax rates they would face in North Carolina. The comparison of North Carolina’s combination tax rates indicates that the state should lower these costs in order to induce more businesses and economic activity into the state.

18

Corporate Income Tax Rate North Carolina’s corporate income tax rate is similarly uncompetitive compared to its neighbors, see Figure 10.

North Carolina’s corporate income tax is slightly less than the national average. However, it is higher than all of its neighbors. As a result, corporations have a greater incentive to locate in any of North Carolina’s neighbors where the corporate income tax burden is smaller compared to North Carolina where $6.90 of every $100 in profits is paid to the government.

Summary While many other state policies are important from an economic growth perspective, a pro-growth state tax policy is also crucial. North Carolina’s tax system fails the progrowth criteria. Confirming this review, the Tax Foundation’s Business Tax Climate index ranks North Carolina’s business climate as the 7th worst in the nation.15 And, the consequences are becoming visible in North Carolina’s relative economic slowdown – note that the economic slowdown began prior to the 2008 recession, and because the measure is relative, takes into account for the nation’s slower economic recovery.

In other words, North Carolina’s economic struggles predate the recession and are more than just a reflection of the state being hard hit in the economic bust.

Specifically, North Carolina’s trouble spots are: • An exceptionally high personal income tax rate; • An uncompetitive corporate income tax compared to other states in its region; • A combined sales and income marginal tax burden that significantly exceeds the nation and region; and, • An overall tax burden that has gone from generally below the national average to generally above the national average.

Addressing North Carolina’s uncompetitive tax system, consequently, can help re-establish North Carolina as a national growth leader As illustrated below, a pro-growth tax reform that addresses these trouble spots is associated with faster economic growth. Addressing North Carolina’s uncompetitive tax

system, consequently, can help re-establish North Carolina as a national growth leader.

Revenue Stability: Further Reasons to Eliminate Personal and Corporate Income Taxes Another major tax reform concern is the stability of tax revenues over the business cycle. Instability of tax revenues causes serious problems. During economic downturns personal income, capital gains, and corporate income tax revenues decline by more than the actual decline in economic activity. North Carolina’s expected revenues from such revenue sources can fall far below forecasted revenues and create severe pressure to raise revenues from other sources, cut spending or borrow. Unfortunately, such pressures often result in tax increases at the worst possible time – a recession.

During periods of economic expansion, capital gains and corporate income tax revenues rise much faster than economic growth. During these times actual tax revenues

FIGURE 10: Top Marginal Corporate Income Tax Rate: North Carolina Compared to U.S. and Neighbors 2012 8.00% 7.00%

6.90%

6.50% 6.00%

6.00%

6.00% 5.00%

5.00%

Average Top Marginal Corporate Income Tax Rate: 6.93%

4.00% 3.00% 2.00% 1.00% 0.00%

NC

VA

TN

GA

SC

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FIGURE 11: Volatility of Tax Revenues: Total Income Taxes versus Sales Taxes 1970-71 through 2011–1217 7.4%

7.3%

7.2% 7.0% 6.8%

6.5%

6.6% 6.4% 6.2% 6.0%

Total Income Taxes

exceed forecasted revenues. Often the state under such conditions will easily meet or exceed balanced budget requirements. A false impression that these good times are “here to stay” can take hold. Given the inevitable pressure to increase spending to garner votes, much of the new revenue bounty can lead to an excessive increase in government spending. When normal or slower economic conditions take hold it becomes difficult to cut back on the new spending.

The revenue volatility has, consequently, led to a prospending bias over the business cycle. The greater volatility of income taxes versus sales taxes in North Carolina is visible in Figure 11.

Figure 11 measures the volatility of revenues by the standard deviation – or a statistical measure of dispersion that illustrates the historical volatility of the tax revenue data. A higher standard deviation is indicative of greater historical volatility. In this case, income tax revenues in North Carolina have experienced greater historical volatility than sales tax revenues.

20

Sales & Use

To stem the revenue volatility problem over the business cycle, more stable sources of revenue should be emphasized while the reliance on more volatile revenue sources should be reduced. This is another benefit gained from eliminating the personal income and corporate income taxes.

The Theory behind a Pro-Growth Tax System High marginal income taxes crowd out the private economy, diminishing its rate of growth. The driving force of the economy is the incentive to engage in market activities.

In both the long and short run, individuals and groups of individuals allocate resources according to the after-tax rate of return. If market activities are profitable, the economy will concentrate on ever-increasing market successes. When the profitability of market activities is reduced, market activity diminishes and welfare enhancing activities cease.

It is true that all tax changes create two primary economic effects. Economists deem these the income effect and the substitution effect. The income effect examines the changed behavior that directly arises from changes in

income or wealth. For example, people will tend to increase the amount of consumption in response to an increase in income. The substitution effect examines the changed behavior that arises from changes in the relative costs of different goods or activities. For example, a switch in tax policy that reduces the costs of good A compared to good B will provide incentives for people to consume more of good A than good B.

earned was zero, there is very little incentive for anyone to work, save or invest under such a punitive tax rate. Now imagine the work or investing incentives a person would face if the marginal tax rate on the next dollar earned was zero. Under this scenario, the investor or worker would get to keep the full value of the income or return that they earn. Obviously, the second scenario is more favorable to the worker or investor than the first.

Although tax changes create both income effects (the incentive to work less following a tax reduction because of the desire to “consume” more leisure) and the substitution effect (the incentive to work more following a tax reduction due to the increased returns to work), these effects are often confused. In fact, this confusion led to the misguided stimulus policies of the Bush and Obama Administrations following the financial crisis.

Any tax reform in North Carolina should increase the aftertax income for the next dollar earned, raise the reward to work, and thereby increase the cost of leisure – the cost of leisure can be measured by the amount of other consumption goods that people could purchase (e.g., a new car or a highdefinition TV) with the extra work effort. This opportunity cost to leisure increases following a decrease in the marginal income tax rate. Whenever a good’s cost increases, rational people will economize on its use. These incentives are encapsulated by the aforementioned substitution effect that induces people to work more. Because the substitution effect captures the trade-off between work and leisure, it is the marginal tax rate (the amount of extra consumption that a person must give up by not working) that is the appropriate incentive driver.

However, there is not stimulus in these types of government stimulus programs. When the government pays someone (Paul) by taking the money away from someone else (Mary), any stimulative impact from Paul’s spending will be completely offset from an equal amount of reduced spending caused by the money being taken away from Mary.

In economic terms, the income effects offset one another.

This is not the end of the story, however, because when the government takes money away from Mary, her after-tax rate of return declines. The lower after-tax rate of return reduces Mary’s incentives to work, save, and invest, which leads to fewer private sector market activities and lower overall economic growth.

With respect to taxes, increased taxes as a share of the economy diminish economic growth. For any economic decision (i.e., work effort, saving, or investing) the marginal tax rate on the next dollar earned is crucial. To see why the marginal tax rate matters, imagine the work or investing incentives a person would face if the marginal tax rate on the next dollar earned was 100 percent. Under this scenario, every extra dollar a person earns would go straight to the government. Regardless if the tax rate on the previous dollar

Government revenues are not immune from the incentive drivers either. Individuals want to maximize their after-tax income. It is clear that the government will raise no revenue by levying a zero percent tax on income; the government takes none of the income earned so government revenues are zero. Similarly, the government can expect to raise no revenue by levying a 100 percent tax on income; there is no incentive for anyone to work so taking 100 percent of nothing is still nothing. This effect (i.e. the Laffer Curve Effect) incorporates the economy’s dynamic realities and importantly illustrates that government revenues are not always raised when the marginal tax rate is increased.

Government revenues can be significantly enhanced when tax reforms lead to positive growth-enhancing incentives that grow the tax base. The government will, consequently,

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share in the beneficial growth impacts. The resulting growth in the economy and consequently the consumption base will lead to a larger tax base and lead to even larger revenues.

Growing revenues resulting from higher economic growth will enable future lawmakers to lower tax rates to encourage still greater economic growth.

Tax policies that increase the incentive to produce, invest and innovate will attract industries and entrepreneurs Tax policies that increase the incentive to produce, invest and innovate will attract industries and entrepreneurs. Increased economic growth, income and employment follow. Tax reform should reduce the penalty from additional work, savings, and investment and subsequently encourage increased: • Work effort • Work demand (and subsequently wages)

• Savings • Investment and subsequently, greater capital accumulation

State Income Taxes an Impediment to Growth The proposed consumption-based tax system described in detail below improves the overall economic incentives in the economy by transforming North Carolina’s current high marginal income tax system into a broad-based flat tax on consumption, thereby producing increased incentives to work and produce in the state. As Slivinski (2012) nicely explains: Income taxes don’t just open the door to multiple levels of taxation of each dollar of economic growth. They are also not neutral with respect to all economic decisions. Even an income tax system that existed without any extraneous credits and deductions would still discriminate against saving and investing because of its application to all forms of income. By lowering the after-tax return on an

FIGURE 12: Average Annual Growth for States without Corporate Income Tax Compared to All Other States19 No Corporate Income Tax Corporate Income Tax

4.4% 3.7%

2.7%

1.8% 1992–2001 22

2002–2011

investment relative to the return on consumption, the income tax system biases the economy in favor of consumption. In other words, income taxes stack the deck against the most important elements of a vibrant economy: savings and investment.18 Real world illustrations of this theory can be seen in the relative economic performance of those states without a corporate income tax compared to all of the other states; and, the relative performance of those states without a personal income tax compared to all of the other states.

The average annual growth rates for those states without a corporate income tax exceeded the growth rate of all other states by 0.7 percentage points per year between 1992 and 2001, and by 1.0 percentage point between 2002 and 2011, see Figure 12.

There was a similar growth premium for the states that do not impose a personal income tax compared to all other states. The average annual growth rates for those states without a personal income tax exceeded the growth rate of

all other states by 0.7 percentage points per year between 1992 and 2001, and by 0.5 percentage points between 2002 and 2011, see Figure 13.

While over this 20 year period, those states without a corporate income tax or without a personal income tax consistently experienced stronger economic growth than the other states, this was not the case for those states without a sales tax. The states that do not levy a sales tax experienced slightly more growth during the 1992 through 2001 period, but grew slower than the states with a sales tax during the 2002 through 2011 period, see Figure 14.

In other words, over the last 20 years those states that did not tax income (either corporate or personal) gained a growth advantage vis-Ă -vis all other states. Alternatively, those states without a sales tax did not outperform the states with a sales tax.

Such findings substantiate the theory presented above and are consistent with the studies that have examined the impact from income taxes on economic growth. For

FIGURE 13: Average Annual Growth for States without Personal Income Tax Compared to All Other States20 No Personal Income Tax Personal Income Tax

4.4%

3.7%

2.2% 1.7% 1992–2001

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FIGURE 14: Average Annual Growth for States without a Sales Tax Compared to All Other States21 3.7%

3.7%

No Sales Tax Sales Tax

1.9% 1.5%

1992–2001

instance, Poulson and Kaplan (2008) directly examined the impact of higher average marginal state taxes on economic growth finding that: ‌differences in tax policy pursued by the states can lead to different paths of long-run equilibrium growth. Regression analysis is used to estimate the impact of taxes on economic growth in the states.

The analysis reveals that higher marginal tax rates had a negative impact on economic growth in the states. The analysis also shows that greater regressivity had a positive impact on economic growth. States that held the rate of growth in revenue below the rate of growth in income achieved higher rates of economic growth.

The analysis underscores the negative impact of income taxes on economic growth in the states. Most states introduced an income tax and came to rely on the income tax as the primary source of revenue. Jurisdictions that 24

2002–2011

imposed an income tax to generate a given level of revenue experienced lower rates of economic growth relative to jurisdictions that relied on alternative taxes to generate the same revenue22 Dye (1999) explicitly examined the impact of a state income tax by examining the relative economic growth impacts on those states following the adoption of an income tax. Reiterating the rationale against an income-based tax system, Dye explains that It is not only the total tax burden that creates disincentives to economic growth, but also the types of taxes governments choose. Consumptionbased taxes, notably state sales taxes, may not have the same negative effect on productivity as corporate or individual income taxes. It is true that sales taxes are paid out of personal income, but it is consumption that is being taxed directly, not work, savings, or investment. Income taxation with graduated rates has a more harmful effect

because it substantially lowers the rate of return on the work and savings of the most productive citizens. Even relatively modest overall tax burdens can have a very adverse effect on economic growth if these burdens are carried disproportionately by the most productive individuals and firms.

These individuals and firms are usually the most mobile, and a state income tax with a high top rate creates a strong incentive to relocate.23 Overall, Dye found “…strong econometric evidence that an income tax does indeed drive up the size of state government. Further, it has a significant adverse effect on the state’s economy.”24 These findings are echoed in Laffer and Winegarden (2012). 25 Laffer and Winegarden examined the impact on relative economic growth in each one of the last 11 states that implemented an income tax finding that …the size of the economy in each one of these states [the last 11 states to implement an income tax] has declined as a share of the total U.S. economy compared to a time just prior to when each state introduced its income tax. Some of the declines are quite large. Connecticut, for example, went from 1.74 percent of U.S. GDP in the 1986-1990 period to 1.63 percent in 2010. New Jersey fell from 3.66 percent of U.S. GDP from the 19711975 period to 3.35 percent in 2010. From 1967 to 1971 Ohio was 5.42 percent of total U.S. GDP yet in 2010 it fell to 3.28 percent. Rhode Island and Pennsylvania respectively went from 0.44 percent and 5.72 percent of the U.S. in the 1966-70 period to 0.34 percent and 3.91 percent in 2010. Maine’s and Illinois’ pre-tax period was 1964-68 and they dropped respectively from 0.39 percent and 6.52 percent of the total U.S. GDP to 0.35 percent and 4.48 percent in 2010. Our beloved Michigan, which seems never to get a break, went from 5.08 percent in the 1962-1966 period to 2.64 percent in 2010. Leaping Lizards!

And lastly, Indiana in 1963 and West Virginia in

1961 went from 2.61 percent and 0.79 percent to 1.89 percent and 0.48 percent, respectively.

And, who could have thought that West Virginia could actually decline further from its state of abject poverty in the early 1960s? But it did.26

Statistical Testing Illustrates Marginal State Tax Rates Hamper Growth To test the theory that higher marginal tax rates are associated with slower state economic growth, we leveraged the methodology used by Besci (1996), and Poulson and Kaplan (2008) to estimate the relative average marginal income tax rates across the 50 states from 1977 – 2012.27 This methodology estimates the average marginal tax rates across the states and then, based on these estimates, examines the impact from higher average marginal tax rates on economic growth (a detailed description of this methodology is included in the appendix).

Instead of using total tax revenues, we analyze the separate impacts of income tax revenues (personal and corporate) and sales tax revenues. Figure 15 presents each state’s calculated average marginal income and sales tax rates compared to the average personal income growth rates between 1977 and 2010. Figure 15 illustrates a negative correlation between a state’s average marginal personal income tax rate and its average annual total personal income growth rate – those states with lower average marginal income tax rates experienced stronger average annual personal income growth.28 These findings are consistent with the results presented in Figure 12 and Figure 13. Figure 15 also illustrates that the same correlation does not hold for the average marginal sales tax rates, which is also consistent with the findings from Figure 14 (these measures taken to the first differences of data are presented in the Appendix in Figure 19).

Once the estimated average marginal tax rates are estimated, we analyzed the impact from the different estimated average marginal income tax rates on overall economic growth and the impact from the different estimated average marginal

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FIGURE 15: Estimated Average Marginal Tax Rates Compared to Personal Income Growth Data from: 1977 - 2010 7% Estimated Income Taxes 6% 5% 4% 3% 2% 1% 0% 1% -1%

2%

3%

4%

5%

6%

Average Personal Income Growth Rate

0% 7%

Estimated Sales Taxes

6% 5% 4% 3% 2% 1% 0% 1% -1%

3%

4%

5%

Average Personal Income Growth Rates 0%

26

2%

6%

sales tax rates on overall economic growth. Overall economic growth is measured as the average annual rate of total personal income growth in the states between 1977 and 2010.29

Overall, our results found that states with higher average marginal income tax rates are associated with slower economic growth; while states with higher average marginal sales tax rates are not associated with slower economic growth The results from the analysis are presented in detail in the Appendix, Table A-I. Overall, our results found that states with higher average marginal income tax rates are associated with slower economic growth; while states with higher average marginal sales tax rates are not associated with slower economic growth. And, the empirical literature substantiates our results.

Studies Illustrate a Strong Link between Economic Growth and Tax Policy The effect of fiscal policies—especially with regard to taxation—and relative economic growth rates is a paramount concern to legislators, businessmen, economists, and the general public. Not surprisingly, an extensive literature examining taxes impact on relative economic growth has emerged. In fact, taxes impact on the economy has been a core part of economic analysis beginning with Adam Smith in 1776.

John Maynard Keynes in “The General Theory” represents the first major break with the classical economic paradigm, including the classical view of tax policy. However, Keynes himself subscribed to many of the tenets of sound tax policy as espoused by the classical economists.

Keynesian economics, as differentiated from the actual ideas of Keynes, developed tax policy theories that departed further from the ideas of the classical economists during the 1950s and 1960s. The Keynesian approach to tax policy is predicated on several key errors – including the subjugation of economic incentives and the belief that

income effects, which by definition must sum to zero from a macroeconomic perspective, are the predominate economic impact from changes in tax policy.

Many of the insights from supply-side economics can be appropriately viewed as (1) an illustration of the errors of the Keynesian break from classical tax theory and (2) an extension of the classical economic analysis to current issues and realities. The supply-side tax policies, along with sound monetary policy and the deregulation of the late 1970s and 1980s, are directly responsible for the prosperity and extraordinary economic growth between 1983 and 1999.

Despite the successes of supply-side tax theory, many of the errors from Keynesian tax theory persist in modern mainstream public finance theory – what is often referred to as neoclassical economics. Tax theory errors manifest themselves in poor public policies and a misunderstanding of major current economic trends. For instance, the logic behind the 2008 “stimulus rebate checks” are based on these flawed economic tax policy studies. In fact, many studies have found a negative relationship between government spending and economic growth including: Barro (1991), Gwartney, Lawson, and Holcombe (1998), Laffer (1971), Laffer (1979), Landau (1983), Mitchell (2005), and Scully (2006).30 This review, however, examines the impact from taxes (not spending) on economic growth. Many studies have also found a significant and negative relationship between higher government taxes and lower rates of economic growth, in addition to the ones already cited. Starting with studies that examined the impact from a national level, Nobel Laureate Edward Prescott uses a Growth Accounting framework to measure the impact of taxes on the economy.31 Growth Accounting decomposes the drivers of growth into three primary factors: labor, capital and technology. Prescott uses this decomposition to evaluate the impact of taxes on labor, capital and technology on economic growth from a national perspective – particularly the causes of economic depressions. For instance, Prescott (2002) finds:

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The United States is prosperous relative to France because the U.S. intratemporal tax wedge that distorts the tradeoff between consumption and leisure is much smaller than the French wedge. I will show that if France modified its intratemporal tax wedge so that its value was the same as the U.S. value, French welfare in consumption equivalents would increase by 19 percent. Consumption would have to increase by 19 percent now and in all future periods to achieve as large a welfare gain as that resulting from this tax reform.

The United States is prosperous relative to Japan because production efficiency is higher in the United States. In the United States, total factor productivity is approximately 20 percent higher than in Japan. If Japan suddenly became as efficient in production as the United States, its welfare gain in consumption equivalents would be 39 percent.

Prescott finds that tax policies matter because taxes impact the incentive to work, innovate, and accumulate capital.

Countries whose tax policies discriminate against any of these factors of production discriminate against economic growth. Countries that impose significantly onerous tax policies (such as the labor taxes in France or the tax discrimination against productivity in Japan) risk “economic depressions” according to Prescott. States should certainly learn a lesson from Prescott’s findings.

A series of studies on the impact of differential levels of taxation on the growth rates of various states illustrates that states with relatively uncompetitive state tax systems experience slower economic growth. For instance, Poulsan and Kaplan (2008) discussed above. Becsi’s (1996) analysis also focused on whether state and local taxes affect relative state economic growth.

The study finds that relative marginal tax rates have a statistically significant negative relationship with relative state growth averaged for the 28

period from 1961 to 1992. … Reestimating the regressions when the sample period is split in half shows that the tax effects grow even stronger when compared with the convergence effect, which is insignificant in the latter half of the sample.

Thus, it appears that state and local taxes have temporary growth effects that are stronger over shorter intervals and a permanent growth effect that does not die out over time, at least for the sample considered. This finding also supports the inference that part of growth is endogenous and susceptible to policy influence.32 Fully accounting for the adverse impact from income taxes (like all taxes) must also account for the difference between the actual tax incidences versus the statutory tax bases, which is the final topic in this brief literature review. For instance, Entin (2004) argues that the actual tax incidence of the progressive tax system falls on savings, workers and lower income retirees.33 Consequently, due to the dynamic adjustments of the economy, the progressive tax system both reduces our economy’s economic growth potential and imposes unwanted social outcomes. More troubling, the manner in which our tax system is currently displayed does not account for the tax incidence issues, suppressing the information necessary to rationally change our current tax system. Obviously, this change should be toward a flatter tax – or in the case of this proposal, a flat broadbased consumption tax.

The development of theoretical models exploring the relationships among the incidence of a tax (the factor on whom the tax is levied), the final incidence or burden of a tax (the factor that suffers a net reduction in earnings), and factor mobility within the U.S. has its roots in the long tradition of the classical economics of international trade.

Among the first of these papers is Arnold C. Harberger’s classic article “The Incidence of the Corporate Income Tax” (1962).34 Due to the continued importance of Harberger’s findings, it is worth reviewing in some detail.

Harberger employs a general equilibrium approach in the development of his model. Economic activity is divided into the corporate and non-corporate sectors. It is assumed that the aggregate factor supplies of capital and labor are fixed, factors are perfectly mobile between the two sectors, perfect competition exists in factor and product markets, and that the economic system is closed. Harberger illustrates how taking into account factor flows between the corporate and non-corporate sectors leads to different conclusions.

The imposition of an income tax on the corporate sector induces capital to move from the corporate to the noncorporate sector until the rates of return are equilibrated in the two sectors. The capital movement causes an expansion of non-corporate output and employment at the expense of the corporate sector, and the burden of the corporate income tax can fall on labor if the corporate sector’s production process is labor intensive, and the elasticities of factor substitution are low in the two sectors. As a result, the tax forces the corporate sector to lay off workers. Their total reemployment in the non-corporate sector implies a reduction in the wage rate.

Harberger’s work, along with the research program it has inspired, raises an important caveat when it comes to tax policy. The economic harm created by poor tax policy is not necessarily borne by those groups that statutorily pay the tax. Like gravity pushing water downhill, specific demand and supply sensitivities (elasticities) push the incidence, and therefore economic costs, of taxes toward those groups that are the most insensitive to price changes.

Consequently, as Harberger noted, the true incidence of a corporate income tax may be a corporation. It could also be workers. The same is true for personal income taxes, sales taxes, property taxes, excise taxes, etc. Such considerations are crucial as distribution analyses focus on the statutory tax base overlooking the true economic incidence of the tax, which may be unknowable.

There are many other analyses that have linked uncompetitive tax rates at the federal level to slower economic growth, and a selection of these are summarized in the Appendix.

Summary of Academic Findings In summary, this review of the relevant academic literature strongly suggests several implications for state tax reform: • Taxes matter. Specifically, states with lower marginal income tax burdens perform noticeably better than those states with higher marginal income tax burdens. Higher marginal sales tax burdens, however, are not associated with slower economic growth.

• Tax policies that discriminate against work, innovation and capital accumulation will harm economic growth.

• The after-tax rate of return has a direct and significant impact on levels of investment.

• Switching to a more consumption-based tax will lead to higher economic growth.

• Tax burdens are not necessarily borne by those physically paying the tax – a concept known as tax incidence. Research shows that the tax incidence of progressive income tax systems falls on workers, lower income retirees and savings.

The Proposed Tax Reform If the goal of tax reform in North Carolina is to increase the underlying rate of economic growth, then the results presented above provide strong support for the implementation of a tax reform that eliminates the state’s personal income tax and corporate income tax and replaces these revenues with an expanded consumption-based tax.

A proposal in North Carolina that would implement this reform is being discussed by state lawmakers and should be given serious consideration in the 2013 legislative session.

This proposal would transform North Carolina’s current tax system into primarily a consumption-based tax system.

The reform is designed to be statically revenue neutral –

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without accounting for any increase in North Carolina’s rate of economic growth (the entire purpose of the reform), the state will raise the same amount of revenues both prior to and following the tax reform. The proposed tax reform would repeal North Carolina’s personal income tax, corporate income tax, and franchise tax due to the larger negative economic impact these taxes impose on the economy and replace these revenues with the following tax system: • Expand the current sales tax base to include all services currently taxed in at least one state • Expand the current sales tax base to close current loopholes (e.g. preferential rates for certain goods) • Expand the real estate conveyance fee • Implement a business license fee levied on all businesses with a base equal to assets minus liabilities minus retained earnings, determined in accordance with Generally Accepted Accounting Principles.

Setting the Tax Rates to be Revenue Neutral The primary purpose of any state tax system is to raise sufficient revenues for the state government to operate.

Raising too much revenue—imposing an excessive tax burden on the state’s taxpayers—is detrimental to growth—as illustrated by the negative impact on growth from excessive state spending in our econometric model.

However, the right level of government spending is not under consideration here. Instead, the goal is to raise, on a static basis, the same amount of revenues following the reform compared to prior to the reform.

In FY2011-12, total state tax revenues were $18.5 billion.35 Of these, the personal income tax, corporate income tax, and the franchise tax raised $12.0 billion or approximately 65 percent of North Carolina’s total tax revenues. Adding the $5.3 billion in state sales tax revenues brings the total for these revenue sources to $17.3 billion, see Figure 16.

Due to the large share of current revenues, replacing these taxes solely with the current sales tax base requires

FIGURE 16: North Carolina Tax Revenues by Source FY2011-12 All Other

6% Sales & Use

Franchise

3%

Corporate Income 30

29%

6%

56%

Individual Income

a very high sales tax rate. Approximating the current sales tax base, the current 4.75 percent sales tax rate raises $5.3 billion implying a state sales tax base around $110.7 billion.

According to the Fiscal Research Division, the current state sales tax base is approximately $115.2 billion. Based on these estimates, replacing the current income and franchise tax revenues ($12 billion) using the current state sales tax base require a state sales tax rate of 15.0 percent to 15.6 percent. As long as the tax base is sufficiently expanded, the proposed tax reform can be implemented with a reasonable state sales tax rate. The proposed tax reform addresses this high sales tax rate by: (1) statutorily imposing some of the tax burden on businesses through the creation of a new, lowrate, evenly applied business license fee; (2) creating a new 1 percent real estate conveyance tax; and, (3) significantly expanding the sales tax base to cover more products and services not currently taxed.

Due to the repeal of the corporate income tax (C-corporations and S-corporations) and the personal income tax (LLCs), these businesses would not be statutorily required to pay any tax to the state under the new tax system. The business license fee is designed to statutorily incorporate these entities into the tax base. Specifically, the base for calculating the business license fee is the amount of capital stock surplus, and undivided profit apportioned to North Carolina, excluding retained earnings (the apportionment options being discussed are either the current three factor formula with sales double-weighted or a single sales factor).

The business license fee is designed to raise $4 billion, which according to the Fiscal Research Division, is achieved with a 1.05 percent business license fee. For smaller businesses, a $500 minimum annual payment would be required.

Incorporating the expected revenues from the business license fee, still leaves $8 billion in revenues that need to be replaced.

The new real estate conveyance tax would add a 1 percent tax on all commercial and residential real estate transactions in North Carolina. According to the Fiscal Research Division, a 1 percent tax on the total value of real estate transactions

in North Carolina would generate $390 million, leaving $7.6 billion in revenues that need to be replaced. Real estate transfers would not be subject to the retail sales tax.

The remainder of these revenues would be replaced by expanding the current state sales tax base to include the following categories: • Repealing current exemptions, preferential rates, and refunds • Expanding the tax base to include services taxed in at least one state according to the Federation of Tax Administrators (FTA) • The expanded sales tax base would exclude capitalized goods purchases by businesses • Incorporating insurance premiums, groceries, residential leases, lottery ticket sales, and out of pocket medical expenses into the tax base

TABLE 3 Estimated Expansion of North Carolina’s State Sales Tax Base37 Repealing current exemptions, preferential rates, and refunds Capital Outlay Exclusion Expand Tax Base to FTA Services Insurance Premiums Residential Leases Lottery Ticket Sales Out of pocket medical expenses Leakage Allowance Total Sales Tax Base Expansion TOTAL NEW SALES TAX BASE

$83.83 ($19.88) $44.20 $13.30 $0.79 $1.46 $0.08 ($45.41) $78.37 $193.60

According to the Fiscal Research Division, this tax base expansion will broaden North Carolina’s sales tax base from the current estimated $115.2 billion to $193.6 billion or a 68.0 percent expansion of the state sales tax base, see Table 3 for a detailed breakdown of the sales tax base expansion.

Based on a $193.6 billion sales tax base and $7.6 billion

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in necessary additional sales tax revenues, the static revenue neutral state sales tax rate under the proposed tax reform would be 6.53 percent. Local governments also impose sales taxes. However, due to the expanded sales tax base, the local sales tax rate could be lowered without costing the local governments any revenues. Based on a 68.0 percent expansion of the sales tax base, current local revenues (on a static basis) could be raised via a 1.49 percent local sales tax – which is consistent with the Fiscal Research Division’s estimated revenue neutral local sales tax rate of 1.52 percent.36 Combining the sales tax rates together, the revenue neutral state and local sales tax rates, according to

Fiscal Research estimates, would be 8.05 percent.

Putting the components together, the proposed tax reform would raise the equivalent of $17.3 billion raised by the following components: • $4.0 billion through the expanded business license fee; • $0.4 billion through the real estate conveyance tax; and, • $12.9 billion through the expanded sales tax base (including $7.6 billion in new revenues).

FIGURE 17: Income plus the Cash Value of Federal and State Government Welfare Programs

32

Regressivity Concerns Static analyses criticize consumption-based tax systems based on the claim that consumption taxes are regressive.

The criticisms, which are true as far as they go, argue that lower-income individuals spend a higher share of their income on products that are subject to consumption taxes than do higher income individuals. Therefore, these analyses conclude, that the burden from a consumption tax is larger on lower income individuals than higher income individuals.

If, for example, a person making $10,000 a year (Paul) spent his entire income on goods subject to a 10 percent sales tax, then Paul would pay $1,000 or 10 percent of his income in taxes. If a person making $20,000 a year (Mary) spent one-half of her income on goods subject to a 10 percent sales tax, then she would also pay $1,000 of her income in taxes. But, this $1,000 represents only 5 percent of Mary’s income. The consumption tax in this example is a larger burden on the lower income individual (Paul) who must pay 10 percent of his income in sales taxes than the higher income individual (Mary) who must pay 5 percent of her income in sales taxes. This math is a simplified illustration of the regressivity concerns. However, regressivity concerns do not account for the beneficial impacts to all residents created by the accelerated rate of economic growth.

Moreover, a major shortcoming of virtually all attempts to measure regressivity by various income groups fail to take into account the value of government transfer payments and government services received by low-income household.

To illustrate this, one can examine Figure 17 provided by Pennsylvania’s Secretary of Public Welfare. It shows the cash value of federal and state government welfare programs and clearly shows how low-income and middle – to uppermiddle class households are quite similar once income tax burdens and government benefits are taken into account.

While this is a measure examining Pennsylvania residents, there is little doubt that such a chart constructed for North Carolina would show very similar results.

Additionally, the static regressivity concerns can be alleviated through modifications to the sales tax system (more on that later).

Benefits to North Carolina from Income Tax Elimination: Our Findings Accounting for the growth impacts, transforming North Carolina from an income-based tax system to a consumption-based tax system, by definition, reduces the average marginal income tax rate to zero. Income taxes have a larger negative impact on economic growth than consumption taxes; therefore, the proposed tax reform will have beneficial pro-growth economic impacts. Based on the analysis summarized in the Appendix, a consumptionbased tax reform can increase North Carolina’s average annual rate of personal income growth by 0.38 percent to 0.66 percent.38 Such a growth differential would have made a significant difference in North Carolina’s relative growth performance between 2000 and 2011.

A consumption-based tax reform can increase North Carolina’s average annual rate of personal income growth by 0.38 percent to 0.66 percent As noted above, North Carolina’s relative personal income growth ranking fell from the 4th fastest in the U.S. between 1981 and 1999 to the 26th fastest in the nation between 2000 and 2011. However, had a consumption-based tax reform been implemented in 2000, then based on the estimated increase in North Carolina’s average annual rate of personal income growth, North Carolina’s expected average personal income growth would have been between 4.4 percent and 4.7 percent, increasing North Carolina’s relative growth rank to between the 18th fastest and the 14th fastest over this time period. In dollar terms, total personal income would be between $14.4 billion and $25.0 billion higher than the state’s actual total in 2011. This is an additional $1,500 to $2,600 in income per resident of North Carolina – or an additional $6,000 to $10,400 per family of 4.

Additionally, the accelerated income growth would have also created additional job growth. Based on the connection

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FIGURE 18: Potential Additional Economic Growth Impacts in North Carolina Difference between Actual 2011 Values and Estimated Values Under Consumption-based Tax Reform

Growth in Personal Income

$25.0

$14.4

Low Growth Estimate

Percentage Increase in Total Employment

High Growth Estimate

7.18%

4.13%

Low Growth Estimate

34

High Growth Estimate

between income growth and employment growth, total employment in 2011 would have been between 4.1 percent and 7.2 percent higher – an additional 217 thousand to 378 thousand jobs. Figure 18 summarizes the beneficial economic impacts from a consumption-based tax reform.

Increasing North Carolina’s average rate of economic growth is the whole purpose of implementing a consumptionbased tax reform. Greater economic growth leads to more jobs in North Carolina, increases economic prosperity, and empowers people to better provide for themselves and their families. Simply put, increasing people’s economic opportunity is the best way to help lower-income families.

Simply put, increasing people’s economic opportunity is the best way to help lowerincome families Along with the dynamic benefits that will increase the welfare of lower-income and higher-income residents, static concerns with respect to the consumption tax can be directly addressed as well. Sales taxes are generally designed to tax goods. Over the past 30 years goods share of transactions has been declining as the U.S. economy has become oriented toward services. Like many state sales tax systems, North Carolina’s has not kept up with these transitions. Consequently, North Carolina’s sales tax base has become inefficiently narrowed. Expanding the sales tax base to include services becomes an important component of an effective tax reform.

First, by taxing a broader tax base, the revenue neutral state tax rate (on a static basis) is lower – 6.53 percent under the current proposal – than it would be if applied to the current base. Second, with respect to regressivity, the expansion of the sales tax base incorporates purchases made, to a larger extent, by higher income individuals. Referring to our simplified example above, the sales tax paid by Mary (the higher income individual) was a lower percentage of her income because she only spent one-half of her income on goods that were taxable. Expanding the sales tax base

to include services brings more of Mary’s expenditures into the tax base, thereby raising both the total dollars contributed by Mary and the percentage of Mary’s income paid in taxes. Broadening the sales tax base to purchases skewed toward higher income individuals helps reduce the static regressivity concerns.

Alternatively, the static regressivity concerns can be alleviated through greater exemptions of the items that account for a greater share of lower-income individual’s budget. For instance, removing food and out of pocket medical expenses from the tax base eases the tax burden across the board but especially for lower income individuals.

Thus, the static regressivity concerns would be lessened.

However, narrowing the tax base comes with a cost. In this case, the tax base would fall from the estimated $193.3 billion to an estimated $180.4 billion. The necessary state sales tax rate under this option would be 7.03 percent.

Certainly the most important impact from the proposed tax reform is its significant impact on North Carolina’s rate of economic growth. And, because economic growth will increase, all citizens (rich and poor) will benefit.

Accelerated economic growth is the best way to address problems of regressivity. Relatedly, expanding the sales tax base conforms to the criteria for good tax policy, allows the sales tax rate to be as low as possible, and also addresses concerns about regressivity by expanding the sales tax burden to goods and services primarily purchases by higher income individuals. To the extent that other measures to address regressivity are desired, sales tax refunds or sales tax exemptions on goods that consume a larger portion of lower-income households can be implemented. Again, these programs come with a cost – they require a higher sales tax rate in order to maintain revenue neutrality on a static basis.

Conclusion Tax policy matters because North Carolina must compete with other states for tomorrow’s growth industries.

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Although North Carolina was once a growth leader for the nation, this is no longer the case. Consequently, reforms are necessary to help North Carolina regain its premier growth status. A pro-growth tax reform can help North Carolina achieve this goal.

Pro-growth tax reforms generate both increased economic activity and, due to the dynamic impacts they generate, the same or greater dollar amount of revenues for the government. The longer a pro-growth tax system is in place, the greater these gains and the more prosperous a state’s economy becomes. During prosperous times, when economic growth is greater, there is the added benefit of falling demand for government social spending programs (e.g., unemployment, welfare, etc.) that further benefits a state’s budget.

Recognizing that taxes impact behavior and incentives matter, North Carolina’s tax system needs to become more pro-growth. State economic competition is fierce – especially from high growth zero-income tax states such as Texas and South Dakota, as well as North Carolina’s progrowth neighbor, Virginia. As the review of North Carolina’s tax policies showed, there are many areas for improvement.

North Carolina imposes one of the highest state personal income tax rates in the nation, an uncompetitive corporate income tax rate compared to its neighbors; and an overall tax burden that exceeds the national average.

A growing literature examining the impact of income taxes on economic performance illustrates that high personal and corporate income tax rates have a large and negative

36

impact on economic growth. Our analysis confirmed these findings. Because high income tax rates have a larger negative impact on economic growth than consumptionbased taxes, eliminating North Carolina’s uncompetitive personal income tax and corporate income tax systems is a pro-growth tax reform that will increase the state’s rate of economic growth.

Toward this end, there is no shortage of ideas. In this study we analyzed the beneficial impacts from one proposal that would replace North Carolina’s tax system that primarily relies on income taxes and transforms it into a primarily consumption-based tax system. Based on the empirical relationship between income taxes and economic growth, the proposed tax reform could increase the average annual rate of economic growth in North Carolina by 0.38 percent to 0.66 percent. Had a consumption-based tax reform been implemented in 2000, by 2011 total personal income could have been between $14.4 billion and $25.0 billion higher than it was. The accelerated income growth would have also created additional job growth. Based on the connection between income growth and employment growth, there could have been an additional 217 thousand to 378 thousand jobs in in North Carolina as of 2011.

The proposed tax reform represents an opportunity to break from North Carolina’s past and address the current weaknesses in the state’s tax system. Such a pro-growth tax reform will make North Carolina more competitive than all of its neighbors and help the state reclaim the designation of one of the premier growth states in the country.

APPENDIX Methodology Citing Poulson and Kaplan (2008) on the methodology used in the paper:

oester and Kormendi (1989) have suggested a method K for estimating average marginal tax rates, using a linear approximation. If we assume a linear flat tax, then tax revenues can be divided into two parts. One part is independent of behavioral changes, while the other part is dependent on those changes: (1) Revenue = a + MTR (Income)

where the constant term (a) is that portion of revenue not dependent on income. The marginal tax rate (MTR) captures the effect on revenue of small changes in income.

The constant term in equation (1) can be thought of as a lump sum tax. Because lump sum taxes do not influence behavior, they are considered nondistorting. Such lump sum taxes are implicit in all tax schedules. If the lump sum tax is positive, the tax schedule is considered to be regressive. If the lump sum tax is negative, the tax schedule is progressive.

If the lump sum tax is zero, the tax schedule is proportional.

There are a number of assumptions in using this equation to estimate average marginal tax rates in the states. The marginal tax rate is estimated over all taxed units in the state. The assumption is that this is the marginal tax rate for a representative taxpayer in the state. It is also assumed that the tax base is proportional to income.39 Because both time series are growing over time, our analysis also estimated the average state marginal income tax rates based on the first differences between total income tax revenues and personal income between 1978 and 2010.40 The results summarized in Figure A-1 are similar to the results

based on the total tax revenue and personal income data presented in Figure 15.

Based on the theory and evidence presented in the paper, states with higher average marginal income tax rates should experience slower average economic growth than those states with lower (or no) average marginal income tax rates. States with higher average marginal sales tax rates – in part because those states with no income taxes tend to have higher sales tax rates – should be unrelated to the rate of economic growth.

State economic growth can also be influenced by other factors,41 such as location. States in the mid-west have been experiencing slower economic growth, for instance, while the southeast and southwest regions have been experiencing stronger economic growth – possibly due to their favorable climate coupled with an increased preference of people to live in these climates. Our analysis accounts for such location issues by incorporating a series of dummy variables for each of the 9 U.S. Census regions. The dummy variable assigns a value of 1 for states within that region, and a value of 0 for states that are not in that region. States that are part of the New England region, for instance, have a value of 1 for the New England dummy variable and receive a value of 0 for all other census region dummy variables. Each state, by definition, is categorized into 1, and only 1, of the 9 U.S. Census region dummy variables. The dummy variables capture whether regional location is a significant factor in a state’s economic performance, a minor factor, or an insignificant factor. Because several of the regions were found to have an insignificant impact on average personal income growth, the regions included in the final analysis only included the South Atlantic (which includes North Carolina), the East North Central, the West North Central, and the Mountain regions.

The relative size of the state government matters as well.

Over time, government spending is government taxation.

Therefore, those states seeing a long-term rise in government More Jobs, BIGGER Paychecks | A Pro-Growth Tax Reform for North Carolina

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expenditures relative to the growth rate of the economy should experience slower growth compared to those states maintaining greater government affordability. Table A-1 summarizes the results from this analysis based on the marginal income tax rates estimated based on levels (estimate 1) and differences (estimate 2). Numbers in parentheses are the standard errors of the estimated coefficient.

Additional Studies Linking Poor Tax Policy to Adverse Incentives at the Federal Level While the paper touched on several studies that have linked high income taxes to slower economic growth, and progrowth tax systems to faster economic growth, there are several other studies worth noting. These studies illustrate the strong link between the incentives created by alternative tax policy regimes and economic outcomes – a lesson that the states ignore at their own peril.

Starting with Mankiw and Weinzierly (2005), N. Gregory Mankiw and Matthew Weinzierl examined the dynamic impacts from tax cuts in a 2005 paper.42 They found that in nearly all cases, tax cuts are partly self-financing due to the economies dynamic responses. Robbins and Robbins, in a series of papers, illustrates that there is an elastic response between taxes and labor supply and capital accumulation.43 In this series of papers, Robbins and Robbins examine the relationship between taxes and savings, capital accumulation, and overall economic growth. The initial paper, (Report #131) updates an analysis by Boskin (1978). Boskin found the elasticity of savings between 1929 and 1969 was 0.4 – a 10 percent increase in the return to savings would cause a 4 percent increase in savings.

Robbins and Robbins estimate the return to savings as the return to all capital, which includes the returns to both eq-

TABLE A-1 Estimated Impacts from State Marginal Tax Rates on State Personal Income Growth Constant Average Marginal Income Tax Rate Average Marginal Sales Tax Rate South Atlantic East North Central West North Central Mountain Expenditure Burden Adjusted R-squared F-Statistic

Estimate 1 0.046974 (0.006214) -0.18426 (0.062431) 0.052256 (0.067683) 0.005232 (0.002105) -0.006453 (0.002676) -0.005128 (0.002203) 0.00807 (0.002122) -0.01157 (0.004064) 0.583648 10.81270

* Significant at the 0.067 significance level; ** Significant at the 0.099 significance level.

38

Estimate 2 0.041142 (0.006134) -0.049979* (0.026608) 0.114409 (0.041859) 0.004329 (0.002085) -0.006379 (0.002695) -0.004048** (0.002402) 0.007072 (0.002215) -0.009759 (0.004161) 0.578693 10.61497

FIGURE 19: Estimated Average Marginal Income Tax Rates Compared to Personal Income Growth Based on First Differences of Data 7% 6% 5% 4% 3% 2% 1% 0% 1% -1% 0%

2%

3%

4%

5%

6%

Average Personal Income Growth Rate

uity and debt. Between 1947 and 1994 the average aftertax return to capital was 5.4% according to Robbins and Robbins. Perhaps just as important, the private savings rate over this time period moves in lock-step with changes in the after-tax return to capital – when the after-tax return to capital rises, the savings rate rises; and when the after-tax return to capital falls, the savings rate falls. In fact, Robbins and Robbins find that the elasticity of savings between 1949 and 1994 was 2.5 times greater than the Boskin’s (1978) estimates – between 0.7 and 1.1.

In the TaxAction Analysis Policy Report #134, Robbins and Robbins use their earlier results to link savings sensitivity to changes in the after-tax rate of return (i.e. tax policy) and investment. However, since investment is driven by the marginal after-tax rate of return (not the average), Robbins

and Robbins estimate the marginal after-tax rate of return from 1954 – 1995. Robbins and Robbins find that changes in the capital stock are very sensitive to changes in after-tax rate of return. On average, the long run marginal after-tax rate of return to capital has been 3.4 percent. Furthermore, in response to tax policy changes, the capital stock adjusts quickly bringing the marginal after-tax rate of return back to the long-run average. Typically, this process is completed within 5 years according to Robbins and Robbins.

Robbins and Robbins (1996) leverage the estimates from Policy Report #131 & #134 to derive a dynamic macroeconomic model of the U.S. economy. This model is predicated on changes in savings, investment and capital formation being significantly more sensitive to their after-tax returns than the papers summarized above. Consequently, Robbins More Jobs, BIGGER Paychecks | A Pro-Growth Tax Reform for North Carolina

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and Robbins (1996) finds that tax reforms that reduced the disincentives to savings would have a large and positive impact on economic growth.

Barber and Odean (2003) examined investors’ responsiveness to tax policies.44 Specifically, Barber and Odean examine whether “individual investors consider taxes when making asset location decisions”, finding evidence that investors are sensitive to the tax implications of asset allocations. For instance, investors tend to locate assets that tend to provide annual taxable income distributions (such as taxable bonds and mutual funds) in tax free retirement accounts.

Desai and Gentry (2003) examine whether corporations respond to capital gains taxes.45 Desai and Gentry establish that capital gains taxes impacts the incentives of companies.

e taxation of corporate capital gains affects incentives in Th three broad categories. First, it affects ‘real’ decisions that impact investment and financing decisions and the allocation of capital across firms and throughout the economy.

Second, taxes can affect the timing of corporate decisions.

Third, tax policy towards corporate capital gains can affect corporate tax planning activities.

Desai and Gentry conclude that: Corporate capital gain realizations are a significant component of corporate cash flow and increasingly so. Net longterm capital gains are significant compared to individual capital gains and are gaining in relative importance. As this paper outlines, the distortionary effects of such taxes largely subsume those associated with individual capital gains. Specifically, lock-in effects at the corporate level may alter productivity levels by changing the patterns of corporate and asset ownership in a manner that taxes on individual capital gains do not.

The time series analysis of this paper suggests that the elas-

40

ticities of corporate realizations to tax costs is higher than those derived in similar equations used to estimate the elasticities of individual capital gains. Micro analysis further suggests that firms time their sales and magnitudes of investments and PPE opportunistically. Moreover, the micro analysis suggests that the realization of gains appears to be particularly shaped by tax incentives. In sum, the corporate capital gains tax regime appears to significantly influence the decisions of firms to dispose of assets and realize gains and losses.

Desai and Hines (2003) examine the implications of taxing business income in a manner that is not consistent with international norms.46 Desai and Hines posit that alternative tax treatments across countries impact the level and ownership of foreign direct investment (FDI). Specifically,

Home–country taxation has the potential to affect the ownership of foreign assets by changing after–tax returns and thereby inducing the substitution of one investment for another. As a general matter, investors from countries that exempt foreign income from taxation have the most to gain from locating their foreign investments in low–tax countries, since such investors benefit in full from any foreign tax savings. Investors from countries (such as the United States) that tax foreign profits while providing foreign tax credits may benefit very little (in some cases not at all) from lower foreign tax rates, since foreign tax savings are offset by higher home–country taxation. These relative tax incentives therefore create incentives for investors from countries that exempt foreign income from taxation to concentrate their investments in low–tax countries, while investors from countries that tax foreign income while providing foreign tax credits have incentives to concentrate investments in high–tax countries.

However, such incentives can lead to allocations of capital and investment that are not consistent with global economic efficiency. Desai and Hines introduce two principles to guide tax policy: “capital ownership neutrality (CON), the

principle that world welfare is maximized if the identities of capital owners are unaffected by tax rate differences, and national ownership neutrality (NON), the principle that national welfare is maximized by exempting foreign income from taxation.” Desai and Hines suggest the ideals of CON and NON to ensure that the goals of national and global economic efficiency are met.

Koenig and Huffman (1998) echo these findings as do Engen, Gravelle and Smetters (1997).50 Although the Koenig and Huffman model is designed to illustrate direction of change, not magnitude, they find that output, consumption, wages, stock prices and the total capital stock will rise in the long-run due to the adoption of a consumptionbased tax.

The Joint Committee on Taxation (JCT) 1997 Tax Modeling Project and 1997 Tax Symposium provided a comprehensive examination of the beneficial economic impact from pro-growth tax policies.47 In response to Congres-

Engen, Gravelle and Smetters use two different types of

sional requests to incorporate dynamic analyses into JCT revenue forecasts, the JCT held a series of meetings to examine the methodologies and feasibility of incorporating a dynamic macroeconomic model into the revenue estimating procedures for alternative tax reforms – including consumption-based taxes. These meetings culminated in a symposium where the participating academics each presented the results of their individual models. All of the models projected that a switch to a consumption tax will ultimately lead to higher economic growth.48 Higher economic growth: “…arises because all of the models are based on a set of commonly held assumptions about economic behavior…These properties include the following basic assumptions: •

r educing the cost of capital through less taxation of capital provides an incentive for additional investment;

•

r educing the marginal tax rate on labor provides an incentive for increased labor effort;

•

i ncreasing the returns to labor through capital deepening can provide an incentive for more labor; and,

•

r educing distortions in investment decisions by eliminating differential taxation of different types of capital promot[ing] a more efficient allocation of resources.”49

models (reduced form growth models and inter-temporal general equilibrium models) to examine the impact of transition to a consumption-based tax system. Again, in all of the models the tax reform has a positive impact on output, savings, consumption and the growth in the capital stock in the long-run. Further studies by Dale Jorgenson (1995), Alan Auerbach (1996), Michael Boskin (1995), and Laurence Kotlikoff (1993) have all shown positive impacts on economic growth if the current tax code is replaced by a single-rate flat tax ranging from a total increase in economic output of 5.7 to 17 percent.51 Laffer (1984) proposed “The Complete Flat Tax” which replaced the current income tax system with a flat tax. This study illustrated that such a proposal would likely increase economic growth by between 8 and 15 percent in the long-run.52 Viard (2009) illustrates the importance, when evaluating the economic consequences of income taxes, to comprehensively measure the adverse impacts on all forms of income, what is termed the elasticity of taxable income (ETI). Comprehensive measures of income reveal the negative and significant impacts from income taxes on economic growth: Some analyses of the behavioral effects of income taxation examine only the effect on hours worked and often find little impact. As Martin Feldstein observed, however, income taxes can induce people to reduce their taxable income through means other than a reduction in hours More Jobs, BIGGER Paychecks | A Pro-Growth Tax Reform for North Carolina

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worked. People can reduce taxable income by holding taxexempt municipal bonds rather than taxable bonds, receiving fringe benefits rather than cash wages, engaging in tax shelters, and spending more money on tax-deductible items. Economists could investigate each of these behavioral changes, one by one. Or, as Feldstein suggested, they can simply investigate the overall change in taxable income prompted by changes in tax rates.[5]

ecent studies have therefore focused on the overall elasticR ity of taxable income, which roughly equals the percentage change in taxable income that results from a 1 percent change in (1 - t), where t is the tax rate. Suppose, for example, that the elasticity is 0.5, the estimate that I use below. Consider an increase in the marginal income tax rate from 25 percent to 26 percent, which reduces (1 t) from 0.75 to 0.74, a decline of 1.33 percent. With a 0.5 elasticity, the rate increase reduces taxable income by roughly 0.67 percent (0.5 times 1.33 percent).[6]

Two recent papers, one by Seth Giertz and one by Emmanuel Saez, Joel Slemrod, and Giertz, provide surveys of the numerous statistical studies that have used tax return data to estimate the elasticity of taxable income.[7] As these papers describe, early estimates were very high, often well above 1. Recent estimates have been more modest, with considerable variation across studies. There is strong evidence that the elasticity is higher for high-income groups. A recent Tax Foundation analysis assumes that the elasticity for taxpayers with incomes above $100,000 is 0.6.[8] The 0.6 value for high-income taxpayers appears to represent a reasonable middle ground, as some studies have estimated much higher values while others have estimated lower values.[9]53

Of course, the actual response of taxpayers varies. Gruber and Saez (2002) examined this issue.55 A larger share of higher-income groups income can be altered for tax purposes – the size, timing and location of the income.

The income of lower-income taxpayers, on the other hand, is primarily from wages. Consequently, you would expect the ETI for higher income taxpayers to be more sensitive to tax rates than lower income taxpayers. And, this is what Gruber and Saez found. The elasticity for those with incomes above $100,000 was around 0.6, while other taxpayers had an elasticity of approximately 0.2. Taxes will affect the behavior of all taxpayers, however, the impact on higher income taxpayers is the most sensitive.

And, the changes in behavior create additional economic costs on taxpayers beyond the revenues raised. Carroll (2009) estimated the economic costs created by income taxes or what is called the excess burden of the income tax (in this case the federal income tax) finding these costs to be very large:

Directly citing the Saez, Slemrod and Gertz (2009) study regarding the importance the elasticity of taxable income (ETI):

42

evertheless, the essential insight underlying the ETI reN mains valid: that income tax rates cause taxpayers to respond on a wide range of margins and, under some conditions, all of these responses reflect inefficiency, because they would not have been undertaken absent the tax rates. This is especially true of high-income, financially savvy taxpayers who in most countries have access to sophisticated tax avoidance techniques. There is clear evidence of responses that would fall in the first two tiers of the Slemrod (1995) hierarchy/timing, shifting, avoidance/based on U.S. evidence since 1980, but only at the top end of the income distribution.54

e excess burden of the current individual income tax is Th not inconsequential, amounting to roughly 11 to 15 percent of total income tax revenues.

is means that in the course of raising roughly $1 trilTh lion in revenue through the individual income tax, an additional burden of $110 to $150 billion is imposed on taxpayers and the economy.

The combined effect in 2011 of increasing the top two tax rates and the health care surtax is an additional excess burden of $76 billion. When combined with the $88 billion in additional revenue, the total burden of these higher tax rates is $164 billion.56

Increased tax rates on higher-income households impose very large excess burdens that, under reasonable assumptions, nearly equal the revenue collected.

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ENDNOTES 1. Figure 1 is divided into two lines due to the change in industrial classification that began in 1997 – the U.S. moved from the Standard Industrial Classification system (SIC) to the North American Industrial Classification System (NAICS). The SIC and NAICS data are not directly comparable.

2. Source: Author calculations based on data from Bureau of Economic Analysis; www.bea.gov.

14. The combination tax rate does not account for corporate income, dividend and capital gains taxes.

Nor does the combination tax incorporate property taxes, which are the main revenues for localities. As designed, the combination tax provides a means to compare the marginal tax rates across states for the personal income and sales tax only.

3. Source: Author calculations based on data from Bureau of Economic Analysis; www.bea.gov.

15. Drenkard, Scott (2012) “2013 State Business Tax Climate Index” Tax Foundation Background Paper, October, Number 64.

4. Source: Author calculations based on data from the U.S. Census; www.census.gov.

16. Sales tax revenues are adjusted to reflect changes in the sales tax rate.

5. Source: the Tax Foundation.

17. Volatility measured as the standard deviation of tax revenues. Sales tax revenues are adjusted to reflect changes in the sales tax rate.

6. Bishaw Alemayehu (2012) “Poverty: 2010 and 2011” American Community Survey Briefs September; http:// www.census.gov/prod/2012pubs/acsbr11-01.pdf.

7. Source: U.S. Census Bureau, Current Population Survey, 2009 to 2012 Annual Social and Economic Supplements; www.census.gov.

8. Tax Foundation, http://www.taxfoundation.org/taxdata/.

9. Tax Foundation, http://www.taxfoundation.org/taxdata/.

10. Tax Foundation, http://www.taxfoundation.org/taxdata/.

11. ALME calculations based on data from the Bureau of Economic Analysis and U.S. Census.

12. Source: State Government Tax Collections Data, U.S. Census, www.census.gov.

13. “Tax Modernization Working Group, Senate Appropriations Meeting”, Fiscal Research Division, North Carolina General Assembly, October 17, 2012

18. Slivinski, Stephen (2012) “A New Tax Plan for a New Economy: How Eliminating the Income Tax Can Create Jobs” Goldwater Institute Policy Report No. 250, September 20.

19. Author calculations based on Bureau of Economic Analysis data.

20. Author calculations based on Bureau of Economic Analysis data.

21. Author calculations based on Bureau of Economic Analysis data.

22. Poulson, Barry W. and Kaplan, Jules Gordon (2008) “State Income Taxes and Economic Growth” Cato Journal, Vol. 28 No.1.

23. Dye, Thomas R. (1999) “The Economic Impact of the Adoption of a State Income Tax in New Hampshire” Heartland Institute, October 1; http://heartland.org/ policy-documents/economic-impact-adoption-stateincome-tax-new-hampshire.

24. Ibid.

25. Laffer, Arthur B. and Winegarden, Wayne (2012) “Eureka! How to Fix California” Pacific Research Institute.

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26. Ibid.

27. Poulson, Barry W. and Kaplan, Jules Gordon (2008) “State Income Taxes and Economic Growth” Cato Journal, Vol. 28 No.1; Becsi, Zsolt (1996) “Do State and Local Taxes Affect Relative State Growth?” Economic Review, March/April. The analysis was also performed for the 1987 – 2010 time period. The shorter time period is used to control for the impact from the major federal income tax reform passed in 1986 could have had on state behavior. Using the post-1986 time frame does not alter the conclusions.

28. The correlation coefficient between the relative average marginal income tax rate and relative personal income growth rate was -0.42.

29. Due to the possible impact on state income taxes due to the fundamental tax reform at the federal level in 1986, the values were also run for the 1987 – 2010 period. The conclusions do not materially change based on the post-reform only period.

30. Robert J. Barro (1991) “Economic Growth in a Cross Section of Countries,” Quarterly Journal of Economics, Vol. 106, No. 2 May; Gwartney, James, Lawson, Robert and Holcombe, Randall (1998) “The Size and Functions of Government and Economic Growth” Joint Economic Committee, U.S. Congress, April; Landau, Daniel L. (1983) “Government Expenditure and Economic Growth: A Cross-Country Study” Southern Economic Journal, 49: January; Mitchell, Daniel J. (2005) “The Impact of Government Spending on Economic Growth” Heritage Foundation, Backgrounder #1831, March 15; and, Scully, Gerald W. (2006) “Taxes and Economic Growth” National Center for Policy Analysis, NCPA Policy Report No. 292, November.

31. Prescott Edward C. (2002) “Prosperity and Depression: 2002 Richard T. Ely Lecture” Federal Reserve Bank of Minneapolis Research Department, Working Paper 618, January; and, Kehoe Timothy J. and Prescott Edward C. “Great Depressions of the Twentieth Century” Federal Reserve Bank of Minneapolis Research Department 32. Becsi, Zsolt (1996) “Do State and Local Taxes Affect Relative State Growth?” Economic Review, March/ April.

33. Entin, Stephen J. (2004) “Tax Incidence, Tax Burden, and Tax Shifting: Who Really Pays the Tax? A Report 46

of The Heritage Center for Data Analysis CDA04-12 November 5.

34. Harberger, Arnold C. (1962) “The Incidence of the Corporation Income Tax” Journal of Political Economy, Volume 7, Issue 3, June, p.p. 215-240.

35. “2012 Annotated Conference Committee Report on the Continuation, Expansion, and Capital Budgets” Fiscal Research Division, North Carolina General Assembly.

36. “Tax Modernization Working Group, Senate Appropriations Meeting”, Fiscal Research Division, North Carolina General Assembly, October 17, 2012 37. “Tax Modernization Working Group, Senate Appropriations Meeting”, Fiscal Research Division, North Carolina General Assembly, October 17, 2012 38. The range of estimates is based on the estimated equation based on the first differences (lower estimate) and levels (higher estimate). The values are calculated using the estimated income coefficients from both equations and North Carolina’s estimated marginal income tax rates based on the first differences and based on the levels.

39. Poulson, Barry W. and Kaplan, Jules Gordon (2008) “State Income Taxes and Economic Growth” Cato Journal, Vol. 28 No.1.

40. Because both time series are growing over time, the first differences analysis was incorporated to measure the marginal average income tax rates based on the change in tax revenues and the change in personal income instead of the levels. The consistency of the findings for the equations based on the first differences with the equations from the level data supports the findings that the results are not driven by the growth trends.

41. The convergence hypotheses – personal income across the states will tend to converge and therefore states with lower initial per capita personal income should experience faster income growth – was also tested, but not found to be significant. This finding is consistent with Besci (1996) who found that the strength of the convergence hypothesis diminished over time.

42. Mankiw Gregory N. and Weinzierl Mathew (2005) “Dynamic Scoring: A Back-of-the-Envelope Guide” Working Paper, Revised: April 7, 2005.

43. Robbins Gary and Robbins Aldona (1996) “Accounting for Growth” The Institute for Policy Innovation, Policy Report #138; Robbins Gary and Robbins Aldona “Eating Out our Substance: How Taxation Affects Saving” TaxAction Analysis, Policy Report #131; Robbins Gary and Robbins Aldona “Eating Out our Substance II: How Taxation Affects Investment” TaxAction Analysis, Policy Report #134. For an early estimate of the dynamic impact from labor supply response see: Boskin M. (1973) “The Economics of the Labor Supply” in Cian Glen G. and Watts Harold W. eds Income Maintenance and Labor Supply. Chicago: Rand McNally. Boskin also examined the dynamic impact with respect to capital and savings in: Boskin M. (1978) “Taxation, Saving and the Rate of Interest” Journal of Political Economy Volume 86, April 1978 pp S3 – S28.

44. Barbera, Brad M., and Odean, Terrance (2003) “Are individual investors tax savvy? Evidence from retail and discount brokerage accounts” Journal of Public Economics 1 (2003) 000 –000.

45. Desai, Mihir A. and Gentry, William M. (2003) “The Character and Determinants of Corporate Capital Gains” Working Paper prepared for the Tax Policy and the Economy Conference.

46. Desai, Mihir A. and Hines, James R. (2003) “Evaluating International Tax Reform” National Tax Journal, Vol. LVI, No. 3 September.

47. Joint Committee on Taxation “The Joint Committee on Taxation 1997 Tax Modeling Project and 1997 Tax Symposium” November 20, 1997. They symposium included several types of economic growth models.

These included Inter-temporal General Equilibrium Models by Diane Lim Rogers; Alan J. Auerbach, Laurence J. Kotlikoff, Kent Smetters, and Jan Walliser; Eric Engen and William Gale; and, Dale W. Jorgenson and Peter J. Wilcoxen. Neoclassical Growth and Disequilibrium Models were presented by Joel L. Prakken, Gary and Aldona Robbins; Roger E. Brinner; Jane G. Gravelle; and, John G. Wilkins.

48. While there was unanimous agreement regarding the benefit in the long run, there was disagreement in the short run. Both Koenig and Huffman, and the symposium papers by Joel L. Prakken, Roger E. Brinner, and John G. Wilkins, all found that transforming our current tax system into a consumption-based tax system involves a short-run cost in terms of consumption

and output. Engen, Gravelle, and Smetters found that under certain models this result could hold. On the other side, symposium papers by Diane Lim Rogers; Alan J. Auerbach, Laurence J. Kotlikoff, Kent Smetters, and Jan Walliser; Eric Engen and William Gale; Dale W. Jorgenson and Peter J. Wilcoxen; Gary and Aldona Robbins; and Jane G. Gravelle found a positive impact and in some instances a significantly positive impact from a transformation to a consumption-based tax in the short-run.

49. Ibid. Bullets added for easier reading.

50. Koenig Evan F. and Huffman Gregory W. (1998) “The Dynamic Impact of Fundamental Tax Reform Part 1: The Basic Model” Federal Reserve Bank of Dallas Economic Review (First Quarter); and Engen Eric, Gravelle Jane and Smetters Kent (1997) “Dynamic Tax Models: Why They Do the Things They Do” National Tax Journal Vol. 50 no. 3 pp. 657 – 82.

51. The above referenced studies include: Jorgenson Dale “The Economic Impact of Fundamental Tax Reform”, Testimony before Committee on Ways and Means, U.S. House of Representatives, June 6, 1995; Auerbach Alan “Tax Reform, Capital Allocation, Efficiency and Growth” Unpublished Draft, December 21, 1995; Boskin, Michael “A Framework for the Tax Reform Debate” Testimony before Committee on Ways and Means, U.S. House of Representatives, June 6, 1995; and Kotlikoff Laurence J. “The Economic Impact of Replacing Federal Income Taxes With a Sales Tax” Cato Institute Policy Analysis NO. 193, April 15, 1993 , and “Replacing the U.S. Federal Tax System with a Retail Sales Tax – Macroeconomic and Distributional Impacts,” Report to Americans For Fair Taxation, December, 1996.

52. Laffer Arthur “The Complete Flat Tax” (1984) A.B. Laffer Associates.

53. Viard, Alan D. (2009) “The Case Against the Millionaire Surtax”, Working Paper, American Enterprise Institute for Public Policy Research, December. Studies cited in this quote include: Feldstein, Martin S. (1999) “Tax Avoidance and the Deadweight Loss of the Income Tax,” Review of Economics and Statistics, 81(4), November, pp. 674-680; Giertz, Seth H. (2009) “The Elasticity of Taxable Income: Influences on Economic Efficiency and Tax Revenues, and Implications for Tax Policy,” in “Tax Policy Lessons from the 2000s”, ed. Alan D. Viard (Washington, More Jobs, BIGGER Paychecks | A Pro-Growth Tax Reform for North Carolina

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DC: AEI Press, 2009), pp. 101-136; Saez, Emmanuel Slemrod, Joel B. and Giertz, Seth H. (2009) “The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review,” National Bureau of Economic Research Working Paper 150 12, May; Carroll, Robert (2009) “The Excess Burden of Taxes and the Economic Cost of High Tax Rates,” Tax Foundation Special Report No. 170, August; Auten, Gerald, Carroll, Robert, and Gee, Geoffrey (2008) “The 2001 and 2003 Tax Rate Reductions: An Overview and Estimate of the Taxable Income Response,” National Tax Journal, 61(3), September, pp. 345-364; Heim, Bradley (2009) “The Effect of Recent Tax Changes on Taxable Income: Evidence From a New Panel of Tax Returns,” Journal of Policy Analysis and Management, 28(1), pp. 147-163.

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54. Saez, Emmanuel, Joel Slemrod and Seth Gertz (2009) “The Elasticity of Taxable Income with Respect to Marginal Tax Rates: A Critical Review” NBER Working Paper No. 15012, May. 55. Gruber, Jonathan and Saez, Emmanuel (2002) “The Elasticity of Taxable Income: Evidence and Implications” Journal of Public Economics, Vol. 84, pp. 1-32.

56. Carroll, Robert (2009) “The Excess Burden of Taxes and the Economic Cost of High Tax Rates” Tax Foundation Special Report, #170, August.