Tax Reform Must Be Sustainable

By John Hood

RALEIGH — Earlier this month, the voters of Missouri decisively defeated a constitutional amendment authorizing an end to the state’s income tax. It was an overwhelming defeat — 17% for, 83% against — for a ballot measure that failed in urban, suburban, and rural counties alike.

Did this event just set off a progressive counteroffensive against 15 years of state-level tax reform across the country? That’s no academic question in North Carolina, a leader in the tax-reform movement. Through legislation, not referendum, the General Assembly has slashed tax rates on personal and corporate income while broadening the tax base, broadening and reducing the sales tax, and reforming other taxes. Our use of revenue triggers to phase in tax changes has become a national model. And lawmakers have placed a constitutional amendment on the North Carolina ballot that will have the effect of limiting future property-tax increases.

Does the vote in the Show Me State portend a similar result in the Tar Heel State? Nah. I expect the property-tax amendment to pass, albeit not by a comparably overwhelming margin.

Missouri voters don’t love taxes generally or the income tax specifically. But on fiscal matters, they are conservative with a small “c,” as are our own voters. Capping future increases in property tax is a very different ask than abolishing an entire form of taxation, especially when voters are being asked to do so without a clearly laid out plan to fund core public services some other way.

There was a plan, to be sure, and in broad outlines it conformed with prudent reform principles. The purpose of taxation is to finance public services, not to engineer economic or social outcomes. It is best accomplished by applying a single marginal rate to a properly defined tax base. To do otherwise is to create disincentives to work, save, and invest, and to violate the principle of proportionality; if you are, say, three times better off than I, you ought to pay three times as much tax.

Although total income might seem like the proper tax base, it is not. If you tax the principal of an investment, the money used to buy equities or build factories, then you have already reduced the future stream of income by that percentage. To tax the resulting dividends or capital gains is artificially to make consumption more attractive than investment.

In Missouri, the plan was to phase out the income tax in favor of a sales tax more broadly applied to all goods and services sold at retail. Okay, but to accomplish that would require taxing medical care, legal representation, banking, and other services sold by powerful interest groups that will fight tooth-and-nail against it. That’s why broad-based sales taxes are extremely rare. When Missourians were told that, in practice, their sales tax might shoot up north of 10%, they got antsy. What if some future governor and legislature reintroduced an income tax on top of a skewed and costly sales tax? Or a failed sales-tax reform led to budget deficits and fiscal chaos?

In other words, “grand bargain” strategies for tax reform are risky. They contain lots of moving parts, some easier than others to sell or maintain. They change established systems and practices that may not comport with abstract principle but around which households and businesses have long structured their daily operations. Ideological opponents can readily identify these risks, exaggerate them into guarantee calamities, and then partner with spending lobbies and special-interest groups to destroy the grand bargain, as just happened in Missouri.

There are alternatives. Regarding North Carolina’s tax code, my John Locke Foundation colleagues recommend that the General Assembly index the standard deduction to inflation, remove long-term capital gains from the tax base, and attempt to expand the sales tax to other retail services only after fully exempting business-to-business transactions (which are not, of course, retail sales).

Tax reform succeeds to the extent it is sustainable and retains public confidence. North Carolina has the right approach.

John Hood is a John Locke Foundation board member. His books Mountain Folk, Forest Folk, and Water Folk combine epic fantasy with American history (FolkloreCycle.com).