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1 Beacon Hill Institute BHI Policy Study May 2011 An Economic Analysis of State Tax Changes in North Carolina David Tuerck, PhD Paul Bachman, MSIE Michael Head, MSEP THE BEACON HILL INSTITUTE AT SUFFOLK UNIVERSITY 8 Ashburton Place Boston, MA Tel , Fax bhi@beaconhill.org, Web: Revised May 10, 2011 Tax Changes in North Carolina 1

2 Executive Summary The John Locke Foundation asked The Beacon Hill Institute at Suffolk University (BHI) to use its North Carolina State Tax Analysis Modeling Program (NC-STAMP ) to analyze three state tax proposals. 1 NC-STAMP is a Computable General Equilibrium model of the North Carolina economy and is used to determine the economic and fiscal effects of a tax change when compared to a baseline scenario of no change. BHI modeled four proposed tax changes: (1) an individual income tax calculated using federal adjusted gross income and the elimination of most credits and exemptions; (2) a 2 percent corporate income tax reduction and the elimination of several credits; (3) the expiration of the 1 percent temporary sales tax increase together with the removal of most tax preferences and (4) the expiration of the individual (2% and 3%) and corporate tax surcharges (3%). We modeled the tax changes for 2012, when they would be partially implemented, and 2013, the first full year of implementation. Table 1 displays the results. Table 1: Effects of the Tax Changes Net Employment (jobs) 14,922 17,016 Investment ($, millions) ,052.7 Real Disposable Income ($, millions) 1, ,612.7 State Revenue Change ($, millions) ,206.4 The tax changes would provide a powerful stimulus to the North Carolina economy. Employment would increase by 14,922 in 2012, and when fully implemented in 2013 would create 17,016 by leaving more money in the hands of the state s households and businesses. The combination of individual income tax and sales tax changes would increase real disposable income by $1.1 billion in 2012 and $1.6 billion in The corporate income tax changes lead to a reduction in the tax burden on capital investments. As a result, both local and out-of-state businesses would find investment more attractive in North Carolina. We estimate that investment will increase by $651.2 million in 2012, increasing to $1.1 billion in State revenues would drop by $888.9 million in 2012, increasing to $1.2 billion in However, as the state economy grows even faster in ensuing years, revenues would recover. 1 For more information on the STAMP model, see the methodology and Tax Changes in North Carolina 2

3 Introduction Each time lawmakers put forth a tax proposal, the decision to enact or reject the proposal requires detailed information about costs and benefits, many of which are not immediately obvious. For example, tax cuts reduce the amount of money that state households and businesses pay in taxes, conversely increasing the money available for them to save and spend. At the same time, tax cuts reduce the amount of revenue available to state and local governments for spending. However the less obvious secondary, or dynamic effects, offer a twist: the increased spending and investment will produce an uptick in the state economy that, in turn, will increase tax collections. For example, an increase in the sales tax from 6% to 7%, would cause revenues to rise by 16.7% (= (7-6)/6). A dynamic estimate would show a smaller rise in revenue because it would capture the negative effect on the tax base of the rise in the sales tax. Each of these taxes influences the Tar Heel state economy in different ways, affecting the choices made by households and firms by changing the tradeoff between work and leisure, savings and investment and saving and spending. Using an economic model allows BHI to calculate the differences in various economic variables compared to a baseline projection of no tax change. The Individual Income Tax North Carolina has been reducing its top income tax rates since 2006, when the tax rate on income above $100,000 was 8.25 percent. In 2007, a married couple, filing jointly, had to pay 6 percent on their first $21,250 of income. Any income above that, up to $100,000 would was taxed at 7 percent, while the next $100,000 was taxed at 7.75 percent, and income above and beyond $200,000 was taxed at 8 percent. Beginning in 2008, North Carolina eliminated the top tax bracket and taxed all income for married couples, filing jointly, above $100,000 at 7.75%. 2 However, during the economic downturn the state imposed an individual income tax surcharge of 2% on married couples with $100,000 in AGI and $60,000 for single filers. The surcharge jumps to 3% for income over $300,000 for married couples and $150,000 for single filers. In our modeling, BHI altered the way taxable income is calculated for the state personal income tax. The new methodology would begin with Federal Adjusted Gross Income (AGI), eliminating all current tax credits, except for Charitable Contributions. North Carolina s standard deductions and exemptions would then be increased. These changes would be, in net, a reduction to total individual income tax collections of $245.6 million in 2012 and by $447.6 million in Table 2 shows the difference in several economic indicators compared to a baseline of no tax change. Net employment would increase in North Carolina by 2,866 in 2012 and by 5,055 in As more workers enter the state economy, investment will increase by $7.3 million in 2 North Carolina Department of Revenue, Tax Rate Schedules, (accessed May 3, 2011). Tax Changes in North Carolina 3

4 2012 and $13.3 million in State real disposable income would increase by $538.8 million in the first full year of implementation. Table 2: Effects of the Individual Income Tax Reduction Net Employment (jobs) 2,866 5,055 Investment ($, millions) Real Disposable Income ($, millions) State Revenue Change ($, millions) The result of the income tax reduction is that state coffers would see a reduction in total income tax revenue. This is countered in part by the positive dynamic effects to the state economy, as the new jobs increase the total income tax base. Additionally, with more disposable income, residents will purchase more goods, marginally increasing sales tax collections, corporate profits and other state taxes and fees. The total revenue effect to the state government would be a net decrease of $235.5 million in 2012 and by $429.3 million in To put this amount in perspective, in fiscal year 2009 total state expenditures were $48.59 billion, so the tax reduction would account for about percent of total 2012 expenditures. 3 The Corporate Income Tax The North Carolina corporate income tax, which primarily falls on investment, stands at 6.9 percent. A shift to a lower rate would encourage entrepreneurs establish new businesses or existing companies expand in North Carolina, since at the margin, their tax liability would be lower. The proposed tax change would drop the corporate income tax by 2 percentage points to a rate to 4.9 percent and eliminate the 3% surcharge. Additionally it would eliminate various tax credits, such as the film tax credit. Table 3 displays the results. Investment in North Carolina would surge by $367.5 million in 2012 and $774.7 in 2013 million as firms approve investment projects that would become profitable on an after tax basis under the tax cut. The corporate income tax cut would produce a smaller employment effect than the individual income tax reduction, with a net gain of 765 jobs. The tax cut would increase real disposable income by $143.5 million in 2012 and $334.8 million in 2013 as business owners and the newly employed gain from the tax cut. 3 U.S. Census, State Government Finances 2009: North Carolina, (accessed May 3, 2011). Tax Changes in North Carolina 4

5 Table 3: Effects of the Corporate Income Tax Reduction Net Employment (jobs) Investment ($, millions) Real Disposable Income ($, millions) State Revenue Change ($, millions) In addition to the economic boost, state tax collections would fall by $109.4 million in 2012 and by $226.3 million in Individual income and sales tax collections increase as businesses and households earn more income and increase spending. The Sales and Use Tax Effective September 1, 2009, North Carolina temporarily increased the state portion of the sales and use tax by 1 percent to 5.5 percent. 4 On October 1, 2009 an additional, permanent, 0.25 percent was added, bringing the state portion of the sales and use tax to The local government portion of the sales tax varies from 2 percent to 2.5 percent, bringing the total average sales tax rate to between 7.75 percent and 8.25 percents. 5 The temporary sales tax increase is set to expire on July 1, 2011, but discussions are underway in Raleigh about extending the increase. Our economic modeling is used to evaluate what would happen to the state economy, should this temporary increase expire. Table 4 shows the results. Table 4: Economic and Revenue Effects of the Sales Tax Reduction Net Employment (jobs) 11,734 11,195 Investment ($, millions) Real Disposable Income ($, millions) State Revenue Change ($, millions) Those supporting the extension of the sales tax increase detail the benefits that the revenue could bring to the state government. While true, the higher sales tax rate would also prevent the North Carolina economy from realizing large positive economic effects. Our modeling shows that the expiration of the temporary increase would create 11,734 jobs in 2012 and 11,195 jobs in The results are less for 2013 because the full effect of the temporary increase expiration begins in 2012, but part of the elimination of sales tax preferences would not be felt fully until Lower costs at the cash register and more employment in the state would work to increase total real disposable income by $690.9 million in 2012 and by $ in In addition to the gained economic opportunity, total state tax collections would drop by $543.9 million in 2012 and $550.8 million lower collections in North Carolina Department of Revenue, Important Notice: Sale and Use Tax Rate Change, (accessed May 3, 2011) 5 North Carolina Department of Revenue, Sales and Use Tax Rates Effective January 1, 2011, (accessed May 3, 2011). Tax Changes in North Carolina 5

6 Conclusion Tax increases bring more revenue into government coffers, but that money comes out of the state s households and businesses, reducing their buying power. Conversely, a tax cut will necessitate losses in government jobs and services, while increasing the purchasing power of those same households and businesses. Here, the tax cuts produce larger benefits to the private sector than the cost to the public sector, while the tax hikes produce smaller benefits to the public sector than the costs to the private sector. Tax Changes in North Carolina 6

7 Methodology To identify the economic effects of the tax discounts and understand how they operate through a state s economy, BHI utilized its STAMP (State Tax Analysis Modeling Program) model. STAMP is a five-year dynamic CGE (computable general equilibrium) model that has been programmed to simulate changes in taxes, costs (general and sector specific) and other economic inputs. As such, it provides a mathematical description of the economic relationships among producers, households, governments and the rest of the world. 6 A CGE tax model is a computerized method of accounting for the economic effects of tax policy changes. A CGE model is specified in terms of supply and demand for each economic variable included in the model, where the quantity supplied or demanded of each variable depends on the price of each variable. Tax policy changes are shown to affect economic activity through their effects on the prices of outputs and of the factors of production (principally, labor and capital) that enter into those outputs. A CGE model is in equilibrium, in the sense that supply is assumed to equal demand for the individual markets in the model. For this to be true, prices are allowed to adjust within the model (i.e., they are endogenous ). For instance, if the demand for labor rises, while the supply remains unchanged, then the wage rate must rise to bring the labor market into equilibrium. A CGE model quantifies this effect. Finally, a CGE model is numerically specified ( computable ), which is to say it incorporates parameters that are believed to be descriptive of the actual relationships between quantities and prices. It produces estimates of changes in quantities (such as employment, the capital stock, gross state product and personal consumption expenditures) that result from changes in prices (such as the price of labor or the cost of capital) that result from changes in tax policy (such as the substitution of an income tax for a sales tax). Because it consists of a large number of interrelated equations, a CGE model ordinarily requires the application of a nonlinear computational algorithm, typically some variation on Newton s method. STAMP requires the development and application of a sophisticated computer program for the solution of its equations. BHI entered the following parameters into the STAMP model for the simulations. We modeled the individual income tax change as a net static decrease in revenues of $246.6 million in 2012 and $456.7 million in We modeled the 2 percent cut in the corporate income tax, along with the elimination of various corporate income tax preferences, as a static decrease in collections of $139 million in 2012 and $291.1 million in For a clear introduction to CGE tax models, see John B. Shoven and John Whalley, Applied General-Equilibrium Models of Taxation and International Trade: An Introduction and Survey, Journal of Economic Literature 22 (September, 1984): Shoven and Whalley have also written a useful book on the practice of CGE modeling entitled Applying General Equilibrium (Cambridge: Cambridge University Press, 1992). See also Roberta Piermartini and Robert Teh Demystifying Modelling Methods for Trade Policy (Geneva, Switzerland: World Trade Organization, 2005) (accessed June 18, 2010). Tax Changes in North Carolina 7

8 We modeled the expiration of the 1 percent sales tax increase, along with elimination of sales tax preferences, as a net decrease of $1,024.2 million in 2012 and $1,019.9 million in Tax Changes in North Carolina 8

9 The Beacon Hill Institute Team David G. Tuerck, PhD is Executive Director of the Beacon Hill Institute for Public Policy Research at Suffolk University where he also serves as Chairman and Professor of Economics. He holds a Ph.D. in economics from the University of Virginia and has written extensively on issues of taxation and public economics. Paul Bachman, MSIE is Director of Research at the Beacon Hill Institute for Public Policy Research at Suffolk University and a Senior Lecturer in Economics Suffolk University. He holds a Master of Science in International Economics from Suffolk University. Michael Head, MSEP is an Economist at the Beacon Hill Institute. He holds a Master of Science in Economic Policy from Suffolk University. The authors would like to thank Frank Conte, Director of Communications at the Beacon Hill Institute, for editorial assistance. Tax Changes in North Carolina 9

The Beacon Hill Institute at Suffolk University in Boston focuses on federal, state and local economic policies as they affect citizens and businesses.

10 The Beacon Hill Institute at Suffolk University in Boston focuses on federal, state and local economic policies as they affect citizens and businesses. The institute conducts research and educational programs to provide timely, concise and readable analyses that help voters, policymakers and opinion leaders understand today s leading public policy issues. May 2011 by the Beacon Hill Institute at Suffolk University THE BEACON HILL INSTITUTE FOR PUBLIC POLICY RESEARCH Suffolk University 8 Ashburton Place Boston, MA Phone: 617(573(8750 Fax: 617(994(4279 bhi@beaconhill.org Tax Changes in North Carolina 10

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