Guest Opinion: Cut State Capital Gains Tax – The Coastland Times

Guest Opinion: Reduce state capital gains taxes

Published on Monday, May 20, 2024 at 8:02 PM

By John Hood

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

I support most of the tax policies enacted by the state legislature to date. But on one point I will say goodbye to some legislators. They seem to believe that North Carolina cannot eliminate corporate taxes on its own all income taxes while continuing to fund key public services.

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

Despite years of gradual rate cuts, personal income taxes will generate about half of all General Fund revenues this year. No reasonable projection of future economic growth or non-tax revenue can possibly replace all or even a substantial portion of personal income tax revenues. I also don’t think future lawmakers will engage in the political fight necessary to tax medical, legal, or financial services sold at retail.

That said, I agree that North Carolina can and should do more to make our tax code friendlier to growth and investment. That means to recover the way we define taxable income, and not end the entire system.

Here’s a simple equation to keep in mind: Total income equals what is spent today (consumption), what is spent later (savings), and what is given away to someone else to spend (charity). When governments tax total income, they actually create a costly and counterproductive bias toward savings and investments. That’s because income consumed is taxed only once (when we buy goods and services with after-tax dollars), while saved income is taxed multiple times (once before investing principal in an asset, again if it earns dividends or interest but also as a capital gain if the asset is sold, and even more so if the asset in question is shares in a taxable company).

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

However, there is a more practical solution: retain the personal income tax mechanism, but deduct net savings (and donations to charities) from taxable income. One proven way to move toward such a system is to fully or partially exempt long-term capital gains from the tax base.

The federal tax code already contains a version of this idea. This also applies to the tax laws of many industrialized countries. Countries such as Belgium, the Czech Republic, Luxembourg, Slovakia, Slovenia, Switzerland and Turkey do not even tax long-term capital gains at all.

Below the federal level, several states’ income taxes distinguish between long-term capital gains and other forms of income. Take the case of South Carolina. While the top income tax rate of 6.3% for 2024 is much higher than our flat 4.5%, South Carolina excludes 44% of long-term gains, making its effective tax rate lower than ours. Other states that tax capital gains at a lower rate include Arkansas, Arizona, Wisconsin, North Dakota, Montana and New Mexico. Seven other states, including Tennessee and Florida, have no capital gains tax (because they do not impose income taxes).

I recommend that North Carolina establish an exclusion similar to South Carolina’s, and then expand it over time. Together with the already planned elimination of corporate taxes, such a policy would make our state friendlier to savings and investment, without creating budget imbalances or provoking political battles with the service sector that state lawmakers are unlikely to win.

John Hood is a board member of the John Locke Foundation.