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North Carolina Supplemental Report

Tax Environment

North Carolina has a very unusual and progressive history of taxation and state and local government finance. In the early 1930s, it took over full funding of the operating expenses of the public schools and roads; thirty years later the state took on the responsibility of funding the courts. In the case of both schools and courts, capital spending was left in the hands of locals.

One of the hallmarks of the North Carolina tax system is that its property taxes — and particularly its commercial property taxes — are quite low. It’s alcohol and gasoline taxes are higher than average, but it has one of the lowest cigarette taxes in the country (only 5-cents per pack.) The centralization of funding, and the insignificance of the property tax in terms of funding school operating expense, has helped the state avoid some of the equalization funding issues faced by many other states. At the same time, as noted below, its choice of taxes has tended to make revenues more volatile.

Last year, the Governor’s Commission to Modernize State Finances came out with a number of recommendations on restructuring the state’s tax system to gear it more toward a 21st century economy. http://www.osbm.state.nc.us/osbm/pubs.html As the December, 2002 report concluded, the state’s tax system has not had a major overhaul since the Great Depression. (Another commission in 1991 also made many of the same suggestions as were made in this report, but without much result.)

In terms of non-tax revenues, North Carolina is the only East Coast state that doesn’t have a lottery. Early last fall, lawmakers agreed to create a North Carolina Toll Road and Bridge Authority and embark on construction of the state’s first toll road. With heavy pressure on the budget, a variety of governmental fees have been escalating and a higher education tuition hike of 8 percent for in-state students and 12 percent for out-of-state students was approved by the legislature.

Recent Tax Developments

• In 2001, the North Carolina General Assembly voted for a $1 billion tax increase. This included an increase in income tax rates on higher income individuals, a temporary half-cent increase in the sales tax, imposing a sales tax on liquor and taxing HMOs

• In 2001, 50 additional staffers were hired for the Department of Revenue to increase audit and collection activity, after the General Assembly increased resources to deal with high accounts receivable.

• Governor Mike Easley established the Governor’s Commission to Modernize State Finances in February, 2002, with the goal of creating a revenue system that was more “stable, fair, and sufficient” over the long-term

• In late summer, 2002, the state held a sales tax holiday for clothing, footwear and school supplies under $100 and on computers under $3500.

• In Fall 2002, the legislature clarified and altered a law that had been passed the previous year that had sought to close some corporate loopholes that affected banks. A lack of clarity in the way the original law was written, and big increases in the tax due from many banks, led the banking industry to seek an amendment to the 2001 legislation. The law was rewritten to clarify expense deductions related to nontaxable dividend income and cap an individual bank’s additional tax liability at $11 million per corporate family.

• A new tax incentive program, designed to be more targeted than past efforts was passed last fall by the legislature. It will give selected companies up to 75 percent of workers’ state income tax withholdings — the amount taken out of their paychecks, not the amount owed at the end of the year — in cash as an incentive to locate or expand in the state. The program is capped at $10 million annually.

• The Governor’s Commission to Modernize State Finances released its recommendations in December, 2002. These included: removing differential sales tax rates and caps, eliminating sales tax exemptions, consideration of taxing more services, adopting changes in order to comply with the Streamlined Sales Tax Agreement, tying the state income tax more closely to the federal income tax code, consideration of ways to reduce the income tax burden on lower income individuals, eliminating and simplifying corporate tax credits, moving to a combined reporting system, broadening the base and potentially lowering the rate of the franchise tax, and conforming to the federal definition of corporate income.

• On July 1, a half-cent sales tax decrease and a half-percent drop in the top income tax bracket will take affect, unless the House and Senate agree to retain these temporary tax increases.

Budget Information

North Carolina has been battling budget shortfalls for the last two years. To close FY2002, the state borrowed money from its hurricane relief fund and also took money from its tobacco trust fund.

The state struggled through the summer to pass its FY2003 budget and finally arrived at a $14.3 million House/Senate compromise in September (compared with $13.7 billion the previous year.) Governor Mike Easley won money for his pre-kindergarten program and for a plan to reduce class size in first grades statewide. In order to balance the budget, the legislature substantially cut money to local governments, used about $800 million in one-time money and provided state employees (except for teachers) with no raise for the year. Agencies were asked to do substantial cutting as well. After the budget was passed, the legislature also agreed to let cities and counties add a half-penny to their sales taxes to recoup some of the money that they lost through the cut of state funding.

During the fall, a $1.5 to $1.8 billion shortfall was projected for FY2004. In addition to proposed cuts, a variety of proposals circulated in winter 2003, to erase the budget gap through proposed increases in cigarette taxes, a continuation of temporary tax increases, a proposed lottery, and other suggested sin tax increases. Revenues continued to come in weaker than expected during the spring. In May, the FY2004 budget was still up in the air, but the state’s short-term budget problems were somewhat alleviated by the $510 million in federal dollars — about $275 to go to Medicaid — that came from the U.S. Congress’s decision to devote $20 billion to help out financially stressed states.

Adequacy

The state has a fairly balanced tax system, but revenues in recent years have fallen far short of expectations — they were 4 percent under projections in FY2001 and 11 percent under projections in FY2002. Ongoing budget problems in recent years have stemmed partly from a string of bad luck in terms of natural (and legal) disasters, the volatility of the income tax and the steep decline of the corporate tax. As in many states, a significant shortfall in revenues for the FY2002 and FY2003 stemmed from a decline in non-wage income as well as a decline in corporate profits.

Looking at state and local taxes together, North Carolina relies very heavily on the volatile income tax. In fact, the state ranks 11th nationally in individual income tax burden, according to the Governor’s Commission on Modernizing State Finances. The state is much less reliant on sales taxes and property taxes than its neighbors or the nation as a whole. Property taxes, particularly, tend to be generally recognized as a more stable tax. Therefore the basic tax structure — a dependence on volatile incomes taxes and little dependence on stable property taxes — tends to make the state’s revenues far more vulnerable in periods of economic downturn.

Another issue faced by the state stems from $1.5 billion in permanent annual tax cuts, enacted by the legislature in the late 1990s. Since income tax revenue was booming at the time, the state didn’t need to cut back on services. When income tax revenue significantly declined budgetary balance was imperiled.

There is a widespread understanding within the state, that the tax system, developed during a time when North Carolina was heavily dependent on manufacturing and farming, hasn’t shifted to deal with an economy that is increasingly service based. North Carolina’s sales tax covers very few services. http://www.taxadmin.org/fta/pub/services/services.html

Fairness

A number of factors give the state a roughly proportional tax system. The state does not place a sales tax on food (though local governments currently do) and it has a four-step graduated income tax with a relatively high rate of 8.25% on the top bracket which kicks in at $120,000 for single individuals. The availability of a tax credit for dependent care and a dependent child credit are progressive features, while the lack of indexing for the personal exemption is a regressive element, according to the Institute on Taxation & Economic Policy study, “Who Pays? A Distributional Analysis of the Tax Systems in All 50 States,” http://www.itepnet.org/whopays.htm

With its very limited tax on services, the state faces a number of fairness issues in terms of tax policy. For example, if a person buys a lawn-mower, he pays tax; if he hires someone to mow his lawn, he doesn’t. The Governor’s Commission to Modernize State Finances has recommended that the tax be broadened to include more services.

The sales tax is also complex. It’s applied at eight different rates to different goods and services, and a variety of caps exist for certain purchases.

In terms of corporate tax loopholes that create an uneven playing field for businesses, the state has done a reasonably good job in recent years in tightening the rules. It is among a small group of states that have created statutes specifically aimed at preventing companies from protecting income from taxes by siphoning it off to passive investment companies.

Management

In the recent past, the Department of Revenue (DOR) has suffered from under-staffing. The current administration has focused on dealing with these problems, in spite of the troubled budget situation.

North Carolina does well on basic processing tasks. DOR has implemented a number of new systems (Data Capture, Electronic Filing, Electronic Funds Transfer) during the last several years that are used to receive and process taxpayer information more efficiently.

The state has high speed scanning equipment and DOR officials believe that the department’s imaging activities are ahead of most other states. Efficiencies in processing returns has allowed the processing unit to focus on increasing collections — for example, by concentrating more on efforts to garnish the salaries of those who owe taxes. The state’s website is comfortably in the second tier — above average, but not quite up to the level of the ten best. According to its own website, North Carolina has participated in the Federal/State Electronic Filing Program for ten years and has ranked near the top nationally in individual income tax returns filed electronically. Thirty-three percent of individual returns are now processed electronically, according to department officials.

In terms of compliance activities, the state has stepped up its collection activities through Project Collect Tax (see notable programs). It’s also making efforts to get a good grip on the size of the non-compliance problem. In summer 2002, The North Carolina Department of Revenue said tax cheats were costing the state about $100 million a year. According to its figures, about 20,000 incorporated businesses didn’t file tax returns this year and at least 30,000 people a year who file federal tax returns and owe state taxes don’t file state income-tax returns.

The state has a somewhat sizeable backlog of planned audits. While it does the kind of data-matching that is common in most states — exchanging information with the IRS, customs department and other agencies — it does not yet have sophisticated data mining capability — using internal and external data in a more sophisticated way to flag individuals who have inconsistencies in their returns and would make the most productive audit candidates.

The state does quite well in its collecting, reporting and analyzing of tax-related information. It prepares a tax expenditure report, though this is not available on the web. The Tax Subsidy Law, passed in 2002, requires that companies report on the tax credits they receive. Companies must disclose the number of jobs created in designated development zones and the percentage that go to local residents. This effort to establish better accountability stemmed from criticism that the drive to promote the economic development of the state through tax incentives had neglected poor regions in favor of already prosperous areas like the Triangle and Charlotte.

The state has limited ability to determine the impact of tax changes on different segments of the population, according to the Corporation for Enterprise Development. http://sadrc.cfed.org/states/nc.php

The Governor’s Commission on Modernizing State Finances suggested that an area that may need further review, streamlining and improvement is the administrative tax hearing process, and the appeals process to the Tax Review Board and the Property Tax Commission. One possibility would be a new tax court.

Property tax reassessment is required by the state every eight years, though most counties do it more frequently than that.

Local Issues

Local governments in North Carolina lost several revenue sources in the last decade when the legislature got rid of the property tax on business inventories and the property tax on intangible property. Both of these taxes were used by local government for capital needs in schools and courts and for supplementing state funding of school operating expenses. The state promised to reimburse local governments for these lost taxes, but budget problems resulted in cuts to those funds in FY2002 and again in FY2003. In an effort to provide local governments with more revenue, the North Carolina General Assembly voted in fall 2002l to give cities and counties the ability to charge an additional one-half cent sales tax, bringing the sales tax rate to 7 percent in most areas, at least temporarily. (Half a cent of the state portion of the sales tax is scheduled to expire at the end of June.) The legislature also passed the “Secure Local Revenue” act, designed to prevent the state from seizing money intended for local governments in the future.

Although North Carolina stands out among states in its heavy funding of education, roads, the courts and corrections, it is one of the very few states that asks local governments to pitch in to help fund Medicaid. Local governments also have significant capital funding responsibilities both in the courts and schools and these have proven tough to meet. In general, state and local relations have grown quite tense in recent years over funding issues. The portion of the state’s general revenues that is devoted to local funding has been declining, whereas most states are heading in the opposite direction. In North Carolina, state aid as a percentage of local general revenues fell from 47 percent to 38 percent between 1977 and 1997, according to “Are State and Local Revenue Systems Becoming Obsolete?” by Robert Tannenwald.

One problem for local governments is that breaks for farmers exclude a good deal of land from taxation and there are many other common property tax exemptions as well. In general, commercial and industrial property taxes on business are very low compared with other states (in the bottom five for the country). Homestead taxes are somewhat below the average for urban areas and in the bottom fifteen states for rural areas.

In contrast to South Carolina, counties are prohibited from offering property tax exemptions. Any property tax exemption or preference has to be approved by the general assembly.

Noteworthy Programs

• Project Collect Tax. This effort to bolster the collection activities of the Department of Revenue began in 2001 in response to a $370 million backlog in accounts receivable. Fifty new staffers were added to the department by the General Assembly, enabling the state to focus its attentions on 250,000 seriously delinquent taxpayers. The Revenue Department set a target of $150 million of new collections over current collections during the following two-year timeframe. Midway through this period, the department appeared to be meeting its goals, with a first year collection of $75 million.

Part of the department’s successful efforts involved setting clear policy guidelines for dealing with delinquent accounts. It developed a three strikes policy. If you’re a good taxpayer with a good compliance record, then if you’re late one time, the penalty is waived. On the second time, half the penalty is waived, and after that the penalties stick. “It takes away a lot of time spent reading through taxpaper letters about how their bookkeeper left the country,” says one revenue department official. It has also improved reporting requirements on tax credits, to prevent businesses from falsely claiming credits for jobs created when they weren’t created.

In addition to utilizing standard collection techniques, the department has wielded the threat of publishing names of tax debtors on the Internet, along with the amount of back taxes owed. www.dor.state.nc.us/collect/delinquent.html

• North Carolina is one of five states that have created statutes specifically aimed at preventing companies from protecting income from taxes by siphoning it off to passive investment companies.

• A revision in the tax subsidy law is creating a much more accountable system in terms of the reporting of tax credits. Newly passed legislation requires companies to report their tax credits and it asks them to report, as well, the number of jobs created in designated development zones, as well as the percent that go to local residents.

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