How North Carolina double taxes capital gains and what to do about it

Raleigh, NC – North Carolina policymakers should boost entrepreneurship and economic growth by focusing their next round of tax reform on capital gains. That’s the recommendation in a new John Locke Foundation Spotlight report, available here.

Lawmakers could end taxation of capital gains in one step or in phases.

Capital Gains Tax“A good target for future tax reform should be the complete elimination of capital gains from the tax base,” said report author Dr. Roy Cordato, JLF Vice President for Research and Resident Scholar. “The current system produces a form of double taxation that creates a systematic bias against the investments that lead to economic growth.”

Complete repeal of state capital gains taxes would return about $500 million to N.C. taxpayers in 2017, according to the Beacon Hill Institute at Suffolk University in Boston.

“If complete elimination is considered to be too big of a hit to the state treasury all at once, a phase-in process could be put in place similar to the approach the state has used in reducing North Carolina’s corporate tax rate, possibly using revenue triggers,” Cordato said.

In the case of the corporate tax, state lawmakers agreed in 2013 to two initial rate cuts for 2014 and 2015. Lawmakers also pledged to reduce rates again if budget revenues met certain targets, or “triggers.” The triggers allowed the corporate rate to fall from a high of 6.9 percent to as low as 3 percent.

Cordato applies the same concept to capital gains. His phase-in plan would allow taxpayers to exclude a certain percentage of capital gains from taxation, with that percentage gradually increasing over time. “The state could consider a plan that starts at excluding 25 percent of capital gains from taxation and then increases to 50 percent, with complete elimination as the ultimate goal.”

The 25 percent exclusion would return $125 million to taxpayers in 2017, while the 50 percent exclusion would return about $250 million, according to the Beacon Hill Institute analysis. Those same dollar figures represent the cost to North Carolina’s treasury.

“It’s important to note that this is a static estimate, which means that Beacon Hill analysts made no assumptions about positive economic growth effects from the tax cut,” Cordato explained. “Positive growth effects would feed back into the taxable income stream via other forms of income or additional spending, and therefore greater sales tax collections.”

That makes the revenue estimate “particularly conservative,” Cordato said. “The loss to the state treasury could actually be less than the projection.”

North Carolina could make up for lost revenue by eliminating special industry subsidies and targeted business tax credit programs, Cordato said. “These programs give rise to economic inefficiency and reduce economic growth,” he said. “Getting rid of them would reinforce the positive economic impact of changing the tax treatment of capital gains, swapping inefficient targeted tax breaks for growth-enhancing, broad-based tax reduction.”

Cordato devotes much of the report to explaining how the existing state tax system leads to double taxation of capital gains.

Any tax on income used for investment purposes reduces both the amount of the investment, called the principal, and the entire income stream from that investment, Cordato explained. “A separate tax on capital gains serves as a form of double taxation.”

As an example, Cordato looks at a taxpayer who chooses whether to spend $100 of his income on a fancy dinner or to invest the same $100 in a stock, with the expectation of a 10 percent gain in one year.

“It’s the basic choice between consumption and investment: Enjoy $100 worth of consumption now or forgo that consumption and gain an additional $10 in a year,” he said. “Now factor in a 10 percent income tax with no additional tax on capital gains. The taxpayer has a choice between a $90 dinner or a $9 return from his investment in a year. The returns to consumption and the returns to investment are reduced by the same amount: 10 percent.”

If the taxpayer is also forced to pay a 10 percent tax on his investment income, the picture changes, Cordato said. “An additional layer of taxation on his capital gain reduces that gain from $9 to $8.10,” he said. “That’s double taxation. It biases the person’s decision against making the capital investment and in favor of consumption.”

“In a broader economic sense, since economic growth springs from capital investments, including the return on investments made in small businesses across the state, the taxation of capital gains is a penalty on growth,” Cordato added.

Other governments recognize this problem, Cordato said. “North Carolina’s policy flies in the face of federal tax law and the law in several other states, where capital gains are taxed at a lower effective rate than other forms of income.”

North Carolina has an opportunity to continue down a road paved by historic 2013 state tax reform legislation, Cordato said. “An important first step would be to begin a process that would lead to the ultimate elimination of capital gains from the tax base and the penalty on entrepreneurship and economic growth that our tax code currently imposes.”

Dr. Roy Cordato’s Spotlight report, “Capital Gains: How North Carolina Double Taxes Capital Gains and What To Do About It,” is available here. For more information, please contact Dr. Cordato at (919) 828-3876 or .