Before exploring possible solutions that address our state’s revenue challenges, it is important to understand the underlying causes of our tax system’s problems.

Lack of Balance Among Tax Revenues
In order for states to have steady, constant revenue bases, it is important that tax revenues come from diverse sources, such as the personal income tax, corporate income tax, and the sales tax. Over time, North Carolina has come to depend heavily on the volatile personal income tax as our main source of tax revenue (See charts below. Note: Corporate Income Tax (CIT) and Personal Income Tax (PIT)).

This system proves to be inefficient especially during a recession when fewer people are working and contributing to the tax base at the same time that demand for services increases. As a result, our government is forced to make harsh budget cuts, and sometimes raise taxes to make up for loss in personal income tax revenues.

Erosion of the Sales Tax Base
Like many states, North Carolina’s sales tax system was designed in the 1930s for an economy where most spending was on tangible things, like cars and clothing.  We now spend our money on services, most of which are not subject to the sales tax, such as car repairs, doctors visits, and live entertainment. North Carolina currently taxes less than one-fifth of all services, below average compared to other states (see below).

This shift in spending habits is one reason why sales tax revenues are a smaller share of total state revenue.  Unfortunately, as households spend less of their budgets on taxable items, we’ve had to raise sales tax rates on the items we do tax—just to maintain sales tax revenue levels.  Continuing to rely on ever increasing sales tax rates  is not fair to producers and consumers of these products.

Solution
In order to address these problems, North Carolina must adopt a solution that is comprehensive. To reduce the dependence on the personal income tax, North Carolina should broaden the sales tax base to include more services, and lower the sales tax rate.

Expanding the sales tax base to include services would bring a variety of important benefits:

• -a more stable source of tax revenue, one that wouldn’t fall precipitously in a recession;
• -a fairer tax system that no longer discriminates against producers of goods;
• -growth in revenues that better match the growth of our economy; and
• -a reduction in the sales tax rate

Since 2005, IEI has been involved in the Financing the Future program of work. This program of work was honed through the collaborative effort of its three Working Groups, comprised of members from the business, government, nonprofit, and higher education sectors. The Working Groups began with three separate broad agendas that then merged into one comprehensive task force to consider the most promising set of possibilities. The three subgroups focused on Financial Innovation, Bridging the Financial Gap and Modernizing Local Finances.

Then, at the 2006 Emerging Issues Forum, the Working Groups presented “Options for Consideration” under the following broad areas for change:

State Revenue: Restructure the state’s revenue system in a way that promotes growth with equity.

Local Innovation: Ensure sufficient revenues to meet the future needs of counties, cities and the state.

Best Practices: Develop a transparent budget and management process for both state and local government.

Following the Forum, IEI’s work was pursued in a variety of arenas.  It held five community forums around the state to connect local issues to the big challenges facing state finance, which demonstrated the many ways in which the future of local government finance was tied to choices made in Raleigh.

In partnership with the Z. Smith Reynolds Foundation, IEI also organized a leadership retreat in Asheville for a broad range of business leaders, where the challenges facing the state were spelled out for the first time using the tax calculator developed by IEI.

In 2007 the issue achieved new salience through the work of the General Assembly’s State and Local Fiscal Modernization Study Commission.  IEI helped staff the work of the Commission, and supported its work through the use of the calculator. A version of the tax calculator was also placed on the North Carolina Association of County Commissioner’s website that included property tax rates for all 100 counties.

One of the results of the Study Commission was legislation that eliminated the county share of Medicaid, a pressing burden on local government that had been identified by IEI’s work.

In addition to numerous presentations by IEI staff to civic groups and local government across the state, IEI convened a Business Committee on Financing the Future (BCFTF). The BCFTF met five times, most recently in March 2011, and has heard from numerous nationally recognized experts. The group  is co-chaired by three business leaders, Jack Cecil, John McNairy, and Richard Vinroot, and is comprised of high-level business leaders representing the state’s varied regions and industries. On Monday, April 14, 2009, it released its Statement of Principles on tax modernization, the culmination of four years of work.

These principles were broadly adopted by a tax plan proposed by the Senate Finance Committee of the NC General Assembly, although much was ultimately excluded in the final budget.