Tax reform will lure capital


RALEIGH — Even if you’ve never had any interest in doing it yourself, you should want North Carolina to be a great place to start a new business.

Why? Because that new business might employ you or a family member one day. Start-up companies create a disproportionate share of net new jobs. New businesses also offer valuable new goods and services. They benefit your community by expanding the local tax base and creating new civic leaders.

Our state has made progress on this front in recent years. In the 2016 Index of Growth Entrepreneurship published by the Kauffman Foundation, North Carolina went up seven slots to rank eighth out of the 25 most-populous states. That was the largest year-to-year improvement of any state in the study.

We’re not at the top of the list yet, however, and when it comes to the rate of new business starts — a somewhat different measure — North Carolina is closer to the middle of the pack. In short, there is still plenty of room for improvement.

One way to accomplish that would be to continue restructuring North Carolina’s tax code to encourage more private investment in our state. Previous rounds of tax reform have pulled our income-tax rate to just below 5.5 percent, down from a top rate of 7.75 percent as recently as 2013. Because North Carolina’s tax code treats capital gains like other income, that means we’ve become more competitive.

But capital gains aren’t like other forms of income. Wage income is hit once by the income tax, when it is received by employees. It is deductible to the employer and is not itself the result of taxable investment.

The tax treatment of investment income works quite differently. If you buy stock or invest money directly in a business startup, the money you spend is after taxes. In other words, the future returns on that investment — the annual earnings you receive from the business, as well as capital gain you realize when you sell it — have already been reduced by the initial tax rate. By having to pay taxes on the principal of the investment, your future stream of income from it has already been reduced by a comparable percentage.

If the government then taxes it again, when you receive annual earnings or the proceeds of a future sale, you’re getting hit twice. If the company is a C corporation, the earnings are taxed again (although not as much as they used to be, if the corporation does business in North Carolina). And because the system is not adequately adjusted for inflation, the tax bias is worse than it seems on paper.

Well-designed tax systems — within the United States and around the world — address this bias by either 1) excluding the money you invest from tax (like a traditional IRA does), 2) excluding the income you subsequently receive from the investment (like a Roth IRA does), or 3) applying a lower tax rate to capital gains and dividends (like the federal government and a number of states do for investments outside of retirement accounts).

When policymakers talk about taxing consumption instead of total income, the bias against investment is one of the problems they’re trying to solve. Total income, after all, is simply what you spend plus what you save plus what you give away. If you can deduct your charitable giving and your net savings, the remainder is your consumption.

I think the next round of tax reform should move in this direction. One approach would be to allow North Carolinians to exclude a portion of their capital gains from state tax — in effect, reducing the marginal tax rate on capital formation. South Carolina already does this. A good selling point is that, unlike other proposals, it need not be done in one fell — and politically challenging — swoop. It can be phased in.

By taxing capital less, we’ll get more of it — more capital invested in new businesses creating new jobs. Investors gain, sure, but so do the rest of us.

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John Hood is chairman of the John Locke Foundation.

John Hood is chairman of the John Locke Foundation.

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