By Rob Schofield
Tough negotiations over complicated legislation have a way of getting down to basics. At some point, lawmakers are forced to reveal their hand and show their adversaries what they really want most of all. This week in Raleigh, state Senate leaders reached that point.
After several days of tough negotiations with their House counterparts, Senators have made it abundantly clear that one thing matters most to them in the negotiations over this year’s budget bill: cutting taxes on the richest North Carolinians. Lowering this rate is more important than funding health care for low income children or hard to insure adults; more important than Medicaid “relief” for counties; more important than building affordable housing; more important than funding for disadvantaged students; more important than the community college system; and more important than targeted tax reductions for the poorest North Carolina families.
The tax cut in question, of course, is the scheduled “sunset” of the extra .25% rate that’s applied the highest income North Carolinians. Right now, individual taxpayers with annual income of $125,000 or more and couples filing jointly with incomes of $200,000 or more are taxed at an annual rate of 8.0%. The next highest bracket is 7.75%. The 8.0% rate is a vestige of the 2001 budget crisis when lawmakers raised the income tax rate on the wealthy to 8.25% and added a half penny to the state sales tax. Despite being scheduled to expire multiple times, the two higher rates have persisted, though each was reduced by half in 2006.
Now, as lawmakers grapple with producing a new, two-year budget deal, all major parties (the Governor, the House and the Senate) appear to have reconciled themselves to retaining the extra quarter cent on the sales tax. All seem to have concluded that there is no way to meet the state’s explosive demand for public services, much less relieve counties of their Medicaid responsibilities, if the sales tax is allowed to expire. Though widely acknowledged to be a regressive tax that disproportionately impacts lower and middle income households, no one has found a politically viable alternative that generates more than $200 million annually.
As far as the Governor and House are concerned, the same is true for the income tax rate on the wealthy. Both put forth budgets that kept the upper income rate and the revenue that it generates (at least $94 million annually in 2008). Both have advanced the view that this money is essential to helping the state meet its current obligations and avoid structural deficits in the years to come.
Both might have also noted the equally important fact that the upper income rate is critical to preserving a degree of fairness in North Carolina’s overall tax structure. Even with the tax in place, North Carolina’s wealthiest taxpayers pay just over 6% of their incomes in state and local taxes combined. The poor and the middle class pay around 10%.
The unfortunate stumbling block to retaining the upper income rate is the state Senate – or more accurately, a select group of senators amongst the Democratic leadership. As best as can be determined (there’s been very little, if any, open debate on the topic) there are two possible rationales that Senate leaders employ.
#1 – The Trickledown Rationale – According to this argument, North Carolina simply cannot “afford” to have a higher marginal income tax rate on upper income taxpayers if it wants to remain “competitive” in the ongoing battle for economic development. According to this argument, wealthy people (and their businesses) will be dissuaded from coming to and staying in North Carolina if the rate remains in place. This seems to be the favored public explanation.
#2 – The Cynical Rationale – This argument is more straightforward. Under this explanation, Senate leaders have made a hardball, political calculation that they must cut taxes on the wealthy in order to retain the friendship and political support of many of their wealthiest supporters. Though never uttered and seldom hinted at publicly, this explanation is popular with legislative insiders.
A third possible explanation – that cutting the tax is essential because lawmakers “promised” such an action when they extended it last year – obviously holds no weight in light of the decision to extend the higher sales tax rate adopted at the same time.
Setting the Record Straight
Whichever of the two possible rationales is the real one, the Senate’s action in making tax cuts for the rich its top priority this session is a bad idea. Rather than crafting state fiscal policy based on prudent, overarching premises like tax fairness and adequacy and/or the public’s need for essential services, senators are instead choosing to worsen the state’s performance in all of these categories in the name of an attempt to assuage a small number of rich people that is at best inaccurate and at worst scandalous.
Rationale number two – that the Senate’s defense of the rich is nothing more than an exercise in kowtowing to wealthy campaign funders – needs no real critique other than to be repeated. As for number one, the trickledown theory, there are no compelling data to support the notion that wealthy individuals or businesses are staying away from North Carolina because of the income tax rate on the rich.
To the contrary, North Carolina continues to experience explosive growth in both areas. The very fact that the revenue generated by the upper income rate continues to grow at a healthy clip provides compelling confirmation of the state’s ongoing success in attracting and keeping wealthy citizens. As a practical matter, it’s simply makes no sense that a person with an annual income of, say, $375,000 is going to decide to leave North Carolina to save, after federal deductions, perhaps $50 per month. Indeed, it should be noted, federal deductibility rules assure that a good chunk of any state income tax cut will simply be turned over to the I.R.S. though lost deductions.
A Better Solution?
Happily, the one-month extension of the current budget agreed to by lawmakers this week provides one last opportunity for senators to rethink their stubborn adherence to the upper income tax cut. Tax fairness advocates are urging negotiators to use the window in order to consider an alternative plan that targets tax reductions at folks of lower income. This, they point out, could be accomplished through the adoption of a fully refundable state earned income tax credit (EITC) set at 5% of the federal EITC as was included in the House version of the budget. Such a proposal would have the triple advantage of costing much less than the upper income cut (only $69 million annually), helping far more people (as many as 800,000 as opposed to 60,000+ for the upper income cut) and targeting resources where they’re needed most.
While Senators have expressed a willingness to consider the EITC, thus far they have argued in favor of one that is either “non-refundable” (thus helping far fewer people and none of the very poor) or set at an even lower level like 3.5% (thus providing very tiny tax cuts). The stated rationale for these limitations is that there simply isn’t enough recurring revenue availability to cover the $69 million price tag. But, of course, this position is premised on the notion of proceeding with the tax cut on the wealthy. Eliminating or scaling back that tax cut could easily free up the necessary revenue for the refundable 5% EITC. (It should be noted that most state EITC’s are set at levels well above 5%).
One middle ground position floated in recent days would pair the 5% refundable EITC with a scaled back cut in the upper income tax rate. This could be accomplished either by a) shaving the upper rate an eighth of a percentage point to 7.875% or, b) by raising the income threshold at which the higher 8% rate kicks in so that only smaller segment of the truly wealthy – say those with incomes of $250,000 for an individual and $400,000 for a couple.
Such a compromise could preserve the critical revenues and tax fairness that comes with an upper income bracket, provide a cut to what might be termed the “upper middle class,” and make it possible to provide a meaningful EITC to those in need. In a world in which sound fiscal policy triumphs over cynical politics, such a result could well amount to a winning combination. Events will soon reveal whether Senate leaders have any interest taking such a sensible step.