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Did you hear the recent radio debate about taxes? Joseph Coletti of the John Locke Foundation said the North Carolina Senate budget plan would increase tax rates. No, said Roland Stephen of The Institute of Emerging Issues, the Senate plan would lower tax rates. Both claims can't be true. Or can they?
In fact, they can. Joe and Roland were talking about different things. Both are recognized authorities on fiscal policy, and both used valid and important arguments essential for citizens to understand.
Two types of tax rates
There are two types of tax rates. Joe focused on the Average Tax Rate (ATR), which the Senate plan would increase. Roland focused on Marginal Tax Rates (MTR), which the Senate plan would decrease. Why increase the ATR but lower MTRs? Increasing the ATR could help North Carolina weather the current fiscal crisis. Reducing MTRs would improve tax efficiency and could shore up the state's eroding tax base.
It may not be easy to see how our General Assembly could achieve three good things – all at once. To see if the Senate plan might work or lead down a primrose path, some details are helpful.
An ATR is calculated by dividing tax liability by total income. Consider a typical N.C. married couple whose total income is $41,000. Subtracting exemptions and the standard deduction, taxable income is $30,000. This couple owed individual income tax of about $1,887 in 2008, so the couple's ATR was about 4.6 percent . But you won't find 4.6 percent in the tax code.
MTRs are the statutory rates stated in the tax code. An MTR is the rate paid on different intervals of taxable income. The MTR on the first $21,250 of taxable income is 6 percent. The MTR on each dollar of taxable income above $21,250 is 7 percent, and so on.
If this lucky couple is blessed with quintuplets in 2009, and nothing else changes, it can take a $500 child tax credit, tax owed would decline to $1,387, and the ATR would decline to 3.4 percent. The ATR declines because the child tax credit narrows the “tax base”. The ATR declines eventhough the MTRs do not change. In fact, a change in the tax base can cause the ATR and MTRs to change in opposite directions.
The Senate plan would broaden the state's tax base by eliminating some income tax deductions, and broadening the sales tax to some services and the franchise tax to more firms. Base broadening tends to boost revenue. But the plan also would lower MTRs, which tends to decrease revenue. In the Senate plan, base broadening dominates so the net effect would be increases in revenue and the ATR.
Would the Senate plan make us better or worse off? A fair answer must consider the two effects separately.
First consider an increase in ATR. People will disagree until kingdom come about whether tax revenue and government should be larger or smaller. Some will argue that more revenue would avert cuts in government services, which some people value highly. If that value equals taxes paid, the Senate plan could be a good deal. However, others will argue that bitter experience teaches we don't always get what we pay for. Not everyone values government services, and bigger government impairs individual freedom and is more wasteful. These benefits and costs are measured according to ethical standards and political philosophies, so the proper size of government cannot be decided purely, or even primarily, on economic grounds. In our democracy the government's size is determined in the voting booth and by those with power to influence votes.
In contrast, it is possible to know whether lower MTRs improve economic efficiency. They do. Just not in the way most often claimed (by lowering ATRs). Here's why: In almost every case, economic inefficiency is due to MTRs, not ATRs. This is so because economic inefficiency is not the revenue taxpayers ante up: Taxes impose a burden on society separate from the amount of tax revenue. Instead, inefficiency occurs because taxes change the way people behave: people substitute untaxed stuff, with relatively low value, for taxed stuff, with higher value. The inefficiency is the decline in economic value caused by taxes.
Consider an extreme case. Suppose a $100 tax is levied per ticket to one Kannapolis Intimidator baseball game. The Intimidators are fun to watch, but the tax makes it possible, if not likely, that ticket sales for that game would drop to zero. In this case, people are worse off although they pay no tax. The tax is inefficient because people forego something they value.
More realistically, some firms pay accountants to invent and operate income tax shelters, and lawyers to defend tax shelters in court. Sometimes tax professionals are so good at this their firms pay no tax. The inefficiency here is the value of the services that could have been produced instead of tax dodges that must be defended in court.
Sales tax avoidance
Memphis, Tenn.'s, sales tax rate is 9.25 percent. People drive to West Memphis, Ark., where they pay lower sales tax. The inefficiency here is extra wear and tear on cars, the cost of gasoline, and the value of the time it takes to drive across the Mississippi. Sales tax avoidance reduces Tennessee's tax revenue. Like most states whose tax bases have eroded in the past 40 years, Tennessee has responded by raising its sales tax rate.
This makes matters worse at an accelerating rate. A brutal fact is that inefficiency increases faster than MTRs increase. The increase in inefficiency from raising a MTR by 10 percent is greater than 10 percent. This fact leads to tax analysts' most useful policy recommendation: whenever possible, broaden tax bases and use the revenue to reduce MTRs. Doing so produces one of the few “free lunches” in economics.
Depending on one's political philosophy, Joe may or may not be correct when arguing that North Carolina's ATR is too high. But Roland certainly is correct to argue that the Senate plan would improve efficiency by broadening the tax base and reducing MTRs.
Benjamin Russo is professor of economics at the University of North Carolina at Charlotte. Reach him at brusso@uncc.edu.
