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Time for state to reconsider its franchise tax

Roy Cordato

Roy Cordato

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Monday, February 11, 2019

North Carolina's franchise tax is a punitive and opaque tax levied on businesses organized under one of the usual corporate forms. It is inconsistent with both good economics and good government and should be abolished.

Conceptually the franchise tax is quite simple. It is a tax on the net value or worth of corporations with operations in the state. Net worth is defined as a business's total assets minus its total liabilities. 

North Carolina’s franchise tax is, in fact, a corporate tax placed on top of the existing corporate income tax. The difference is that it is not levied on business income but on the value of its assets. 

A standard principle of taxation is that expenditures on assets like equipment should be fully deductible from income. The franchise tax is a back-door method allowing the state to tax the value of these purchases after the fact.

Imagine that a construction company purchases a bulldozer. When the company goes to pay its income tax, this bulldozer is a deductible expense. But once the purchase is made, the bulldozer becomes part of the company's stock of capital equipment and therefore part of its asset base. When it is purchased, the value of the bulldozer is deducted under the corporate tax. But once the firm owns it, that same value does get taxed year after year under the franchise tax.

This is not only bad economic policy but an underhanded way of taxing something that shouldn't be taxed at all. It is also a way of decoupling a business' tax liability from how well it performs economically. Even in bad years, when the company might be losing money, the state will still require it to pay this tax on its previous asset purchases.

Viewed in conjunction with the corporate income tax, this is clearly a case of double taxation. It makes no difference that the revenue that went into purchasing the asset is fully deductible under the corporate income tax. The value of the asset comes from the fact that it generates future income, and this will be reflected in the assessed valuation of that asset. That income will be taxed as part of the corporate income tax.

The corporate income tax reduces the value of the asset. So, to tax both the asset and the income that it generates reduces the value twice. The franchise tax not only discourages investment in the accumulation of assets, it is also punitive. As the Tax Foundation notes in their critique, "taxing a company based on its net worth disincentivizes the accumulation of wealth, or capital, which can distort the size of firms and lead to harmful economic effects."

If North Carolina eliminated its franchise tax, its ranking in the Tax Foundation's "state business tax climate index" would improve from 12th in the nation to 11th and in their sub-ranking for property and wealth taxes the state would move from 33rd to 16th.

Maybe the most pernicious aspect of the tax is its implications for honest and transparent government. It is a hidden tax whose burden is not borne by the businesses upon which it is levied but instead by its customers, employees, and shareholders.

The franchise tax, like all taxes, comes out of the pocket of real people. When the franchise tax is levied, customers will pay in the form of higher prices, employees will pay in the form of lower wages, and shareholders will pay in the form of smaller returns. But none of these people actually see a bill labeled "franchise tax." It is a completely non-transparent tax and is therefore inconsistent with principles of good government.

For citizens to know what government is costing them, they must be made keenly aware of how much they are paying in taxes. Obfuscating these costs by using forms of taxation like the franchise tax and the corporate income tax works well for politicians who want constituents to believe that they are getting something for nothing. On the other hand, it is a great disservice to the residents of the state who, as voters, need to be as informed as possible.

Roy Cordato is vice president for research and resident scholar at the conservative John Locke Foundation.

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