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Our antiquated tax code is breaking the bank. So how do we fix it?

Traffic congestion in the Triangle often turns Interstate 40 into a parking lot. Trailers clutter so many Wake school campuses that they resemble mobile home parks. And state lawmakers have grown so desperate for money that they are starting a lottery, planning toll roads and going deeper into debt.

All of these are signs that the state's piggy bank is cracked. North Carolina, many experts believe, is likely to run short of the money it needs for adequate roads, schools and other public services for one of the nation's fastest-growing states.

"We have been put in a situation where revenue will not keep up with growth," said Tom Ross, executive director of the Z. Smith Reynolds Foundation in Winston-Salem and a leading advocate of finance reform. "Forget about additional services or money for education or prisons."

That is why a group of North Carolina political leaders, businessmen and economists, under the leadership of former Gov. Jim Hunt, is beginning the first major effort to reform North Carolina's tax structure since the dark days of the Depression in the 1930s.

The idea, they say, is to replace an antiquated tax system that relies primarily on sales and personal income taxes with a modern system that will provide a more steady stream of revenue.

The experts plan to look at a broad range of issues: Should there be a flat tax? How about a consumption tax? Are corporate taxes too high, or are corporations paying too little? Should local governments continue to help pay for Medicaid? Should local school boards be allowed to control their own budgets? What tax loopholes should be closed?

Breaking the budget: Six questions (and answers) about N.C.'s tax system

1. HOW DOES IT WORK?

North Carolina's existing tax system was created during the desperate days of the 1930s, when local governments were going broke, banks were closing their doors and farms were being sold at auction.

Gov. O. Max Gardner (1929-33) hired The Brookings Institution, a liberal think tank in Washington, to design the system. The state took over responsibility for roads, schools, prisons -- paying for them largely though a sales tax and a progressive income tax. Local governments were financed largely through property taxes.

In many ways, North Carolina's tax system was regarded as a model over the decades.

The system left North Carolina with a relatively high state income tax but relatively low property taxes. As a result, North Carolina has not seen the type of anti-tax revolts -- fueled by anger over high property taxes -- that have occurred in California and other states.

North Carolina ranks 28th in state/local tax burden, according to the Tax Foundation, a conservative Washington-based group. In 2005, Tar Heel residents will pay on average 10 percent of their income in state and local taxes, compared with 10.1 percent nationally. North Carolina has the same tax burden as Washington state, Iowa, Mississippi and Idaho.

But the system has been strained in recent years as the state has experienced Sunbelt growth. The U.S. Census Bureau projects that the state's population will grow from 8 million to 12 million by 2030, surpassing Georgia, New Jersey, Michigan and Ohio.

There are numerous signs of the system's fraying. The State Board of Transportation keeps delaying highway projects because of a lack of money. In Wake County last year, 16,000 students attended class in 700 mobile or modular buildings. The state has been raiding its rainy-day reserve fund to pay ongoing expenses. The state's debt has more than doubled since 2000. And the state is planning to tap new nontax sources, such as the lottery and toll roads.

North Carolina now has a $600 million structural deficit -- that is the annual difference between revenue and expenses, according to David Crotts, the legislature's chief economist. Because lawmakers are constitutionally required to pass a balanced budget, they have been plugging the deficit the best they can.

The chief method has been a temporary tax increase passed in 2001 -- and renewed twice -- that raised the sales tax and the income tax for high earners. Those taxes are scheduled to terminate at the end of the 2007-2008 fiscal year.

2. WHAT WENT WRONG?

Partisans argue over the causes of the $600 million structural deficit. Democrats blame the Republican-initiated tax cuts of the mid-'90s. Republicans cite overspending.

But there are several reasons why the tax system is wobbling, and they have more to do with changes in the economy that all states are facing.

* SALES TAX REVENUE, which provides 29 percent of all state revenue, has been hurt by a shift from the sale of goods to the sale of services, most of which are not taxed. People are spending proportionally less on clothing, but more on personal trainers, chiropractors and accountants to prepare their taxes.

Residents are also buying more goods over the Internet, much of which escapes the state sales tax.

* INCOME TAX REVENUE, which provides 62 percent of all state revenue, reflects the decline of traditional industries such as textiles and furniture. Not only are corporations paying less taxes, but some laid-off workers have moved to lower-paying jobs and are paying less personal income taxes, too.

Corporate income taxes dropped from 11 percent of state revenues in 1988 to 7.7 percent today. Economists say the decline is the result of smaller businesses turning themselves into limited liability companies -- whose earnings are taxed as personal income. Other businesses have found tax shelters to avoid corporate taxes.

Swings in the economy can also cause revenue from income taxes to fluctuate.

North Carolina now faces an increasingly unreliable source of money.

"For just the basic services, you need a revenue structure that will grow with the population," said Tom Ross, the executive director of the Z. Smith Reynolds Foundation. "We are very worried that the sales tax and income tax cannot meet that demand without changes. Without changes we are going to have a structural budget deficit -- continually facing either cuts or tax increases, neither of which is politically palatable."

3. WHO'S WORKING ON IT?

The reform effort comes under the auspices of the Institute for Emerging Issues, a think tank affiliated with N.C. State University. Former Gov. Jim Hunt started the institute in the 1980s.

In November, the institute began assembling a group of experts to study North Carolina's tax system and develop a set or proposals. Those suggestions will be discussed at the institute's annual forum Feb. 6-7 at NCSU. The institute will then begin a multi-year effort to make the case for the recommended changes.

Three working groups of economists and political, business and civic leaders have been studying the tax system. The working groups are headed by John Medlin, retired CEO of Wachovia bank in Winston-Salem; Parks Helms, the chairman of the Mecklenburg County Board of Commissioners; and state Treasurer Richard Moore.

The institute hopes to go far beyond just preparing a report and then discussing it at a February forum. The institute plans a five-year effort to sell tax reform to civic and business groups through regional forums, business roundtables and other events.

"We hope to begin to get the issue in comprehensive ways into legislative and gubernatorial campaigns in 2006, 2008 and 2012," said Luke Bierman, the institute's director. "We do anticipate this as a long-term project. We don't think this is something everyone will magically agree on and [say] 'Let's go run and do it.' "

4. WHAT'S ON THE TABLE?The reform initiative is not about raising taxes, said Medlin, the retired Wachovia CEO. Rather, it is about finding ways to collect taxes that are now being missed.

The Emerging Issues Institute is likely to look at a broad range of changes, such as moving to a consumption tax, which would collect taxes on services as well as goods -- on the guy who cuts the lawn as well as on the purchase price of the lawn mower.

The reform effort is likely to look at ending exemptions in the sales tax, at setting a flat income tax rate, at shifting the costs of Medicaid from local governments to the state, at reducing the corporate income tax and at dozens of other ideas.

5. WHAT ARE THE STAKES?

The debate over North Carolina's tax structure goes well beyond the changes in the Tar Heel economy. The discussions also involve such issues as fairness, competitiveness and simplification.

But changing the tax code is politically treacherous.

"Every single item in the tax code is in there because someone wants it in there," said Michael Walden, an economist at N.C. State University who is working on the tax reform project. "If you take it out, you are going to face opposition from some individual. You have to convince people who lose something by reform that in the long run they are going to be better off because it will put the state on a better financial footing and help grow the economic pie."

Gov. Mike Easley took a stab at the issue in 2002 when he appointed a group -- the Governor's Commission to Modernize State Finances -- to study reform. But the legislature was too busy trying to find the money for the immediate shortfall to worry about long-range solutions.

That is why tax reformers say that the impetus must come from outside government and that business and civic leaders must show the way. The Emerging Issues Institute hopes to provide that approach.

6. CHANCES FOR SUCCESS?

One of the keys to tax reform is winning the support of the state's business community, said Medlin, the former Wachovia CEO. That is one reason he hopes the institute will recommend a cut in corporate income taxes and a reduction in the top bracket for income taxes. Both taxes, he argues, are hurting North Carolina's ability to attract industry.

Medlin said businesses should want tax reform.

"I think it's in the overall interests of the state, businesses and individuals to have a proper revenue system that suits modern times and deals with the legitimate needs for state spending," he said. "The present structure retards the growth of businesses, small businesses in particular."

Other states have attempted tax finance reform with mixed success. A private South Carolina think tank finished a study of that state's tax system in November and is recommending the creation of a legislative study commission. Other states such as Michigan, Virginia and Tennessee have studied specific taxes. But few have attempted what North Carolina is trying.

"If it's successful, it would be one of the first really broad attempts to modernize a state tax system certainly for quite a while," said Nicholas Jenny, a senior policy analyst with the Rockefeller Institute, the public policy research arm of the State University of New York.

But Ross, the Reynolds Foundation director, said the project is worth the effort.

"Modernizing the way we collect revenue in North Carolina is the most significant challenge facing government today," Ross said. "Perhaps it is even one of the most challenging in the last half century. There is a confluence of factors happening that demand that we address this issue. Failure to do so would cause the state to be in great peril."

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