South Carolina: A Road Map For Tax Reform

Introduction

Two decades before he published his famous treatises on government, John Locke’s Fundamental Constitutions of Carolina were adopted as the governing document of provincial Carolina. Voltaire praised the document, encouraging his readers to “behold Carolina, of which the wise Locke was the legislator,” but the early constitution bore few marks of the philosophy for which the Enlightenment giant would later become known.

A feudal document, it upheld the prerogatives of the proprietors. Indeed, it granted them extremely broad powers; unlike the constitutions with which we are now most familiar, it did not operate as any significant check on political power. Whereas the U.S. Constitution, more than a century later, would establish a government of enumerated powers based in no small part on Lockean principles, the constitution Locke wrote had such a strong assumption of governmental authority that it never even mentions the power to taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. . It simply wasn’t necessary to spell that out.

Not until South Carolina’s postbellum Constitution of 1865 did the state’s governing charter first impose any limitation on the taxing power, and not until the twentieth century did anything approaching South Carolina’s modern system of taxation come into view. And it was partly due to the boll weevil.

The destruction wrought by the boll weevil reverberated throughout the state, with farmers’ livelihoods destroyed and state revenues–already buffeted by an economic downturn after the conclusion of the First World War–plummeting. In response, lawmakers adopted an individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. , an inheritance taxAn inheritance tax is levied upon an individual’s estate at death or upon the assets transferred from the decedent’s estate to their heirs. Unlike estate taxes, inheritance tax exemptions apply to the size of the gift rather than the size of the estate. , and a motor fuel tax, the first time the state created taxes on anything other than property and the privilege of doing business. Today, that income tax features the highest top marginal rate in the Southeast, and the highest effective rates in the region for many wage earners.

The sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. would arrive in the 1950s, followed eventually by a proliferation of local option sales taxes—for property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. relief, for capital projects, for school district funding and education capital improvements, for transportation, and tourism development. The entire property tax system would be remade multiple times, most recently with the controversial implementation of Act 388. A robust, and often byzantine, system of fees in lieu of taxes has emerged to offset an otherwise deeply uncompetitive property tax system for many businesses. Meanwhile, local governments choose among a bevy of tourism- and accommodation-related taxes, each with their own strictures.

The problems with South Carolina’s tax code are not, ultimately, questions of revenue. South Carolina is by no means a high tax state in the main, though it can feel that way for certain taxpayers. The problems, rather, come down to questions of tax structure. This book is intended to help policymakers identify ways to make the state’s tax code more competitive.

In the following pages, we examine South Carolina’s economy, outline the existing tax structure, and offer recommendations for reforming the tax code. We seek to identify what the state does well and to point out opportunities for improvement. Underlying our analysis is the goal of enhancing South Carolina’s competitive standing and a commitment to the principles of sound tax policy—that, to the greatest extent possible, taxes should be simple, transparent, neutral, and stable, and that the best tax structures are those with broad bases and low rates.

In the course of our research, we pored over South Carolina’s tax code, dusted off old tax studies, reviewed the economic literature, and examined successful reforms implemented by other states. First and foremost, however, we talked to South Carolinians: state and local government officials, business leaders, and everyday taxpayers alike. The insights and perspectives of those who actually interact with South Carolina’s tax system inform every page of this book.

The South Carolina Chamber of Commerce commissioned the Tax Foundation to prepare a review of the South Carolina tax system and recommend possible solutions, and this book is the result. While they supported our study, they did not direct our study or any of our recommendations. We offer our thanks to the many South Carolinians of all walks of life who met with us as we worked on this book. It is our hope that this book will help reform a robust and much-needed debate about the future of the state’s tax code.

A Menu of Tax Reform Solutions

Corporate Taxes

South Carolina’s corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. is imposed at a low rate, with a base heavily carved out by incentives. Many firms face little or no liability under the corporate income tax, but for others, the tax’s treatment of capital investment, combined with an antiquated capital stock tax in the form of the corporate license fee, can be an impediment to growth. Our recommendations would create a more neutral corporate tax environment which avoids penalizing capital expansion.

Improving Treatment of Capital Investment. While a number of states follow the federal government in allowing the full and immediate expensing of machinery and equipment purchases, South Carolina instead relies on an inefficient and eligibility-limited tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. for qualified investment. A more neutral tax code would allow all corporations to fully deduct the cost of their machinery and equipment purchases in the first year.

Conforming to Federal Treatment of Net Operating Losses. Federal law now provides for unlimited net operating loss carryforwardA Net Operating Loss (NOL) Carryforward allows businesses suffering losses in one year to deduct them from future years’ profits. Businesses thus are taxed on average profitability, making the tax code more neutral. In the U.S., a net operating loss can be carried forward indefinitely but are limited to 80 percent of taxable income. s, capped at 80 percent of tax liability in any given year. Policymakers might consider conforming to federal treatment for simplicity’s sake.

Shifting to Market Sourcing of Service Income. South Carolina has followed the recent trend of adopting single sales factor, which is popular in part because it exports a significant portion of tax liability to out-of-state firms. Oddly, however, the state continues to source service income based on the location of income-producing activity—which is, essentially, an emphasis on payroll and property for services, but sales for manufacturing and production. These policies are at cross-purposes. The state should consider aligning its policies.

Reviewing Business Tax Incentives. A growing number of states have established panels, commissions, or ad hoc committees to review tax incentives periodically. Given South Carolina’s heavy reliance on tax credits, periodic evaluation to assess return on investment is advisable.

Repealing the Antiquated Corporate License Fee. South Carolina’s corporate license fee generates little revenue but is harmful for highly capitalized businesses and is imposed without regard to ability to pay. Policymakers should consider phasing out the tax.

Individual Income Tax

South Carolina’s individual income tax features a high top marginal rate and produces high effective rates for many middle-class taxpayers and small businesses which are structured as pass-through entities and are subject to the individual income tax. Our recommendations are focused on creating a more regionally competitive individual income tax.

Lowering and Flattening Rates and Brackets. For a single filer at every level of taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. above $70,500, South Carolina features either the highest or second-highest income tax burden in the Southeastern United States. Policymakers should consider consolidating rates and brackets, and perhaps even adopting a single-rate income tax with a more generous standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. . We offer several options, with flat rates ranging from 4.65 to 5.7 percent (based on the inclusion or exclusion of other policies), along with an across-the-board rate reduction within the current graduated rate structure.

Addressing Anomalies within the Graduated Rate Structure. If policymakers retain a graduated rate structure, they should consider fully eliminating the marriage penaltyA marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples. –ameliorated but not eliminated by a credit–which increases tax liability for joint filers and adopting full (not partial) inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. indexing to avoid “bracket creepBracket creep occurs when inflation pushes taxpayers into higher income tax brackets or reduces the value of credits, deductions, and exemptions. Bracket creep results in an increase in income taxes without an increase in real income. Many tax provisions—both at the federal and state level—are adjusted for inflation. ,” where a greater share of taxpayers’ income is subject to higher rates over time.

Capping the Earned Income Tax Credit (EITC). The earned income tax credit can be a valuable tool for providing low-income family assistance structured in a way that rewards and facilitates work, particularly if lawmakers opt to adopt a single-rate income tax. However, if the EITC is permitted to expand to 125 percent of the federal amount–an amount intended to offset far higher federal tax liability–the median household in South Carolina will be just on the cusp of having any income tax liability in South Carolina. The new EITC may be a positive development, but it should not be allowed to phase all the way up to an unprecedented 125 percent of the federal EITC.

Rolling Back Tax Incentives. Some of South Carolina’s tax incentives are barely claimed at all, and others fall far short of their objectives, but they create administrative costs by their mere existence. While individual income tax credits only carve out the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. slightly, a cleanup of the existing credit structure is appropriate.

State and Local Sales Taxes

The state’s sales tax is imposed on an extremely narrow base that exempts many goods and most services, a holdover from an earlier era. Our proposals would modernize the sales tax, bringing it in line with today’s economy.

Broadening the Sales Tax Base. A well-structured sales tax applies to all final consumer purchases, both goods and services, while exempting business inputs. South Carolina’s sales tax falls far short of this goal, and in an increasingly service-oriented economy, it erodes further each year. We offer a menu of base-broadening options to enhance the stability of the sales tax and generate additional revenue that could be used to reduce the sales tax rate or pay down reforms elsewhere.

Eliminating Impediments to Online Sales Tax Collections. Although South Carolina is moving forward with remote sales tax collections, the state is not fully in accord with the provisions commended by the Supreme Court in the Wayfair v. South Dakota case. The state should take the steps necessary to pass the “Wayfair Test,” such as adopting uniform definitions and providing lookup software, which will reduce compliance costs for sellers (and thus likely increase compliance) while providing the state greater protection against a legal challenge.

Excluding Business Inputs. South Carolina policymakers have long recognized the importance of excluding business inputs from the sales tax base to avoid tax pyramidingTax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action. , but efforts to expand the scope of these important exemptions have been piecemeal, targeted at specific industries, and sometimes only made available to particularly large purchasers. We recommend eliminating eligibility requirements for exemptions and working to improve the overall treatment of business inputs in the sales tax code.

Property and Related Taxes

Act 388 remade the property tax landscape in South Carolina—and not in an entirely positive way. The exceedingly light taxation of some classes of property has resulted in heavy, uncompetitive burdens on others. Some businesses get the benefit of specially negotiated deals, while others face one of the nation’s highest tax burdens on industrial and manufacturing property. Our solutions involve reducing distortions in the property tax, creating a more competitive system and putting local–and particularly school–finance on a firmer footing.

Addressing the School Operating Costs Differential. The exclusion of the millage associated with school operating costs from taxes on primary residences yields extremely attractive effective rates for those properties, but at a cost in overall state competitiveness and, ultimately, in the ability to ensure appropriate levels of school funding. We propose options for rebalancing some of the inequities between different classes of property.

Narrowing Disparities in Assessment Ratios. South Carolina’s current property classification schedule imposes widely disparate assessment ratios on different classes of property, then exempts select property owners from feeling the brunt of those disparities. All residences should face the same assessment ratio, and, at the very least, the manufacturing and business personal property ratios require a downward adjustment.

Reforming Property Tax Limitations. Assessment limitations create serious inequities, tie the hands of local governments, and influence decisions about whether to improve or sell a property. We offer a range of options for relaxing or even repealing the assessment limitation while maintaining the protections of a rate limitation.

Reducing Reliance on Personal Property Taxes. South Carolina imposes tangible personal property taxes on business machinery, equipment, and other movable property. These taxes are nonneutral and impose high compliance costs. We list options for reducing reliance on, or even eliminating, the taxation of tangible personal property.

Business License and Accommodations Taxes

South Carolina’s local business license taxes are unusually onerous, imposing significant compliance costs on many businesses. A tangle of accommodations taxes adds to the complexity of local tax regimes. Our recommendations seek to bring about simplification and a reduction in compliance costs.

Simplifying Business License Tax Compliance. Many businesses are required to remit business license taxes to multiple–sometimes many–jurisdictions, which can be an arduous process. We offer suggestions for streamlining the process, including moving to uniform tax cycles and classification schedules, but also suggest housing collection authority in the Secretary of State’s office, creating a single point of collections but with the state agency operating only as a payment processor for local governments without ever depositing the moneys in a state account.

Granting Greater Local Authority over Accommodations and Hospitality Taxes. Local governments already stretch the bounds of what accommodations and hospitality taxes are permitted to fund. The existing constraints sometimes force governments to levy more or higher taxes than they would otherwise, since some available revenue is tied up and can only be put to lower-priority expenditures.

Comprehensive Reform

Most of our proposals can stand on their own, providing policymakers with discrete ways of improving the competitiveness of each element of the state’s tax code. Often, however, successful tax reform is more comprehensive in nature, which is not only good policy but often good politics, including additional stakeholders and facilitating a broader rebalancing of the code.

In some cases, moreover, it may be strictly necessary: reduced reliance on a counterproductive tax may require offsets elsewhere in the system. Therefore, while we intend this book to facilitate conversations about priorities within each tax type, it is also important to illustrate the ways that they can complement each other. A broader sales tax base, for instance, would raise additional revenue at both the state and local levels, which could be used to pay down reforms to other taxes.

Below, we offer four packages of comprehensive reforms, ranging from a highly aggressive overhaul of the state’s tax code to modest competitive improvements, with ideas drawn from the pages that follow. These are only four of many possible permutations, but they illustrate how a comprehensive plan could come together. We offer projections for how each plan would improve the state’s ranking on our State Business Tax Climate Index. State-level provisions are designed to be roughly revenue neutral unless otherwise noted, and the referenced sales tax base-broadening options are outlined in Chapter 5.

Option A

This approach is highly aggressive and would require significant political will. It contemplates outright repeal of the corporate income tax and its outmoded counterpart, the corporate license fee. It also simplifies and cuts the individual income tax. These reforms would be paid for by substantial sales tax base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. , though, notably, without adding grocery purchases back into the sales tax base. (Should legislators wish to consider the taxation of groceries, at a full or partial rate, this would provide greater flexibility in considering the inclusion of other base broadeners.) This plan would also see the gradual reintroduction of the school operating cost millage onto owner-occupied real property, to help offset the cost of other property tax reforms designed to make the overall system more competitive. Option A includes:

• Full repeal of the corporate income tax and the antiquated corporate license fee;
• Adopting a 4.75 percent single rate individual income tax with a $12,000 standard deduction (for single filers) and the retention of the personal exemption;
• Freezing the earned income tax credit at 2018 levels, while repealing other individual income tax credits and deductions;
• Meaningfully expanding the sales tax base as outlined in Sales Tax Base-Broadening Option C (see Chapter 5) to offset the above reductions and repeals;
• Implementing the reforms necessary to ensure that the state’s remote sales tax collections are legally compliant;
• Gradually phasing the school operating costs millage back onto owner-occupied residential property;
• Phasing the assessment ratio for nonowner-occupied real property down to 4 percent, in line with primary residences;
• Extending the current phasedown of the manufacturing and industrial property assessment ratio to 8 percent;
• Exempting property newly placed in service from tangible personal property taxation, reducing reliance on the tax over time; and
• Creating a single point of collections and administration for the business license tax.

Option B

This option also contemplates sweeping reform, though it keeps the corporate income tax in place. Its rate would be reduced to 4 percent, while the individual income tax would be set at a flat rate of 5 percent. Other provisions are similar to those in Option A, except that sales tax base broadening is not as aggressive and local property tax reform is somewhat attenuated. Option B includes:

• Lowering the corporate income tax rate to 4 percent;
• Conforming to the federal policy of full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. of machinery and equipment purchases;
• Repealing the antiquated corporate license fee;
• Adopting a 5 percent single rate individual income tax with a $12,000 standard deduction and the retention of the personal exemption;
• Freezing the earned income tax credit at 2018 levels, while repealing other individual income tax credits and deductions;
• Introducing modest sales tax base broadening (Sales Tax Option A) to raise enough revenue to help pay for the individual and corporate income tax cuts, full expensing, and corporate license fee repeal;
• Implementing the reforms necessary to ensure that the state’s remote sales tax collections are legally compliant;
• Extending the current phasedown of the manufacturing and industrial property assessment ratio to 8 percent;
• Exempting property newly placed in service from tangible personal property taxation, reducing reliance on the tax over time; and
• Creating a single point of collections and administration for the business license tax.

Option C

This approach focuses on a more competitive individual income tax and the reform of the least attractive elements of business taxation. It pairs an attractive 5.2 percent flat individual income tax with modest sales tax base broadening and a smattering of other reforms. Option C includes:

• Conforming to the federal policy of full expensing of machinery and equipment purchases;
• Repealing the antiquated corporate license fee;
• Adopting a 5.2 percent single rate individual income tax with a $12,000 standard deduction and the retention of the personal exemption;
• Freezing the earned income tax credit at 2018 levels, while repealing other individual income tax credits and deductions;
• Taxing recreational services and admissions (or a smattering of smaller personal services and consumption goods) to raise enough revenue to help pay for the individual income tax cuts and business tax reforms;
• Implementing the reforms necessary to ensure that the state’s remote sales tax collections are legally compliant;
• Extending the current phasedown of the manufacturing and industrial property assessment ratio to 8 percent;
• Exempting property newly placed in service from tangible personal property taxation, reducing reliance on the tax over time; and
• Creating a single point of collections and administration for the business license tax.

Option D

This approach is more modest. It makes very limited changes to the sales tax base and phases in an across-the-board individual income tax rate reduction over time. That rate reduction is not offset but is instead intended to be phased in subject to revenue availability. Option D includes:

• Conforming to the federal policy of full expensing of machinery and equipment purchases;
• Repealing the antiquated corporate license fee;
• Phasing in a 1 percentage point across-the-board individual income tax rate cut over time, subject to revenue availability;
• Lifting the 4 percent cap on inflation indexingInflation indexing refers to automatic cost-of-living adjustments built into tax provisions to keep pace with inflation. Absent these adjustments, income taxes are subject to “bracket creep” and stealth increases on taxpayers, while excise taxes are vulnerable to erosion as taxes expressed in marginal dollars, rather than rates, slowly lose value. ;
• Replacing the joint filers credit with a doubling of bracket width for joint filers which fully eliminates the marriage penalty;
• Adding personal care services, household maintenance, and newspapers to the sales tax base;
• Implementing the reforms necessary to ensure that the state’s remote sales tax collections are legally compliant;
• Exempting property newly placed in service from tangible personal property taxation, reducing reliance on the tax over time; and
• Creating a single point of collections and administration for the business license tax.

The above options would result in the following changes to South Carolina’s rankings in our State Business Tax Climate Index, compared to the current system.

	Overall	Corporate	Individual	Sales	U.I. Tax	Property
Current System	35th	19th	34th	34th	27th	27th
Option A	5th	1st	10th	32nd	27th	12th
Option B	13th	10th	11th	32nd	27th	12th
Option C	14th	16th	11th	33rd	27th	12th
Option D	21st	16th	21st	34th	27th	12th

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