News & Observer: In NC Budget,
Where Did the $1 Billion Go?

By Dan Kane
First of Three Parts

During the past four years, as Democrats and Republicans battled over sales and income taxes, higher tuition at state universities and the loss of 4,350 teachers in public schools, a substantial amount of money slipped through the fingers of state leaders.

It didn’t disappear in one big sweep. The money stayed out of the state treasury, with little debate or notice, through scores of breaks in the state’s tax code. Some of the cash vanished in a string of new breaks granted by legislators, while still more evaporated because of loopholes approved years ago that continued to grow.

The cost this year, according to an estimate by the state Department of Revenue: $1 billion.

That would be enough to cover Gov. Pat McCrory’s proposed spending for the state’s 58 community colleges, or to give teachers a 12 percent pay raise. Or legislators could cut both the personal and corporate income tax rates by half a percentage point.

These breaks were written by Democrats and Republicans. Some were written to help a single business. Others have grown dramatically in ways some of their backers hadn’t envisioned.

These loopholes are sometimes obscure, poorly tracked, and often left out of the budget debate, taking away options to pay for North Carolina’s growing school enrollments and health care needs.

Add the tax breaks from the past four years to those already on the books, and the totals are substantial: 318 tax breaks worth $9.2 billion a year, equal to nearly half of the $20.2 billion the state will spend this fiscal year.

Some of the breaks help everybody and draw little criticism, such as $2.3 billion for the standard deduction from the state income tax. But others help smaller groups, such as the $336 million break written two years ago to help business owners, including doctors, lawyers and accountants.

And a few help just one company, such as a deal assembled in 2011 by a key senator for a major grocery chain and food distributor.

Experts say governments should create tax systems that are fair and follow basic principles while bringing in enough money to pay for public services. But North Carolina’s tax code, like those of nearly every state in the country and the federal government, is a quilt of often narrowly tailored laws that create winners and losers. And that opens the door to special treatment for those with the knowhow and resources to influence lawmakers.

“The more complicated the tax system is, the easier it is to slip in things that benefit particular groups,” said David Merriman, an economist at the University of Illinois at Chicago. “And the less principled the decisions that are made, the more a legislator can do something that favors a particular group that he has an allegiance with, or even some group where he’s getting campaign financing from.”

This year, lawmakers continue to seek more tax breaks for smaller groups. One bill would extend a sales tax exemption on airplane parts to more carriers. Another would allow federal and state retirees to shield more of their income.

Jeanette Doran, executive director of the N.C. Institute for Constitutional Law, a Raleigh group that advocates for limited government, said breaks where the government pays incentives to lure businesses are generally understood by taxpayers. But she said many of the tax breaks are not.

“People seem to get the idea that when we are writing a check, we are spending their money on a company,” she said. “But a lot of them don’t understand that when we give a tax break, it still costs the taxpayers money because it diminishes the amount of money the government has to pay for necessary services like schools and police and prosecutors.”

The state’s annual revenue loss from tax breaks was a billion less in 2008, before 24 more breaks were added to the books and others grew in cost. The sales tax break on electricity sales to homes and businesses, for example, cost the state $75 million more in lost revenue, while the cost of an income tax break for Social Security recipients climbed more than $83 million.

Even before the legislative session and last year’s election, House Speaker Thom Tillis and Senate leader Phil Berger, Republicans who engineered the $336 million business tax break, have been saying the tax laws are in need of an overhaul. McCrory made it a big part of his election campaign.

Legislative leaders have been trying to craft legislation that would make significant changes in the state’s tax structure. One proposal from a Senate finance chairman would shift much of the tax bite to sales and eliminate the corporate and personal income taxes, while another eliminates some tax breaks and extends the sales tax to other services to reduce the corporate, personal and sales tax rates.

Tillis has said that the special tax treatment had “crept in for decades” and would have to be addressed in any tax-code rewrite. He said last week in a speech to small-business owners that interested parties always tell him that they are in favor of tax reform as long as it doesn’t touch their tax breaks.

“There is a good argument for every single one of them,” he said, but keeping them would “substantiate an argument that we should keep exactly the same tax system that we have today. And I don’t think anybody here believes that is the right way.”

A special deal
Two years ago, Berger cut the kind of deal that prompts people to talk about reform.

Berger, a Rockingham County Republican, quietly maneuvered through the legislature a $400,000 annual tax break for a business that had given the N.C. Republican Senate Committee a $15,000 donation a year earlier.

The political action committee of Alex Lee Inc., the Hickory-based company that owns the Lowes Foods supermarket chain, gave the donation in April 2010. Berger put it to use to help gain a Republican majority in the Senate in the election that fall.

At the time, the company was in danger of losing a tax break it had won earlier for creating jobs. After initially expanding, Alex Lee had started cutting jobs.

The next year, Berger steered a bill through the Senate that protected the tax break, giving a sponsor, state Sen. Linda Garrou, a Winston-Salem Democrat, a list of talking points. She had received $4,000 from the PAC the previous year.

But Berger couldn’t get the bill through the House.

And so, in the waning days of the 2011 session, Berger’s staff arranged for an amendment to an unrelated House bill that would allow Alex Lee to continue receiving the tax break.

The state senator who handled the amended bill, Thom Goolsby, a Wilmington Republican, said he did not realize the amendment had been included. The bill drew questions in the House but still passed and became law. It will save Alex Lee $2.1 million in corporate income taxes over five years.

Berger said in an interview that the tax break would boost the Hickory area because it required Alex Lee to invest at least $4 million in its facilities. Berger said the local senator, Austin Allran, sponsored the original legislation.

Berger said he did not push the legislation in exchange for campaign money.

“I would have walked out of the room if that had been brought up,” Berger said.

On Aug. 16, 2012, the Alex Lee PAC gave another $15,000 to the Senate campaign committee, election records show. The contributions are by far the two largest donations the PAC has made to state party campaign committees. The party committees can accept donations of any size.

Bob Hall, executive director of Democracy North Carolina, a nonpartisan campaign-finance watchdog, spotted the first $15,000 donation. He said the donation and subsequent legislation had the appearance of a conflict of interest, but the sequence of events couldn’t have happened if the state’s tax code didn’t allow for special treatment.

“You have a tax code that is riddled with special breaks and favors that really make no sense from the perspective of the public interest, but there’s a strong special interest that is putting up a lot of campaign money, and hiring lobbyists to push until they win,” he said. “Often you hear the argument that ‘We’re just trying to level the playing field.’ But if it was leveled so that nobody gets the break, then it would be a better policy for everybody.”

Numerous attempts to talk to Alex Lee officials and their lobbyist at the time, Chuck Neely, a former state lawmaker, were unsuccessful.

A haphazard system
There’s little consistency to the reasons or methods by which these tax breaks get on the books. Lawmakers sometimes drop them into larger bills, such as the state budget, that force their colleagues to adopt a questionable tax break in order to keep funds flowing to schools, courts and hospitals.

The reasons range from trying to recruit or retain businesses, matching a break given to someone else, or seeking to help an underprivileged group. Sometimes it’s the courts that dictate tax breaks, such as a case that prevented the state from taxing some retirees’ pensions. That one has soared to more than $400 million a year as more government employees retire.

According to the state’s most recent economic incentives report, there are five tax breaks that each help only one company. One of those companies is US Airways.

The airline is the sole carrier to receive a sales tax cap on fuel and exemptions on lubricants, repair parts and accessories purchased in North Carolina. The airline operates the only major hub in the state, which is in Charlotte; it saved $8.5 million in 2011, the report said.

Incentive reports show that tax break has generally trended upward from $2.7 million in 2006.

Chuck Allen, US Airways’ managing director of government and community relations, said the airline sought the break because, unlike taxes on gasoline that help build roads, the airline wasn’t seeing a benefit.

“It doesn’t build runways; it just goes into the general fund,” he said.

The tax break’s rising cost is a result of increasing fuel prices and airline traffic.

Allen said the company used the tax break savings to help increase its workforce from 6,100 to 8,400 employees in the past eight years and to add numerous international and domestic destinations.

Former state Sen. David Hoyle, a Gaston County Democrat, sponsored the break. He said it was necessary to compete with similar tax breaks in other states.

It’s not the only example of a fast-growing tax break. The exemption that charitable nonprofits receive on franchise taxes – a privilege tax based on the value of a business – now costs the state $115 million, or more than twice what it did four years ago.

The cost is unclear for 43 tax breaks. Some are in the form of exemptions to a tax, which are much harder to track. Recipients do not have to report how much they saved, as they would with a credit or a deduction. The number of such tax breaks is also on the rise; 34 were on the books three years ago. One such example is the sales tax exemption on food sold by churches and other religious organizations.

Once on the books, tax breaks are difficult to remove, even as they become outdated or rapidly grow in cost. A constituency rises for each one of them, lawmakers say, and it becomes a battle to reverse them.

Twenty-five years ago, RJR Nabisco won a tax break worth $12 million a year in exchange for building a $60 million cookie plant in Garner. The plant never got built, but other companies with major in-state operations now use the tax break at a cost of $51 million a year.

Another tax break intended to help LabCorp now provides Expression Analysis of Durham a sales tax break worth about $115,000 a year. The company is a Duke University Medical Center spinoff that performs genomic research services for businesses, universities and government agencies.

Work ends, breaks continue
Then there’s the case of tax breaks to two cigarette giants. In 2003, Democratic state lawmakers extended a tax break to Philip Morris and RJ Reynolds worth up to $6 million annually for using the state’s two ports in Wilmington and Morehead City to ship cigarettes out of the country.

They gave RJR an additional tax break worth up to $10 million annually for exporting cigarettes so long as its in-state employment levels grew by at least 800 jobs after a merger with a former rival.

Lawmakers offered the breaks to keep RJR in North Carolina at a time it was threatening to move to Kentucky as part of a merger with Brown & Williamson. Lawmakers were also worried about Philip Morris, a Richmond, Va., company, which then had a huge manufacturing plant in Cabarrus County.

But RJR had cut about 1,500 jobs in the Winston-Salem area before adding the 800 jobs from the merger, and shortly after winning the tax break, it cut tobacco purchases from North Carolina farmers. So much for job creation, critics said.

Philip Morris closed its plant in Cabarrus County in 2009, eliminating 2,500 jobs. The tax breaks, however, are still open.

Philip Morris has continued to collect the tax break for using the ports since then, and expects to collect it until it expires in five years. That’s because the tax credit allowed the cigarette makers to carry over credits for cigarettes they shipped above what was required for the $6 million tax break.

A Philip Morris spokesman, Ken Garcia, said last year that the company had already shipped enough cigarettes to earn credits until the tax break expires in 2018. It claimed $4.6 million in 2011.

The $6 million tax break does not require the cigarettes to be manufactured in North Carolina, just that they be shipped out of the state’s ports. Garcia said a “significant” amount of those cigarettes were made in North Carolina, but he would not say whether all of them were. Philip Morris also made cigarettes for export in Richmond until the company got out of the cigarette export business in 2008.

Winston-Salem-based RJR, meanwhile, has suffered layoffs that have whittled away the gains from the Brown & Williamson merger, but last year it claimed $6 million from the employment-related tax break, state records show.

“The legislature recognized the benefits of keeping these (cigarette manufacturing) jobs in North Carolina,” RJR spokeswoman Maura Payne said.

Jennifer Weiss, a former state representative from Cary who served as a chief tax writer, said the debate over tax reform has to dig into breaks such as those given to the cigarette makers. Weiss, a Democrat who did not run for re-election last year, said the governor and legislative leaders have spent more time talking about reducing corporate and personal income tax rates than looking at the unfairness that loopholes create.

“Maybe a fairer way to start would be to look at all the current tax breaks and bring them up to the current rate, and once you’ve done that, then look at how you can lower the overall rate,” she said. “But that’s not what I’m hearing.”