North Carolina's tax cut path leads to projected deficits

Bloomberg News

North Carolina faces a more than 10% annual budget deficit in about three years but analysts differ on the significance of the threat.

"North Carolina's financial stability is increasingly at risk as years of tax cuts continue to erode state revenues," the Washington, D.C. based Center on Budget and Policy Priorities said. "With additional tax cuts scheduled and potential federal funding reductions looming, the state faces growing uncertainty about how to sustain essential services such as education, health care and infrastructure," said the CBPP, a nonpartisan think tank that works toward improving access to healthcare and reducing poverty.

"At the same time, lawmakers must find funding for ongoing recovery efforts from recent storms that devastated communities and have further strained the state budget," CBPP said.

North Carolina state government works on a biennium budget and it is currently working on creating a budget for July 1 through June 2027.

Following the state's standard practice, the state budget director worked with the legislature's Fiscal Research Division to create a projection for revenues and for expenditures adjusted by population and inflation through fiscal 2034. The projection released in February indicated the state government faces deficits in as soon as 15 months, when fiscal 2027 starts.

In response to these projections, Democratic Gov. Josh Stein and the Republican-led House and Senate are arguing about what should be done with planned cuts to individual and corporate income taxes. The state passed tax revenue triggers for tax rate cuts in 2023 that have planned triggers in fiscal 2027 and fiscal 2033.

Stein, State Budget Director Kristin Walker and the Fiscal Research Division say that if the cuts go ahead, budget deficits will start in fiscal 2027, widen in the following two fiscal years and remain for the foreseeable future.

Stein proposed a budget that freezes the rate cuts "so that the state can keep up with its rapid population growth and avoid a fiscal cliff," according to his official budget announcement.

State Senate President Pro Tempore Phil Berger told public radio WUNC in March the projections of deficits with the tax cuts were, "Same arguments as we've heard in the past." He said he was confident there would be adequate revenue and if not, "that's why we have a rainy-day fund."

Walker said it would be a bad idea to draw on the rainy-day fund.

Berger didn't respond to a Bond Buyer request for a comment.

In mid-March, Walker said the state's fiscal challenges included an anticipated 2.4% revenue decline in fiscal 2027 from fiscal 2026, Hurricane Helene recovery needs, and uncertainty about federal funding.

"It seems that those like the Senate leader are counting on federal actions to relieve the state of several fiscal obligations — Medicaid, school spending on non-academic programs, less federal dollars lead to not matching fund effort required, just to name a few," said Joseph Krist, publisher of Muni Credit News. He said if congressional Republicans succeed in changing the Affordable Care Act's provisions on Medicaid, and the federal government contributes less to the program, states would scale back their own Medicaid contributions starting in October.

Krist referred to Trump's statements that he might dismantle the Federal Emergency Management Agency.

"Add in the fact that North Carolina is a multi-disaster place — hurricanes and floods and wildfires — so how big would a state FEMA have to be?" Krist said. "And that is all before the tariff announcements and subsequent wealth destructions in the equity market."

Krist said Walker in March released a budget presentation that "is telling in that it lists four areas of greatest risk — all of which are both out of their hands and currently under pressure. The budget expects lower [interest] rates and a good economy, progress on inflation and a strong consumer. The one thing it can control — state tax policy — looks like it won't be lowering risk to the state's revenue stream."

North Carolina Budget & Tax Center Public Policy Analyst Sally Hodges-Copple said the projections from Walker and the Fiscal Research Division were accurate but "not surprising. Legislative leaders have spent the last decade aggressively reducing the corporate and personal income tax rates without consideration for their long-term ability to sustain services, let alone their ability to increase state funding for priorities with popular support from their constituents."

The center advocates for policies that remove barriers to opportunity and well-being for those who have been previously blocked through racism or other systemic barriers.

The projections were released in February and the "underlying economic assumptions were that recent economic growth would be sustained over the biennium," Hodges-Copple said. "Since that time, federal policy (particularly recent announced tariffs) has increased the likelihood of recession, which would worsen the state's budget outlook."

Hodges-Copple said there will be a revised revenue forecast in May.

Potential federal cuts to Medicaid and federal food assistance would shift costs to North Carolina and make the state's future deficits "more severe," Hodges-Copple said.

"North Carolina's personal income tax rate has been slashed repeatedly over the past decade, dropping from a graduated top rate of 7.75% in 2013 to a flat rate of 4.25% today — with further cuts scheduled to bring it down to 3.99% by 2026 and as low as 2.49% by 2029, if the state hits certain revenue benchmarks," the CBPP said. "The corporate income tax, meanwhile, is scheduled to phase out completely by 2030."

Recent tax cuts are projected to cost at least $8 billion annually by 2031 and potentially more than $13 billion if the automatic tax cuts are followed, according to the North Carolina Budget & Tax Center.

North Carolina is rated triple-A by Moody's Ratings, S&P Global Ratings and Fitch Ratings.

In June of last year Moody's said, "One challenge for the state going forward is a series of enacted income tax rate cuts, which all else equal could reduce revenue from current levels by 20% or more [by fiscal 2031]. As the state has been running large operating surpluses, holds a massive amount of unrestricted reserves, and continues to grow robustly, these tax cuts are unlikely to present significant fiscal pressure over the next five years or so. Beyond that, the enacted tax cuts could test the state's very strong credit profile."

On Monday S&P released a report that noted current North Carolina tax laws, due to anticipated cuts in individual and corporate income taxes, would cut revenues by more $3.5 billion per year by fiscal 2028.

S&P said the governor's proposed budget for July 1 to June 30 of 2027 maintains tax rates. The legislature, when it proposes its version of the budgets, may establish "new taxes and savings from implementing cost-efficiency measures… in place of maintaining current tax rates to support spending."

Legislators should repeal the tax triggers, Hodges-Copple said.

"The state's forecast makes clear that the revenue thresholds that trigger deeper tax cuts are completely disconnected from any reasonable estimate of what it costs to fund the state's needs," she said.

If the legislature provides Stein a budget he dislikes, he can veto it.

Republicans have substantial majorities in the state legislature; they can override any veto if one House Democrat votes with the Republicans and all Republicans voted to override.

The fiscal 2024 general fund budget was $29.2 billion and the all-government spending budget was $69.6 billion.

Walker told WUNC that while the state's projected deficit of more than 10% in three years would be smaller than what the state faced in 2008 during the financial crisis, the state benefited then from federal aid addressing the shortfall. No such aid is expected this time and, in fact, federal aid for expensive things like Medicaid may decrease.