North Carolina Sen. Bill Rabon, R-Onslow, said a proposed cap on income taxes that support the state budget is part of the GOP majority's tax reform plan.

BRADENTON, Fla. – Enshrining a lower income tax cap in North Carolina's state constitution may tarnish the state's gilt-edged credit ratings, opponents argue, as the state prepares to launch a $2 billion bond program.

A bill in the North Carolina General Assembly that would ask voters to lower the income tax rate to 5.5% from 10%, a move Republicans say is designed to curtail government spending.

House Bill 3 is advancing quickly as lawmakers race toward completing work on the fiscal 2017 budget and remaining bills. Their goal, some leaders say, is to adjourn before July 4, or shortly after the holiday.

HB 3 includes a section entitled "Taxpayers Protections" that would ask voters on the Nov. 8 ballot to amend the state's constitution and lower the income tax rate.

It would also mandate annual contributions to the state's rainy day fund and bar the governor from tapping the money in an emergency.

"It's part of our plan for tax reform," said Sen. Bill Rabon, R-Onslow, who sponsored the legislation. "It's the smart thing to do. It shows North Carolina is trying to work in the 21st century."

If voters agree to lower the tax cap, Republican lawmakers say they plan to continue budgeting reforms that include heavier reliance on the state sales tax, which they have broadened to include more items.

Opponents of the amendment – primarily Democrats and the state treasurer - said the changes could undercut key elements supporting the state's triple-A ratings from all three major rating agencies, which allow the state to enjoy low borrowing costs.

North Carolina is preparing to issue the first $200 million of $2 billion in voter-approved general obligation bonds next month for the Connect NC bond program.

"This bill has a real potential to put our triple-A ratings at risk," said Sen. Jay Chaudhuri, D-Wake, adding that the tax cap could "hamstring" the state's ability to increase revenues.

"How can we possibly lift ourselves up from an economic recession with one hand tied behind our back," he asked Monday, before the Senate passed an amended HB 3 on second reading.

On Tuesday, the Senate gave final approval to the bill on a vote of 31-18, sending it to the House for concurrence. From there, it would be placed on the November ballot.

North Carolina's budget is primarily backed by income and sales tax collections.

A majority of state budgets rely on a combination of income and sales tax revenues, according to Nick Samuels, vice president and senior public finance credit officer with Moody's Investors Service.

For most states, income taxes represent about 40% of revenues and sale taxes represent 30%, Samuels said in an interview.

Some states, like Florida, don't have an income tax. Other states, such as Oregon, don't have a sales tax.

Whatever the source, state budgets are sensitive to volatility in revenue, depending on how spending plans are structured, said Samuels. He declined to comment directly on North Carolina's bill because it hasn't passed.

Sales taxes can be more sensitive to immediate economic trends, while high income states can be affected by changes in the stock market, which can have an impact on income tax filings, he said.

Some states have maintained the ability to budget even with difficult-to-change revenue restrictions in their constitutions.

"Generally speaking having more governance flexibility to be able to raise revenue or cut expenses is positive for a state's credit," Samuels said.

Colorado, Oregon, Missouri and Oklahoma have constraints on their ability to raise revenue or must take action if certain metrics are exceeded, but that doesn't necessarily affect their ratings, Samuels said.

Colorado's Taxpayer Bill of Rights, for example, is a constitutional measure approved by voters in 1992 that limited the annual growth in state revenues or spending to the rate of inflation and the percentage of change in the state's population. It also requires the state to rebate revenues to taxpayers in certain circumstances.

In 2005, Colorado voters in a statewide referendum approved a suspension of TABOR for five years after a sharp decline in funding for K-12 schools, colleges, and health programs partly because of the recession in the early 2000s.

Moody's assigns Colorado an Aa1 issuer rating.

"These kinds of provisions create some limitation and contingencies on what happens in terms of rebating revenue but don't inhibit the state [from] otherwise maintaining a very strong credit profile," Samuels said. "Even in states that have these provisions, the states have a lot of other governance strengths that allow them to make adjustments."

Illinois has a flat income tax rate mandated by the state's constitution that can be difficult to change, he pointed out.

Moody's rates Illinois's senior debt Baa2 with a negative outlook as the state nears its second fiscal year without an adopted budget due to a political stalemate over spending issues between parties.

In North Carolina, Moody's rates the state's general obligation bonds Aaa because of its strong fiscal management and economic growth, which benefits tax collections, the agency said in a report in February.

In fiscal 2015, general fund revenues grew by 6.4% over the prior year.

The largest source of state revenue, the individual income tax, came in 7.8% higher than 2014 collections, exceeding the state's 6% forecast, the report said.

Samuels said state ratings tend to be high because budget leaders have flexible governing strength.

North Carolina's proposed constitutional amendment seeking to lower the state's income tax rate doesn't offer the state an avenue for adjustment, other than returning to voters if changes are necessary.

The amendment would require lawmakers to annually place 2% of general fund revenues into the rainy day fund until the balance equals 12.5% of the budget. Today, the deposit amount is discretionary.

If passed, the fund could only be accessed by lawmakers on a vote of two-thirds in each chamber, which would potentially require a special session if an economic downturn or natural disaster occurs.

"The emergency reserve saving fund may not be spent by the governor even in a declared emergency," Sen. Brent Jackson, R-Sampson, said during Senate discussion on the amendment Monday.

In 2009, the last time the state's rainy day fund was tapped, then North Carolina Gov. Beverly Perdue, a Democrat, used emergency reserves saying it was a "precautionary measure to further manage the state's cash flow and budgetary requirements."

Today, the rainy day fund balance is $1.1 billion. It is expected to grow by as much as $600 million after the legislature acts on the fiscal 2017 budget, which is anticipated this week.

The GOP-move to tighten spending comes as North Carolina prepares to issue the first $200 million of the $2 billion in general obligation bonds voters approved in March for statewide infrastructure improvements.

The bonds are expected to be issued competitively in late July by the office of State Treasurer Janet Cowell, who told legislators that a tax cap would be viewed negatively by rating agencies.

"While the department cannot say that adopting this legislation would definitely result in a credit downgrade, the state would clearly be losing one of its strongest rating factors," Cowell said in a memo opposing the legislation. "A credit downgrade would force North Carolina to make higher interest payments and pushes up the cost of new bond-financed projects."

Cowell also warned that a tax cap would result in greater dependence on sales and other consumption taxes that are "notoriously prone to fluctuation as a result of economic cycles, and would result in a serious depletion of state revenue" in an economic downturn or when natural disasters occur.

In the Senate discussion on HB3 Monday, bill supporters called the credit rating concerns "rhetoric" and said that Democrats wouldn't like having a tax cap because it restrains spending.

Sen. Floyd McKissick Jr., D-Durham, speaking against the amendment, warned that lawmakers should do what is wise, and "not messaging to get voters out there on election day."

All 50 seats in the Senate and all 120 seats in the House are up for election in November, although some were decided in the primary. The GOP now holds majorities in both chambers.

Gov. Pat McCrory, a Republican who took office in 2012, is also up for reelection. He faces current Attorney General Roy Cooper, a Democrat, and Libertarian candidate Lon Cecil in November.

McCrory, who has no say about whether the proposed constitutional amendment appears on the ballot, has not commented publicly about the restriction that would prevent him or a successor from accessing reserves during an emergency.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.