If the District of Columbia becomes a State: Fiscal Implications

Alice M. Rivlin
Alice Rivlin
Alice M. Rivlin Former Brookings Expert

July 13, 2009

Mr. Chairman and Members of the Committee:
The nation’s founders decided to carve a separate entity, the District of Columbia, out of Maryland and Virginia to serve as the capital of the new country. The decision doubtless seemed right at the time, but it has left the residents of modern DC with two serious problems: (1) they lack the democratic rights enjoyed by Americans who live in states: full self government and an equal voice in the national political process; (2) they lack sufficient financial resources to pay for high quality public services.

Statehood for the District of Columbia is frequently proposed as a solution to both these problems, but it faces formidable political obstacles at the national level. The purpose of today’s hearing is to explore the fiscal implications of DC statehood. Statehood would certainly give DC residents the democratic rights and responsibilities of other Americans, but would it also give them significantly enhanced public resources that could be devoted to improving public services or reducing tax rates or both? How significant would these enhancements be likely to be?

Fiscal disadvantages of the District’s current status
The District’s special status affects its ability to raise revenue and provide public services. First, although it is not a state, it must perform the functions of a state as well as those of a city government. Besides providing local services, such as schools, police and fire, it is responsible for motor vehicle services, Medicaid and mental health services, as well as higher education and other functions normally handled at the state level. Second, despite its state-like responsibilities, the District does not have full state taxing authority. Congress expressly prohibited the District from taxing the income earned within its borders by non-residents, a power that all states have. State income taxes apply to income earned in the state, by residents and non-residents alike. A few cities also have commuter taxes that apply to income earned by commuters in the city, but these are normally small. It is the lack of a state-level income tax on non-resident income that depresses the District’s revenue-raising capacity significantly. Third, the city’s largest employer, the federal government, uses city services, but does not pay property, sales or income taxes. The same is true of embassies and international institutions. Many tax-exempt non-profits also locate here to be near the federal government. Moreover, the federal government often fails to reimburse the District for the costs of dealing with major national events, such as inaugurations and demonstrations.

These limitations are exacerbated by the small size and demographics of the capital. The District is an extremely small central city (only 61.4 square miles) at the heart of a prosperous and growing metropolitan area. It is ringed by relatively affluent suburbs, many of whose residents work in the District, use its roads and parks and other services, but pay no income tax to the District. Indeed, two thirds of the income earned in DC is earned by non-residents, most of whom live in Maryland and Virginia. Moreover, the District, like many central cities, has a large low-income population with way-above-average needs for public services. The cost of providing services in the city is high as a result of elevated rents and property values, wages that reflect the need to compete with suburban jurisdictions and the federal government for employees, and expenses associated with security in distressed neighborhoods. Other central cities face similar problems, but often get substantial financial help from their state. The State of Maryland, for example, provides major assistance to Baltimore, especially for education.

The fiscal handicaps of the District have been described in several studies and reports, including one I co-authored seven years ago with Carol O’Cleireacain. (Carol O’Cleireacain and Alice M. Rivlin, “A Sound Fiscal Footing for the Nation’s Capital: A Federal Responsibility, The Brookings Institution, 2002). One of the most detailed studies was carried out by the agency now called the Government Accountability Office (GAO), which attempted to estimate the size of the District’s structural deficit (District of Columbia Structural Imbalance and Management Issues, 2003). By “structural deficit” the GAO meant the gap between the District’s actual resources and what it would need to be able to deliver an average level of public services with average tax rates (calculated by averaging the fifty states, including their local governments). GAO estimated the District’s structural deficit at somewhere between $470 million and $1.1 billion a year, depending on specific assumptions and made clear that the prohibition against taxing non-resident income was a major contributor to the District’s budgetary disadvantage.

For many years the District received an annual payment from the federal government to compensate for some of the fiscal impairment suffered as a result of its special status as the nation’s capital, especially its truncated taxing power. In 1997, however, as the District was beginning to recover from the severe fiscal crisis that brought on the “control period,” the federal government took a new approach. It phased out the federal payment, but assumed the cost of the District’s courts and the responsibility for incarceration of the District’s convicted felons. It also compensated the District for the unfunded pension liability created while the federal government ran the District Government prior to Home Rule and raised the percentage that the federal government contributed to Medicaid from 50 to 70 percent.