The Orphaned Capital: Revenue Options for the District of Columbia

March 1, 1997

The nation’s capital is in fiscal crisis. The budget deficit for the District of Columbia for the current fiscal year is $74 million. A presidentially appointed Control Board has been charged with balancing the District’s budget by 1999.

Overspending is part of the problem. The District’s spending has exceeded its revenues throughout the 1990s. But there is a longer-term problem on the income side of the ledger, as well.

Unlike other American cities, the District is called on to provide all nonfederal services without any state or county to help. To compound its woes, the capital’s tax base is severely restricted by federal law. And its hometown industry, government, is tax exempt.

Even after the Control Board brings spending under control and restores accountability to the District government, the city’s fiscal problems will continue unless major changes are made in the structure of its revenue.

A Dysfunctional Revenue System

The District of Columbia is neither a state nor a city within a state. The drafters of the Constitution, aiming to ensure the federal government’s independence from any state, established the capital as a “district” and gave Congress the authority “to exercise exclusive legislation in all cases whatsoever over such district.”

The District’s unique status has familiar ramifications. Congress has denied not only the capital’s physical appearance, setting its boundaries and even stipulating the height of its buildings, but also the political landscape. District citizens have been allowed to vote for president and vice-president since 1964. They do not, however, have a voting representative in either house of Congress, even though Congress determines the District’s budget and its taxes.

The revenue implications of the District’s unique status are less familiar. The District is a small open economy that functions like a city. As both the nation’s capital and a city without a state, the District has a limited tax base. From that tax base it must provide a range of nonfederal services to its residents, including the state portion of Medicaid and welfare. As a result, it has enacted a large number of taxes which impose a heavy burden on the rest of the District’s economy. Increasingly, businesses and residents are fleeing. The District’s population has fallen by more than 50,000 residents in the first half of the 1990s alone.

Unlike states, the District lacks the constitutional standing and sovereignty to determine whom and what it taxes. Fully 41 percent of the property in the District, most of it belonging to the federal government, is exempt from property taxes by order of the federal government. On workdays the labor force of the District doubles, but Congress does not allow the District to tax commuters’ earnings—a prohibition that costs about $1 billion a year in lost revenue. Nor is the District allowed to tax nonresidents’ income from the professional partnerships (legal, accounting, management, and political consulting firms) that cluster in the nation’s capital.

In the rest of America, states redistribute tax revenues to cities, towns, and counties. State aid accounts for 28-38 percent of general revenues for Boston, Memphis, and Baltimore, cities similar in population and area to the District. The District receives a unique federal payment of $660 million, which is enough to cover the lost revenue from exempt property, but not enough to make up for the lack of state aid and the need to provide state-type services as well. For example, at 19 percent of District revenues, the federal payment represents only half the share of help that Maryland provides Baltimore through state aid.

Moreover, the District’s tax collection system is broken. After nine directors in 20 years and staff reductions of 20 percent since 1990, the city’s revenue department lacks the capacity to enforce and fairly collect the more than 20 different taxes and 115 fees and charges now on the books. External audits point to serious deficiencies in the accuracy of the tax collection numbers and in the accountability for money received. Voluntary tax compliance is languishing, evasion is significant, and business tax revenues derive largely from audits. With neither an internal auditor nor a resident inspector general watching over collections or assessments, the possibilities for corruption need to be recognized and corrected.

The Proposal

The DC Revenue Project proposes not only to reform the District’s own taxes, but also to create a new formula for federal contributions to the District’s revenues. The goal is to change a dysfunctional revenue system into a structure that more closely resembles that of cities of similar size.

First, we propose streamlining District taxes—eliminating some city-type and state-type taxes that have proved problematic to enforce. The resulting revenues, like the District’s spending responsibilities, would still be a combination of city-type and state-type taxes. They would, however, be lower, simpler, fairer, and easier to collect than at present. Furthermore, the tax burden would be more closely in line with the state and local taxes in the surrounding area.

Supplementing District taxes would be three distinct federal revenues: a payment-in-lieu-of-taxes (PILOT) to make up for the property that is tax exempt; “state” aid comparable to that received by similar-sized cities; and coverage of a portion of the cost of state-type services, including Medicaid, provided by the District to its residents. At the bottom line, the District’s total budget and revenues would be of the same size as that presently approved by Congress (see table).

Proposed Change in District’s Revenue Structure
(Millions of dollars)
  Current Proposed
City-type taxes, including PILOT 1,653.2 1,179.1
Intergovernmental aid
   Federal aid to cities                                             229.4             229.4
   State aid 0.0 434.2
Fees 188.5 188.5
Total city revenues 2,071.0 2,031.2
State-type taxes 1,370.7 1,016.0
State fees—lottery 85.1 85.1
Total state revenues 1,455.8 1,101.1
Total state and city discretionary revenues 3,526.8 3,132.2
Federal categorical grants 653.0 653.0
Federal sharing for state-type spending
   Medicaid and welfare at 75%                                 0              220.0
   All other state services at 50% 0 158.0
Other revenues 142.0 142.0
General fund, budget revenue 4,321.8 4,305.2
Enterprise funds 848.0 848.0
TOTAL BUDGET 5,169.0 5,153.2

City-Type Taxes

The real property tax is the main revenue of local governments. The District’s tax, however, is needlessly complex to the point of being out of control. It has resulted in a $2.15 (per $100 of market value) effective commercial rate on occupied property and $5.00 on vacant property. Commercial tax liabilities in the District average 40 percent higher than those in the suburbs and can be linked to the District’s loss of private jobs.

We propose reducing the current five-class system to two classes—a residential one, with a rate of $0.90, and a commercial one, taxed at $1.35. To prevent a creeping increase in the commercial rate, we recommend that a maximum 150 percent ratio between the two rates be set by statute. We would also combine the many existing property tax relief programs into an income-based program that would focus relief on those with low or fixed income for whom property tax payments are a significant burden.

We would also eliminate two city-type taxes on business: the personal property tax and the professional license fee. At the same time, a small broadly based gross receipts tax on all businesses, common to many cities, should be introduced as a new discretionary revenue, providing $50 million. Such a tax was recommended in 1990 by the Rivlin Commission. The District can model this new general revenue source on the $10 million fee now dedicated to help finance the downtown sports arena under construction.

State-Type Taxes

Most cities do not levy a business income tax or a personal income tax on unearned and earned income; states do. We would lower and simplify the District’s personal income tax and end the two business income taxes.

Even by state standards, District residents pay a large share of their income toward an income tax. Currently the District income tax requires numerous adjustments from the federal form 1040 and is less progressive than the federal tax. The District should follow the lead of two small East Coast states, Rhode Island and Vermont, and piggyback on the federal income tax. The District’s new personal income tax could, as an added advantage, be collected by the Internal Revenue Service, headquartered in the Washington area and acknowledged as the best tax agency in the world. Under the new personal income tax, the District would raise about $200 million less than it does now. Residents would pay a at 28 percent of federal liability. The average effective tax rate in the District would fall from 5.2 percent to 4.3 percent, with the largest drop (from 5.4 percent to 3.3 percent) for those with incomes of $30,000-$50,000. The effective rate for those with incomes of $100,000-$200,000 would fall from 6.7 percent to 5.3 percent. Those with incomes greater than $200,000 would receive only marginal reductions.

The two business income taxes are both seriously flawed. The corporate franchise tax is exceedingly complex and poorly administered. Revenues, largely audit driven, are erratic and unpredictable. The unincorporated franchise tax is without an equivalent anywhere in the region. Eliminating both would cost at most $160 million in revenue.

A Comprehensive Federal Revenue Role

The DC Revenue Project proposes a plan involving three components, each addressing a particular part of the revenue shortage that results from the District being the nation’s capital.

First, to cover the 41 percent of the property tax base of the nation s capital that is tax exempt and receives local services, we propose that the federal government make a payment in lieu of taxes that fully compensates the District for the cost of the tax exemption. Unlike the present federal payment, the amount should not be negotiable. Its value should be determined by assessments and by the commercial property tax rate. It should be a permanent part of the federal budget. Based on existing assessments and the proposed commercial property tax rate of $1.35, this PILOT would be $382 million. About three-quarters of this amount would compensate for federal government property, with the remainder covering federally determined tax-exempt property.

The second proposal involves the aid that states traditionally give localities in the form of general revenue. Massachusetts, for example, in 1995 provided $429 million in state aid to Boston, a city of roughly the District s size. State aid to localities comes from state taxes and is distributed as compensation for services that localities are expected to provide, as well as to spread revenues among wealthier and poorer areas. We propose that the federal government take on the role of state to the nation s orphaned capital and provide $434 million, a figure adjusted for the small difference in population between Boston and the District. That aid would put the District in the same relationship to the federal “state” that many small counties have to their states. They pay taxes; they receive aid.

Finally, lacking a state or an overlying county government, the District of Columbia provides a full range of nonfederal government services. It is useful to distinguish between Medicaid and welfare, which are federally determined programs, and the rest. We propose a payment of $220 million to reimburse the District partially for Medicaid and welfare. At the moment, the federal government is treating the District of Columbia as if it were a state, not a city. It pays half the District’s Medicaid costs, and the District picks up the other half. But in the rest of America (except New York City), the state provides the bulk of Medicaid services. To act as the District’s state, the federal government should provide Medicaid services directly to District residents. But because the federal government does not ordinarily provide Medicaid services, the option becomes compensating the District for its own provision. Full compensation would give the District (with none of its own resources at stake) no incentive to provide this service efficiently. A better model is that of New York City, which pays a 25 percent share. The federal government should pick up an additional 25 percent state share, acting as the state and leaving the District to pay 25 percent and provide the service.

The District also provides other general state-type services, such as courts, prisons, mental health, and higher education. A recent study for the Control Board estimated the annual cost of these services at $316 million. Here, too, there should be a sharing of cost—a 50-50 split, or $158 million for the federal government. Another option would be for direct federal provision, depending on what services the federal government may be able to provide efficiently.

The Only Answer: Revenue Reform

The District of Columbia is, in many ways, in shambles. Its services are deplorable, its accountability almost nonexistent. But even if the District were providing services efficiently and operating under state-of-the-art systems, its revenues would fail to keep pace with spending over the long term.

Under the lead of the Control Board and the District’s chief financial officer, tough management decisions are now being made to restore sound government. As District residents, employees, and political leaders struggle to carry out those tough decisions, they need to know that once they have put their house in order, the District’s budget will be based on a rational revenue structure. It is the least the nation owes its capital city.

Other Approaches to Reform

President Clinton has proposed for the federal government to act, in very limited ways, as the state to the capital city, by taking over court, prison, and road repair services, while increasing Medicaid compensation from 50 percent to 70 percent. Further, the federal government is offering to take back the employee pension burden that it handed to the District when it instituted the current system of Home Rule in 1975. The annual $660 million federal payment would end. The White House proposal is mute on the large amount of federally exempt property, state aid, state-type spending not taken over, and the high tax burden compared with the surrounding jurisdictions. Essentially it offers no net fiscal help to the District.

Eleanor Holmes Norton, the District’s nonvoting delegate to the House of Representatives, has chosen to stress the injustice of taxation without representation, by proposing a large cut in federal taxes for District residents. Further, she argues that a 15 percent flat federal income tax in the District would attract residents and businesses that have fled the city. The Norton proposal generates the largest benefits for District citizens with the largest incomes. For middle-income families earning $40,000-$75,000 a year, about 17 percent of current District taxpayers, the cut would be about $2,100-$2,700 a year. For those earning $100,000 a year, it would be about $6,500-$7,000. As to whether such a tax cut is big enough to affect individuals’ decisions on whether to live in the District, there is no empirical evidence. At an estimated current annual cost to the federal government exceeding $750 million, the Norton plan is a larger increase in federal resources for the District than our proposal without offering any direct budget relief to the District.