Report

The Orphaned Capital: Adopting a Revenue Plan for the District of Columbia

Carol O’Cleireacain

Abstract

The District of Columbia’s revenue is collapsing, but it can be fixed. Unlike other cities, the capital’s tax base is severely restricted by federal law. There is no state aid, and government, the hometown industry, is tax exempt.

A sustainable revenue system is key to the survival of Washington, D.C. First, however, services must improve dramatically. Public officials must show that the District can live within its means. But as painful management reforms are made, District residents, employees, and political leaders should expect a tangible payoff: a rational and stable revenue base on which the city’s budget will rest.

This study offers workable remedies. It proposes a budget-neutral revenue structure more like that of a typical American city, with the federal government playing the role of a state. We propose that four business taxes be eliminated and that commercial property and personal income taxes be cut. The federal government should increase aid in three specific ways: a payment in lieu of taxes to make up for the 41 percent of property that is tax exempt; “state” aid comparable to that received by similar-sized cities; and coverage of 50 percent of the cost of state-type services provided to District residents.

The DC Revenue Project’s plan is fair and manageable. It is the least that the nation can do to ensure the viability of its own capital city.

Policy Brief #11

The nation’s capital is in a fiscal crisis. A presidentially appointed Control Board has been charged with balancing the budget of the District of Columbia by 1999. If the budget is to remain in balance, a number of structural changes will be necessary. This study offers the adjustments required on the revenue side. It presupposes that the Control Board and the District’s chief financial officer will bring spending under control and deliver District services efficiently, thus making possible the proposals offered here.

The District’s long-term fiscal problems stem from its being the nation’s capital. By intention, it is neither a state nor a city within a state. To avoid the inherent conflicts between local and national interests and to ensure the federal government’s independence from any state, the drafters of the Constitution established the capital as a “district,” and in Article 1, section 8, clause 17, retained for Congress the authority “to exercise exclusive legislation in all cases whatsoever, over such district.”

This unique status and congressional oversight have familiar ramifications. Congress has defined the District’s physical presence, setting its boundaries and stipulating its appearance, including the height of its buildings. Congress has also defined the political landscape. While District citizens are now allowed to vote for the president, the vice president, and a nonvoting delegate to the House of Representatives, they do not have voting representation in either house of Congress, even though Congress ultimately determines the District’s budget and its taxes.

The District’s unique status has less familiar revenue implications. As both the nation’s capital and a city that is not part of a state, the District has a limited tax base. As an entity unto itself it must provide a range of nonfederal services to its residents, including welfare and the state portion of Medicaid, financed from that limited tax base. In its oversight capacity, Congress has limited the District’s taxing powers and revenue sources. The more limited the tax base, the heavier the tax burden on the remaining parts of the District’s economy. Increasingly, businesses and residents are leaving town. Truly, this is an orphaned capital.

The Findings

The District of Columbia’s present revenue structure is not sustainable, as explained below.

The Tax Structure is a Dysfunctional Hybrid

As a small, open economy, the District functions like a city. However, because of its unique nature, its budget is a hybrid of city- and state-type taxes and fees as well as state and city service responsibilities (see figure 1).

Compared with cities, the District levies many more, and higher, taxes on resident households and businesses. For example, the District is one of only a handful of cities to levy a full personal income tax (on unearned as well as earned income). Compared with states, the District lacks both the constitutional standing and the state sovereignty to determine whom and what it taxes. For example, its personal income tax looks like a state income tax. But unlike any state, the District is not allowed to tax nonresident earnings. The courts have ruled that this exclusion extends to nonresidents’ income from professional partnerships – the legal, accounting, management, and political consulting firms clustered in the nation’s capital.

For households, the tax burden becomes progressively higher as income levels rise, and at $100,000 and above is the highest in the metropolitan area. For businesses, the District tax bill is at least 25 percent greater than elsewhere in the region. The District’s high commercial property tax and sales tax rates are probably a significant factor accounting for the city’s declining share of metropolitan-area private employment.

Author

The Hometown Industry Is Tax Exempt

The District’s tax base is significantly reduced because it is the nation’s capital. Forty-one percent of the property in the District is exempt from property taxes. Sixty-five percent of the exempt property belongs to the federal government. The rest, exempted by Congress or by executive order, includes property of churches, libraries, hospitals, and universities, plus that of foreign governments, multilateral institutions, and national nonprofit organizations.

Most employment in the District does not generate income tax revenue for the District. It generates it for Maryland and Virginia. Every day, almost half a million workers flow into the District, but Congress does not allow the District to tax their earnings. We estimate a $20 billion earnings gap between suburban commuters into the District and residents who work outside, which is worth about $1 billion in revenue: $366 million to Virginia and $619 million to Maryland and its counties.

Figure 1. District of Columbia Discretionary Revenues, Fiscal Year 1995

thousands of dollars

<FIGURE 1>

Source: District of Columbia 1995 Comprehensive Annual Financial Report.

Finally, other economic transactions, by military and diplomatic personnel as well as by the federal government, go exempt from sales, income, and personal property taxes. The District estimates annual revenue forgone, at present tax rates, at $120 million.

The District Lacks State Aid

In the rest of America, states redistribute tax revenues to localities in the form of aid. State aid accounts for 28 percent to 38 percent of general revenues for Boston, Memphis, and Baltimore, cities of similar population and area. This state aid is not available to the District.

The District does receive a unique federal payment of $660 million ($2.50 annually from every taxpaying American). But at 19 percent of District revenues, that payment represents only half the share of help that Maryland provides Baltimore through state aid. The federal payment is not large enough to cover the revenue shortages resulting from the unique character of the nation’s capital.

The Revenue Collection System Is Broken

Moreover the District does not have the capacity to enforce and fairly collect the more than 20 different taxes and 115 fees and charges now on the books. Enforcement is arbitrary and unsystematic, resulting in unfair tax burdens. Voluntary tax compliance is languishing, evasion is significant, and business tax revenues derive largely from audits.

High turnover in management – the District’s tax agency has had nine directors in the past twenty years – has resulted in lack of leadership, leaving tax collectors no match for the private sector. Internal appraisals indicate that the District’s auditors and assessors have not kept up with the technological developments that have revolutionized tax collecting and have not been trained to use even the outmoded technology that is available to them.

Finally, there is a serious risk of corruption. Neither an internal auditor nor a resident inspector general watches over tax collections. External audits point to serious deficiencies in the accuracy of the tax collection numbers and in the accountability for money received. Many properties are underassessed, some perhaps intentionally. Growing backlogs (in part the result of a 22 percent decrease in staff since 1990 and the lack of technological or management improvements) offer easy opportunities for outstanding tax bills to remain uncollected.

The Proposals

The DC Revenue Project proposes cutting some taxes, eliminating others, streamlining the tax structure, and creating a new federal-District revenue relationship. To produce a revenue structure comparable to that of other American cities, the project takes as given the present size of the District’s budget, which has been approved by Congress.

Our proposal would completely eliminate four taxes including the personal property tax, the professional license fee, the corporate income (franchise) tax, and the unincorporated income (franchise) tax. In addition, two broadly based taxes would be cut significantly. Real property tax revenues would be cut by 27 percent, with five classes reduced to two, and the timing of assessments and payments would be simplified to improve cash flow. The personal income tax would be cut by 30 percent, meaning that all residents with federal adjusted gross income of less than $200,000 would have their taxes cut and that 36 percent of District residents would pay no income tax. The new income tax would be a single rate of 28 percent of federal liability, with collection and enforcement delegated to the IRS. The plan would also increase the broadly based gross receipts tax by $50 million.

The new fiscal relationship with the federal government would have three distinct elements. Each addresses a particular part of the revenue shortage resulting from the unique nature of the nation’s capital. The first is a payment in lieu of taxes, amounting to $382 million, to compensate the District for the reduction of its tax base by federally owned, tax-exempt property. This would allow property taxes to be reduced for all other owners. The second is state aid of $434 million, an amount comparable to that received from their state governments by cities of similar size. The third is a 50-50 sharing of state-type spending, on Medicaid and welfare ($220 million) and on general programs ($158 million), which together amount to an additional $378 million. This partially compensates the District for the fact that it has no state to provide a range of state services. The compensation would not be necessary, of course, if the federal government chose to provide these services directly to District residents. Federal resources in this proposal total $1.2 billion.

Detailed Proposals for Long-Run Budget Balance

Adjusting Washington’s revenue structure will not change its unique status as a city-state, but it can change a dysfunctional hybrid revenue structure into one that more closely resembles that of cities of similar size.

The proposed structure has been governed by the practical constraint of the tax burdens in the surrounding jurisdictions. The District already has the highest per capita tax burden in the region, as well as the highest tax costs of doing business. As a result, businesses and households have been voting with their feet.

The revenues shown here should be treated as orders of magnitude or general neighborhoods rather than budgetable amounts since they are estimates based on the less-than-perfect data available to this study.

Table 1 shows both existing and proposed structures for the District of Columbia’s general fund discretionary revenues. Table 2 demonstrates budget neutrality.

Table 1. District of Columbia General Fund Discretionary Revenues, Current and Proposed, Fiscal Year 1995
millions of dollars

  CURRENT PROPOSED DIFFERENCE

%
CURRENT

%
PROPOSED

City-type taxes

1,653,171

1,179,123

(474,048)

47

38

Property

654,284

477,104

(177,180)

19

15

Personal property

61,305

0

(61,305)

2

0

Gross Receipts

210,269

260,269

50,000

6

8

Other

67,313

59,271

(8,042)

2

2

PILOT

660,000

382,479

(277,521)

19

12

Intergovernmental aid

229,364

663,530

434,166

7

21

Federal aid to cities

229,364

229,364

7

7

State aid

0

434,166

434,166

0

14

Fees

188,509

188,509

5

6

City Revenue (total)

2,071,044

2,031,162

(39,882)

59

65

State-type taxes

1,370,652

1,015,973

(354,679)

39

32

Personal income

643,676

449,676

(194,000)

18

14

Sales (selective and general)

549,490

549,490

16

18

Business income

160,679

0

(160,679)

5

0

Other

16,807

16,807

0

1

State fees-lottery

85,100

85,100

2

3

State revenues (total)

1,455,752

1,101,073

(354,679)

41

35

State and city revenuesa

3,526,796

3,132,235

(394,561)

100

100

Sources: District of Columbia 1995 Comprehensive Annual Financial Report; and author’s calculations.

a. Also called general fund discretionary revenue; see table 2.

City-Type Taxes

City-type taxes could be reduced by almost half a billion dollars by reforming the real property tax; by eliminating two city-type business taxes (the personal property tax and professional license fee); and by increasing one city-type business tax (the gross receipts tax).

Real Property Tax

None of the jurisdictions surrounding Washington has property classification systems or effective commercial property taxes as high as the District’s. The present five-class system in the District has resulted in a $2.15 (per $100 of market value) effective commercial rate on occupied property and $5.00 on vacant property. These rates result in commercial tax liabilities that are, on average, 40 percent higher than those in the suburbs. Our econometric analysis indicates that these differences are significant in explaining some of the District’s declining share of the region’s jobs and showing that a property tax cut may increase employment in the District.

We propose reducing the five-class system to two classes – a residential rate of $0.90 and a comm-ercial rate of $1.35 – with a maximum 150 percent ratio between the two rates, to be set by statute, to prev-ent a creeping increase in the commercial rate. We also offer a series of structural reforms and calendar changes in collecting and budgeting the property tax, including a reserve for delinq-uencies, that will improve cash flow and budget stability. These lowered rates, holding other things constant, will result in increased property values and lower rents, for both households and businesses.

Simplicity argues for a single-class system, but the District’s present rate structure makes it very difficult to get from here to there. The District’s lowest (residential) rate is now $0.96, and its highest is $5.00. The suburban rates range from $0.90 to $1.45 (with the modal rate at $1.07). Imposing a single-class system at the current residential rate would reduce commercial rates in the core of downtown office buildings (now at $2.15) to a level far below that of the surrounding area. Alternatively, imposing a single rate system at the suburban rates would require a tax increase on all homeowners, which this study has ruled out given the present low quality of District services, looming assessment changes, and our proposals for an income-targeted relief program. Thus the inevitability of a two-class system.

Table 2. Budget Reconciliation, Fiscal Year 1995
millions of dollars

 

CURRENT

PROPOSED

DIFFERENCE

General fund, discretionary revenuea

3,527

3,132

(395)

Federal categorical grantsb

653

653

0

Other revenuesc

142

142

0

Federal aid for state-type spending

0

    Medicaid and welfare at 75 percent

0

220

220

    All other state services at 50 percent

0

158

158

General fund, budgeted revenue

4,322

4,305

(17)

Enterprise fundsd

848

848

0

Total budget

5,170

5,153

(17)

Sources: District of Columbia 1995 Comprehensive Annual Financial Report, (CAFR); and District of Columbia 1997 Budget and Financial Plan.

    a. Includes $3,248 million of appropriated revenues as defined in the CAFR, plus $85 million in lottery revenue, plus $229 million in federal aid to cities (total federal grants of $882 million less $653 million in categorical human services grants), less the $35 million motor fuel tax, less the $175,000 health care provider fee, and less the $468,000 general fund portion of the arena fee (CAFR, p. 23, 46).

    b. Federal grants for human support services, primarily Medicaid and welfare (CAFR, p. 46).

    c. Nonappropriated charges for services and miscellaneous revenues (CAFR, p. 23).

    d. Total expenditures for the enterprise funds as reported in the budget (Budget, p. 35).

Personal Property Tax

Having accepted two classes, we determined that the District would be able to meet a further goal of eliminating unenforceable taxes by setting the commercial property tax at a rate that would allow for elimination of the business personal property tax ($61 million), a burdensome and increasingly unenforceable tax. The resulting $1.35 commercial rate is a significant reduction from current burdens and a rate on a par with that in Prince William County. Since surrounding jurisdictions still impose a personal property tax, eliminating the District’s tax provides some competitive advantage.

Professional License Fee

The professional license fee applies largely to professionals doing business in the District and is the remnant of attempts to tax the thousands of legal, accounting, political, and management consulting partnerships that cluster in the nation’s capital. It is not well enforced, which makes it unfair and discourages potential payers from acknowledging self-employment in the District. It should be eliminated.

Gross Receipts Tax

The Rivlin Commission, in its 1990 report to the mayor on budgetary reform, recommended a broadly based gross receipts tax, in large measure because it is so easy to audit and enforce and, at low rates, issues of fairness are minor. The District has implemented a small tax and dedicated the $10 million in revenue to financing the downtown sports arena now under construction. From data provided by the Department of Finance and Revenue, we determined that collecting five times the current amount for general revenue, while continuing the portion designated for the arena, would still keep the burden comparable to that in the surrounding area.

Pilot

We propose that the federal government make a payment in lieu of taxes (PILOT) covering the 41 percent of the property base of the nation’s capital that is tax exempt and receives local services. The federal government should compensate the District for the cost of the tax exemptions by paying a full tax-equivalency PILOT on the value of the tax-exempt property. Unlike the present federal payment, the amount of the PILOT 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, incorporated into the grants section with other PILOTs.

Based on existing assessments and the proposed commercial property tax rate of $1.35, the federal PILOT would be $382 million. Like a state, the federal government has determined which local properties are exempt from taxation. In this proposal we have included all tax-exempt properties, except those belonging to the government of the District of Columbia, as part of a federal PILOT. About 65 percent of the PILOT would compensate for federal government property, with the remainder covering property owned by traditional tax-exempt organizations and diplomatic, national nonprofit, and multilateral institutions. Many consider these institutions part of the fabric of the nation’s capital. If some people question whether the federal government should pick up the costs of the one-third of the property that is not federally owned, the option always exists for the federal government to negotiate to share the burden with those receiving this benefit.

The values for tax-exempt property should be treated with caution. Because the assessments of exempt property have never been used for a material purpose, neither the District nor the owners have had an incentive to ensure their accuracy. Under this proposal, there might be an advantage for both the federal and District governments to form a partnership with the International Association of Assessing Officers (IAAO) to ensure state-of-the-art valuation for some of the unique properties of the nation’s capital. Similar valuation techniques are used by New York City to value Central Park and to arrive at the PILOTs that New York State pays for the World Trade Center and Battery Park City.

State-Type Taxes

We propose eliminating unenforceable and arbitrary business income taxes and converting the personal income tax into a flat percentage of the federal income tax liability, administered by the Internal Revenue Service. While these actions would cost the District revenue, they would improve markedly the fairness of the tax structure and the enforcement and collection process.

The Personal Income Tax

Most cities do not levy a personal income tax on unearned and earned income; states do. Even by state standards, District residents pay a greater share of their income toward an income tax. The District’s income tax is higher than Virginia’s and similar to that in the Maryland suburbs. The income base requires numerous adjustments from the federal form 1040, and the tax, though progressive, is less progressive than the federal tax, which causes some residents who receive the federal earned income tax credit to pay Distr