DC City Council Committee of the Whole, Committee on Finance and Revenue, Committee on Government Operations, and Subcommittee on Public Interest joint public hearing on
Bill 15-180, the “Commuter Tax Act of 2003,” and Bill 15-212, the “District Government Nonresident Employees Tax Act of 2003”
July 9, 2003

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Natwar Gandhi, Chief Financial Officer

Alice M. Rivlin, Brookings Institution

JOINT PUBLIC Hearing
Bill 15-180, "COMMUTER TAX ACT OF 2003"
and
BILL 15-212, "DISTRICT GOVERNMENT NONRESIDENT EMPLOYEES TAX ACT OF 2003"

Before the
Committee of the Whole
Committee on Finance and Revenue
Committee on Government Operations
Subcommittee on Public Interest
Council of the District of Columbia

July 9, 2003, 10:00 a.m.
Council Chamber

Testimony of
Natwar M. Gandhi
Chief Financial Officer
Government of the District of Columbia

Good morning, Chairman Cropp, and chairmen and members of the committees. I am Natwar M. Gandhi, Chief Financial Officer of the District of Columbia. I am here today to testify on two bills: Bill 15-180, the "Commuter Tax Act of 2003", and Bill 15-212, the "District Government Nonresident Employees Tax Act of 2003".

Relationship to the Structural Imbalance

Before I begin my formal remarks concerning these two bills, I would like to make some introductory comments concerning the circumstances under which we are discussing them. As you know, Madame Chairman, I have long argued that the District faces a structural imbalance between our sources of revenue and our needs for public services. I have not, of course, been alone in raising this issue. Recently, the General Accounting Office (GAO) has concluded, after a thorough study, that the structural imbalance indeed exists. The Commuter Tax Act bill would, if it could be enacted, make a significant reduction in that imbalance, and would place the District in the same position as other taxing jurisdictions that can tax income at its source.

The GAO report on this subject estimated that the structural deficit ranged from a low of $470 million to more than $1.1 billion a year, figures arrived at by combining estimates of the District’s cost of providing an average state basket of services with estimates of revenue capacity. Economic changes have led other jurisdictions to begin identifying structural issues as well, and the District shares in the breadth and depth of problems facing most states and localities. In addition, however, the District’s structural imbalance is extreme, driven by the unique set of services provided by the District and the unique set of restrictions that limit the District’s revenue raising capacity. I have testified to these requirements and restrictions on several occasions before this Council and the Congress. In the District, we provide city services, state services, county services and even the services of a school district; we provide public safety and public works services to the federal government itself. The provision of state-type services such as the Department of Motor Vehicles, the Department of Mental Health, the University of the District of Columbia, and the Department of Consumer and Regulatory Affairs costs us as much as $500 million a year. Public safety and public works services provided to the federal government cost us approximately $200 million a year.

We do all this with an artificially constrained tax base. We cannot tax the income of people working in the District and living elsewhere, a restriction faced by no state. A two percent commuter tax would raise approximately $540 million annually. Ironically, even if the District cannot tax income at its source, the District residents who earn income in other states are subject to tax in most of those states. Those District residents, including attorneys in firms with multi-state practices, then claim credits for those taxes against their District tax obligations.

(To illustrate this point, let me cite the example of an attorney who is a District resident, who has a federal lobbying practice within the District, and who is a partner with a multi-state law firm. Even though this attorney works entirely on business activities here in the District, since his/her law firm files a "composite tax return" that lists 15 percent of the law firm’s work as sourced in New York, that District resident partner is required to file a New York income tax return and to pay New York taxes on that 15 percent of his/her income. Under the District Tax Code, the lawyer gets a credit on his/her District income tax return for the amount of income tax paid to New York [Section 47-1806.04(a) of the DC Official Code].

Moreover, while states generally do not object to this operation of the "sourcing rule" due to the reciprocal nature of such income tax payments, the congressional restriction on District taxation of nonresident income means that the rule operates here as a one-way street. District residents’ income is taxed by other jurisdictions under the sourcing rule, and the District provides a credit for such taxes paid. But the District receives no taxes from partners in the New York office of the multi-state law firm, even if that firm does a substantial amount of District-sourced business.)

We cannot count on high-density real property to make up for our limited taxable property because of the height restrictions on District buildings. We cannot tax about 42 percent of the real property in the city, because that property is owned by the federal government, diplomatic missions, or international institutions. The District’s biggest industry does not pay District taxes, but imposes costs on the city. The District, of course, enjoys the honor and privilege of being the Nation’s Capital, and economic benefits of being the seat of the federal government, but on balance the costs outweigh the benefits.

The existence of the structural imbalance does not mean, of course, that our budget is not balanced--quite the contrary. We have now had six consecutive balanced budgets, and the District’s credit rating has been raised. But we have achieved that at considerable long-term cost: our debt is unusually heavy for a city or state of our size, our tax rates are among the highest in the region and the country, and our income tax rates for married taxpayers are 10-15 percent higher than Maryland and more than 50 percent higher than Virginia. Our pay scales for rank and file employees in some of our departments are not competitive, and some of our physical infrastructure is decaying.

The GAO also pointed out that a substantial structural deficit would still exist even as the District Government improves the efficiency and effectiveness of its programs.

Reciprocity with Neighboring States

Let me also suggest that reciprocity among surrounding jurisdictions is the key to an effective implementation of these bills in general and for voluntary compliance with them.

Tax reciprocity among states is a complex issue, often boiling down to whether or not two states have a similar number of residents commuting between them. The District does not have a "reciprocal agreement" with either Maryland or Virginia. In both states, the reference to the District in the statute is apparently attributable to the congressional prohibition restricting the District from taxing the income of Maryland and Virginia residents.

But tax compliance related to income tax is often dependent upon mandatory withholding and remitting of that withholding tax to the resident state. Where District residents are employed in Maryland and Virginia, the District is dependent upon the Maryland or Virginia employer’s willingness to register with our Office of Tax and Revenue (OTR), to set up a withholding account, and to file employer withholding returns. Absent that voluntary withholding by the employer, the District is dependent upon a resident filing estimated tax payments and filing an annual tax return with the District.

We have anecdotal reports that many Maryland and Virginia employers refuse to register with OTR for withholding and refuse to withhold District taxes. In all these cases, the employer generally withholds Maryland or Virginia taxes. Anecdotal evidence also indicates that many of these employees do not think they should have to pay estimated taxes to the District, since their Maryland or Virginia employer is withholding Maryland or Virginia taxes from their paychecks. This means that the District is then dependent upon the resident (1) filing a nonresident tax return with Maryland or Virginia for a refund of the withheld taxes, and (2) filing estimated tax payments with the District throughout the year. This is not only inconvenient for the District resident employed in Maryland or Virginia, but places an additional financial burden on the District resident and the District Government, and can result in taxes not paid and returns not filed.

Provisions of the Bills

Now let me turn to the bills under consideration. These bills impose graduated taxes on wage and salary income of individuals who are employed in the District but live outside the District. The bills appear to be identical except that Bill 15-212 applies only to individuals who are employed by the D.C. Government, whereas Bill 15-180 applies to all employees who work in the District.

The bills are very simple. Each imposes a tax on the "salary and wages of non-resident individuals employed in the District" or "by the District Government." An individual’s tax is determined by calculating specified percentagess of "the taxable income." The percentages are: one half of one percent if the individual’s taxable income is not more than $10,000, one percent if taxable income exceeds $10,000 but is not greater than $40,000, and two percent if taxable income exceeds $40,000.

The effective date provisions of the bills are also identical. Each would take effect on occurrence of the later of two events: (1) the passage of 30 days after the bill had been approved and published in the District of Columbia Register, or (2) Congress repeals section 602(a)(5) of the Home Rule Act, which prohibits the Council from imposing taxes on the income of non-residents. We interpret these effective date provisions to require that Congress take affirmative action to allow the Council to tax non-resident income before any individual would be required to pay the tax (or before any tax would be withheld based on this bill), regardless of when the Council passed the bills.

Revenue Effects of the Bills

To provide reliable revenue projections, we must know when the bills would be effective, which is contingent on congressional repeal of the commuter tax prohibition. Therefore, the revenue and cost estimates that I will give you are illustrative only, and cannot be used as projections that could be incorporated into the District’s Multi-year Financial Plan.

Both bills impose a tax on "salary and wages" but determine the amount of the tax as a percentage of "taxable income." For our revenue estimates, we assume that this apparent distinction is not intended: that is, the tax would be calculated for each individual from that person’s salary and wages sourced in the District without deductions of any kind. The bills make no provision for withholding of the tax by employers. Current District law expressly does not require withholding on non-residents’ wage and salary income. Nevertheless, we assume, for these illustrative revenue estimates, that withholding would be required. This point should be clarified in the statute. (For example, the Philadelphia commuter tax law requires Philadelphia employers to withhold at the source of wages and income earned.)

The legislation also should clarify the impact on self-employed individuals and independent contractors, whom we were not able to include in the fiscal impact calculation. We also assume that Virginia and Maryland would impose taxes at the same rates on District residents who work in those states, and that those commuter taxes would be credited against District residents’ income taxes.

Assuming, again for illustrative purposes, that either bill would be effective for wages and salaries received after December 31, 2003, we estimate that the "Commuter Tax Act" would generate revenue of $1.916 billion for fiscal years 2004 through 2007; the more restrictive District Government Nonresident Employees Tax Act would generate revenue of $75 million over the same period.

Implementation Costs

The bills do not specifically provide that individuals subject to the tax would be required to file returns. However, since the tax is graduated—taxing at different rates depending on income—there would have to be year-end reconciliation and settlement for each affected individual. Therefore, we assume in our analysis that annual returns would be required. We estimate that about 20,000 District Government employees would be affected by both bills, and that 480,000 other individuals would be affected by the Commuter Tax Act bill.

The Office of Tax and Revenue would have to design the appropriate forms and instructions, conduct suitable public education campaigns, and modify computer systems to deal with a new type of tax before its first filing season, which would begin under our illustrative assumptions about February 1, 2005. Also, OTR would have to design new withholding tables and associated instructions for non-resident individuals subject to the tax, and conduct suitable publicity and outreach among employers to implement withholding of the tax by January 1, 2004. The agency would be challenged to accomplish this by that date. Once the necessary forms and instructions, systems modifications, etc., had been completed, OTR would then have to process returns, maintain accounts, and answer taxpayer inquiries for an additional number of new D.C. taxpayers each year. If this legislation is enacted and becomes law, the total first year cost of implementation, including both developmental and ongoing annual activities, could range as high as 10 FTEs and $ 1 million.

Madame Chairman, this concludes my prepared remarks. I will be happy to answer any questions you or the other members may have.

TESTIMONY OF ALICE M. RIVLIN
DIRECTOR, BROOKINGS GREATER WASHINGTON RESEARCH PROGRAM
BEFORE THE COUNCIL OF THE DISTRICT OF COLUMBIA

July 9, 2003

Madam Chairman and Members of the Council: I am delighted that the Council is holding this hearing to highlight the severe disadvantage that the Congress has imposed on the District of Columbia by denying it the right to tax income earned in the District by non-residents. I congratulate the plaintiffs who intend to bring a lawsuit to test the constitutionality of this perverse denial and expose its unfairness and damaging consequences to the attention of the Congress and the public.

I am not a lawyer and am not qualified to opine on the constitutional issue. However, as an economist with considerable public budgeting experience--and as a former chair of the Financial Authority appointed by the federal government to oversee District finances in the budgetary crisis of the 1990's-I can attest that the District's inability to tax two thirds of the income earned within its borders makes it virtually impossible for the District to provide the quality of public services and the modern public infrastructure that a great capital city ought to be able to provide to those who live, work and visit here. I believe the Congress either ought to allow the District to tax income earned by nonresidents or provide adequate monetary compensation for imposing this unique disadvantage on the Nation's capital.

In September 2002 the Brookings Greater Washington Research Program published, A Sound Fiscal Footing for the Nation's Capital: A Federal Responsibility, co-authored by Carol O'Cleireacain and myself. Dr. O'Cleireacain is an economist, a former budget director of New York City, and author of Orphaned Capital: Adopting the Right Revenues for the District of Columbia (1997). I would like to summarize briefly the findings of our study, which I am happy to make available to the Council in its entirety. I would also like to make a few comments on the recent Government Accounting Office (GAO) study, District of Columbia Structural Imbalance and Management Issues. The GAO came to similar conclusions on the basis of a different, far more elaborate methodology.

The Brookings Study

Our study detailed three rationales for increased federal assistance to the District and then discussed various forms that assistance might take. The first rationale grows out of the District's status as the Nation's capital. The federal government is the city's largest employer and generates, directly and indirectly, much of its economic activity. However, the city's major industry-as well as much of the activity it attracts-does not pay taxes, imposes costs on the city, and severely restricts the city's tax base, especially by prohibiting taxation of income earned in the District by non-residents. Federal and other exempt buildings require police, fire, and emergency, and other services. Workers who commute to federal and other tax-exempt buildings cause traffic congestion and wear out the city's infrastructure. During business hours about 70 percent of the vehicles on downtown streets come from outside the city. The visitors and tourists that flock to the capital in large numbers also frequently impose exceptional costs, including policing, emergency services, crowd control, and clean-up after parades, mass demonstrations, and major public events.

At the same time, the presence of the federal government restricts the District's tax base enormously. Fully 42 percent of the real and business property base is exempt from taxation, with the federal government alone accounting for 28 percent of the exemption. Sales and excise tax exemptions for diplomatic and military personnel also reduce the District's revenue, as does the inability of the District to tax the "commercial" activities of the federal government. But by far the most costly restriction the federal government imposes on the District is the prohibition against the District taxing income earned by non-residents. Non-residents-mostly commuters living in the Maryland and Virginia suburbs and working in the District-account for two-thirds of the income earned in the District. If the District were able to tax commuter incomes at its current rates, we estimated that it could raise almost $1.4 billion in additional revenue annually. It would be able to spend substantially more to improve schools and other services and significantly lower its tax rates at the same time. The federal prohibition effectively transfers the bulk of the District's income tax base to the treasuries of Maryland and Virginia, leaving the District taxpayers with a commensurately higher burden.

The second argument for federal assistance to the District follows from the fact that it is the only city in the Nation without a state. In the absence of a state, the District must provide public services normally provided by a state government, as well as those usually supplied by a local government. In recognition of this burden, Congress has authorized the District to levy "state-like" personal and business taxes, such as an income tax, not usually imposed by cities. But Congress also imposed the glaring exception that is the subject of this hearing. States may tax all income generated within their borders, whether or not it is earned by residents. The District, however, may tax only the one-third of that income that is earned by its residents (and the comparatively tiny amount earned by District residents in Maryland and Virginia).

Moreover, state governments are able to collect revenue from diverse tax bases that include suburbs and industrial areas and redistribute those resources to local jurisdictions to equalize public services among localities of differing income and wealth. Central cities, which carry a heavy burden of costs associated with concentration of inner city poverty, normally benefit from this redistribution. The Baltimore City school system, for example, gets more than half its budget from the State of Maryland. The District, however, has to carry these costs without state aid.

In the District of Columbia Revitalization Act of 1997 the Congress recognized the District's unshared burden of state-like responsibilities and transferred some of them to the federal government. It relieved the District of fiscal responsibility for custody of convicted felons and the cost of the local court system. It increased the federal matching rate on Medicaid from 50 to 70 percent and transferred to the federal government the District's unfunded pension liability, created when the federal government ran the District's pension system, along with the corresponding assets of the system. But other functions usually performed by states, such as higher education and mental health, remained the responsibility of the District. Moreover, the same Act phased out the federal payment, by means of which, the federal government over the years had provided the District with compensation for its unusual fiscal burdens.

The third argument for federal assistance to the District relates to the neglected state of the District's infrastructure and the high operating costs it imposes on the city. One result of the city's history of fiscal stress is a legacy of aged and badly maintained school buildings, health facilities, and police stations; out-of-date and inadequate computer systems; and an aging sewer system that contributes to water pollution. Similar problems plague many older cities, but the fact that Washington is the nation's capital gives the federal government a special responsibility for working with the city's leadership to modernize its infrastructure. If the city were able to tax non-resident income-or had adequate sustained compensation from the federal government for its inability to do so -- it would, of course, be better able to undertake the necessary investment.

The combination of these lines of reasoning seemed to us to constitute a strong case for easing the District's fiscal bind by lifting the prohibition on taxing non-resident income OR compensating the District for this and other restrictions by providing it with substantial continuing federal budget support. The level and form of such support should result from negotiations between the city's political leadership and the federal government. Various options are suggested in our paper.

The GAO Study

The recent GAO study deals with the same issue, but attempts to provide an answer to the question: Does the District have a "structural deficit" that undermines its ability to provide adequate services at reasonable tax rates and, if so, how big is it? The GAO defined structural balance as a situation in which the District would be able to deliver an average level of public services with average tax rates. By "average" they meant the average of the fifty states, including their local governments.

When I first discussed this study with the GAO analysts, I was doubtful that their methodology would yield meaningful results. I pointed out that the District is a unique jurisdiction, not comparable to any state. Quite a few states are primarily rural and have no large cities at all. Even those with big cities also contain suburbs, small and mediumsized towns and rural areas. No state is entirely composed of the central city of a large metropolitan area. Central cities face a higher level of costs due to higher rents and wages and the expenses of dealing with high concentrations of poor people, and must deliver a different range of services than states do (even when their local jurisdictions are included). I doubted that a comparison with the average of the fifty states could tell us much that was useful in assessing the fiscal viability of the District.

I am happy to report that the actual GAO study reflects a thorough, sophisticated and ingenious effort to overcome these objections and produce useful comparisons. Not surprisingly, the GAO found that the District's per capita tax capacity (measured a couple of alternative ways) was higher than that of the average state; in fact, higher than any state. The difference reflects the higher incomes, sales and property values of a city, compared with states that include small towns and rural areas. However, GAO also found that the cost of delivering services in the District were higher that any state, and were even higher when the set of services being measured were those associated with urban areas, instead of the average of state and local services. The higher costs are associated with wages, rents and concentration of poverty. Since the cost difference was bigger than the tax capacity difference, the GAO concluded that the District faced a structural imbalance: it could not deliver average services at average tax rates. GAO estimated the District's structural deficit at somewhere between $470 million and $1.1 billion a year, depending on specific assumptions. It made clear that the prohibition against taxing non-resident income is a major contributor to the District's structural problem.

The GAO also examined some of the District's management challenges and made helpful suggestions about enhancing efficiency-for example, by improving the process of seeking reimbursement of Medicaid expenditures and tightening the financial management of the school system. While greater efficiency would improve the level of District services, the GAO points out that "management improvements will not offset the underlying structural imbalance because it is caused by factors beyond the direct control of District officials." (p.15)

Conclusion

Great nations take pride in great capital cities-and support them. Paris, London, Rome, and Tokyo each epitomize their countries, and each of their nations invests substantial resources in their well-being. Washington should enjoy the same prominence and support, but its peculiar status and treatment by the federal government undermines rather enhancing its ability to provide high quality services and infrastructure. The federal government severely limits the District's revenue raising capacity by prohibiting it from taxing non-resident income. To put the nation's capital on a sound fiscal footing, the federal government should either remove the prohibition or provide the District with financial compensation for the structural imbalance that the prohibition creates. Otherwise, despite a high tax burden on District residents, local officials will continue to be unable to provide adequate services for residents and visitors or finance and maintain the modern, efficient public infrastructure that a great capital city ought to have.

The facts should no longer be in dispute. Well-documented studies, using different methodologies have concluded that the District faces a serious structural budget imbalance. The city's leaders need to present the case to the federal government and work with the Congress to design a solution.