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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.
Back to top of page
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.
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