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Ed Lazare, DC Fiscal Policy Institute
Testimony on the Mayor’s proposed FY 2004 Budget and Financial Plan
March 19, 2003




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March 10, 2003

Raising Revenues Without Raising Rates:
Some Options to Help Balance the District's Budget

by Ed Lazere

The District, like other cities and states, is facing extremely serious fiscal problems.  Weak economic conditions have resulted in steep declines in state tax collections across the nation, which in turn have caused the largest state budget deficits in decades.  In the District, Mayor Williams and the Council addressed a $323 million budget shortfall in September 2002 through roughly $200 million in spending cuts and more than $100 million in revenue increases.

Despite these efforts, the DC budget has once again fallen out of balance.  New projections released in February show a new $128 million gap in the current-year budget and a budget deficit of $131 million for fiscal year 2004.

The Mayor and the Council soon will need to take steps to address these shortfalls.  Perhaps most importantly, DC leaders have the option of tapping DC's substantial rainy day fund — which has not yet been used in the current budget crisis.  (As discussed in a forthcoming DCFPI analysis, drawing from the rainy day fund will require changes in strict federal rules that govern the fund.)  Beyond that, some combination of spending reductions and revenue increases will be needed.

While elected officials often are reluctant to increase taxes, there are reasons for District officials to consider doing so now.  In 2002, DC’s budget shortfalls were addressed primarily through spending cuts, causing significant reductions in a wide range of services.1  In addition, tax cuts enacted in 1999 have contributed to the District’s budget problems; they will cost the District roughly $200 million this year.  It is worth noting that one-third of the states raised taxes in 2002, and 17 governors have proposed tax increases in 2003, because they are unable to solve their budget problems through spending cuts affecting critical services, such as education.  (See box on page three for more information on proposed tax increases in other states.)

This report highlights several ways in which the District could raise revenues, generally without having to increase tax rates.  Instead, the District could raise a substantial amount of revenue by closing tax loopholes and broadening the base of some taxes.  Most of these changes would improve the structure of DC’s tax system, by making it more equitable and by helping ensure that tax revenues will grow in tandem with the DC economy.

Closing Corporate Tax Loopholes:  Four out of every five corporations in the District pay only the minimum corporate franchise tax, which is $250 per year.  This partly reflects loopholes that allow large multi-state corporations to avoid paying taxes on profits earned in DC.  As many states have done, the District could close these loopholes.

Broadening the sales tax base:  The District's sales tax was adopted decades ago and was designed primarily to cover purchases of goods.  Services, which represent a growing share of consumer purchases, often are not taxed.  In addition, the District does not collect sales tax on sales at federal museums or other institutions, although it has the authority to do so.  Broadening the sales tax to include selected services and sales at federal institutions would increase revenues and improve the growth rate of the sales tax.

 Limiting the new property tax cap:  Home assessments in many DC neighborhoods have risen dramatically in recent years, reflecting both a strong real estate market and the recent elimination of a system that consistently under-assessed home values.  In response to rising assessments, the DC Council enacted a 25 percent cap on annual increases in property taxes for homeowners.  A recent DCFPI report finds, however, that this cap has created significant inequities.  The vast majority of homeowners in DC’s most affluent neighborhoods are benefiting from the cap, which allows them to pay tax on less than the full value of their home.  Yet most homeowners in less affluent neighborhoods are receiving no benefit and thus are being taxed on the full value of their home.  The majority of the $20 million benefit from this tax break is going to owners of homes worth more than $500,000.  Restricting the property tax cap by making it temporary and by excluding the most valuable homes would raise revenues and help ensure that all homeowners pay taxes on the actual value of their homes.

Income Tax Changes:  The District’s projected budget deficit for 2004 assumes that $24 million in previously enacted income tax cuts will be implemented.  These tax cuts should be suspended.  This would be consistent with legislation adopted last year to require suspension of the income tax reductions if they would place the budget out of balance.

In addition, the District could consider a temporary income tax increase for higher-income residents, as three states already have done and three other states are considering.  Since 1999, DC's income tax rates have been reduced as a result of the Tax Parity Act, with the greatest benefits going to the highest income residents.  An income tax surcharge of five percent for higher-income households would leave nearly all DC residents with a lower income tax burden than in 1999.

Many States Have Enacted or Proposed Raising Taxes

Since 2001, states have experienced severe budget problems, primarily as a result of the weak economy and falling tax revenues.  To address these shortfalls, most states have tapped their rainy day funds and reduced spending.  Many states also have enacted tax increases.  The level of tax increases being considered by states has raised as the fiscal crisis has continued.

  • In 2002, 16 states adopted tax increases totaling $8.3 billion.

  • This year, governors in 17 states have proposed tax increases totaling $14 billion for their 2003 or 2004 budgets.*  In five of the states — California, Nebraska, New Jersey, Ohio, and Oklahoma — proposals to raise taxes this year follow tax increases enacted in 2001 or 2002.

  • The governors proposing tax increases include Republicans and Democrats in all regions of the country.  They have proposed increases in income taxes, sales taxes, corporate taxes, and/or excise taxes, and they include both raising rates and broadening tax bases.

Many of these governors have noted that they support tax increases because they believe further spending cuts would not be in the state’s best interests.  For example, Idaho Governor Dirk Kempthorne explained his decision to propose tax increases this way:  “I have done something that is absolutely not part of my fiber.  But I'm not going to dismantle this state, and I'm not going to jeopardize our bond rating, and I'm not going to reduce my emphasis on education."**  Delaware's Governor Ruth Ann Minner, recently said that “While I believe that we have cut costs and made government more efficient, I also believe that there are certain obligations government has and certain services the state provides that should not be eliminated. We cannot solve a $300 million problem completely through cuts without affecting children, the elderly, the poor, public safety and our state’s competitiveness.”***

*States whose governors have proposed tax increases include Arkansas, California, Connecticut, Delaware, Georgia, Idaho, Iowa, Kentucky, Missouri, Nebraska, New Jersey, Nevada, New York, North Dakota, Ohio, South Dakota, and West Virginia.
**Washington Post, January 9, 2003
***Budget Address, January 30, 2003

Closing Corporate Tax Loopholes

The District, like most states, imposes a tax on the net profits of corporations.  Yet there is evidence that many DC corporations that do business in the District are able to escape paying more than a nominal amount of tax on their earnings.  According to the Office of Research and Analysis of the Chief Financial Officer's office, roughly 80 percent of DC corporations pay just the District’s minimum corporate tax of $250 per year.  That is less than the income tax paid by a family of four with income of $30,000.  Without the District's minimum tax, it appears that many corporations would not pay any income tax.

The limited tax contributions from corporations that do business in the District result in part from loopholes in the District's corporate income tax.  These problems are not unique to the District.  According to the Center on Budget and Policy Priorities, "The corporate income tax laws of the majority of states are riddled with loopholes that permit many large multistate corporations to avoid paying tax on a significant share of their profits."2  Nevertheless, a number of states have taken steps to address these problems.

Two steps that the District could take to close its corporate tax loopholes are described below.  These changes could be adopted without having to make fundamental changes in the structure of DC’s corporate tax.

Closing the "Delaware Passive Investment Company" Tax Shelter

In general, multi-state corporations — those that operate in numerous states — are required to pay taxes to each state based on the share of the profit earned in that state.  A loophole in the District’s corporate income tax law, however, allows many corporations to shift their profits earned in DC to holding companies established in tax haven states such as Delaware and Nevada, where the profits are not taxed.

The transfer of profits out of the District is accomplished through the creation of a corporate subsidiary, known as a "passive investment corporation" or PIC.  These are established most often in Delaware and Nevada.  The PICs are created primarily to hold ownership of the company’s trademarks, patents, or other "intangible assets."  They often do not produce anything tangible or have any employees.  Popular retail companies such as Limited Brands, Inc. (which includes Victoria’s Secret, Lane Bryant, and Bath and Body Works), Home Depot, Circuit City, and Burger King have created PICs to hold their corporate logos and trademarks. 

Once the PIC is created, the corporation’s retail stores in DC and other states pay a royalty or licensing fee to the PIC to use the corporate logo (in one common arrangement).  The payment of these fees, which often are sizable, reduces the taxable profits of the DC stores, while creating substantial income for a corporation's PIC subsidiary.  Because the income of PICs in Nevada and Delaware is not taxable, the use of the PIC allows the corporation to shield its DC profits from taxation.3

It is not possible to obtain a comprehensive picture of how much profit is being shifted into tax haven states through the use of PICs because the information is confidential.  The limited information available suggests, however, that the sums involved may be enormous.  For example, the Delaware PICs of the Limited/Victoria's Secret/Lane Bryant/Express retail conglomerate earned over $400 million in royalty income between 1986 and 1989 by licensing the companies' respective trademarks back to the stores across the country.4

This loophole is relatively easy to close, as a large number of states have done, using one of two methods.

  • At least seven states — Alabama, Connecticut, Massachusetts, Mississippi, New Jersey, North Carolina, and Ohio — have enacted laws that directly address artificial income shifting through the use of PICs.  These states simply deny a deduction from gross income for royalties and interest paid to related corporations.
  • Sixteen states — Alaska, Arizona, California, Colorado, Hawaii, Idaho, Illinois, Kansas, Maine, Minnesota, Montana, Nebraska, New Hampshire, North Dakota, Oregon, and Utah — have adopted measures to prevent shifting of profits among corporate subsidiaries.  These states effectively require corporations to add together for tax purposes the profits of the tax haven subsidiary and the corporation(s) paying the royalties and interest.  This policy, called "combined reporting," is the most comprehensive approach to nullifying a wide variety of corporate tax-avoidance techniques, including PICs.

A Glimpse of Delaware PICs

At the end of 1998, some 6,000 PICs had been incorporated in Delaware alone, with new ones being created at the rate of 600-800 per month.  Similarly, there are 132,000 businesses in Nevada that have no employees, another tax haven state.  Many of these businesses could be PICs.

An investigative report by former Gannet News Service reporter Joseph DiStefano offers a view of Delaware's PICs*:

For a glimpse into this quiet and lucrative world, head up to the 13th floor of 1105 N. Market Street.  Through smoked-glass windows, a visitor can view the high-rise headquarters surrounding     Wilmington's prestigious Rodney Square: DuPont and Hercules, Wilmington Trust and MBNA. But turn back, and look inside this slender office tower.  Tucked within the building's stark, upper floors, is another, hidden corporate center.  Here, more than 700 corporate headquarters make up a vast and quiet business district of their own.  The lobby computer lists their names: Shell and Seagram and Sumitomo, Colgate-Palmolive and Columbia Hospitals and Comcast, British Airways and Ikea, Pepsico and Nabisco, General Electric and the Hard Rock Cafe.  How do 700 corporate headquarters squeeze into five narrow floors? How do 500 fit on the 13th floor alone?  "Frankly, it's none of your business," said Sonja Allen, part of the staff that runs this corporate center for Wilmington Trust Corporation.  "Some of my clients are saving over $1 million a month, and all they've done is bought the Delaware address," said Nancy Descano, holding company chief of CSC Networks outside Wilmington.

*Joseph N. DiStefano, "In the War Between the States, Delaware is Stealing the Spoils," Gannett News Service, January 25, 1996.

Expanding the Definition of Taxable "Business Income"
To Encompass Corporate Profits from Irregular Transactions

In general, corporations that operate in multiple states must divide their profits among the states, using formulas set in state corporate tax laws.  Yet U.S. Supreme Court decisions have made clear that some kinds of profits are not apportioned in this manner but instead must be assigned to one state — typically the company headquarters state.  An example of such assigned income is interest earnings on a pool of cash being held for future corporate acquisitions.

In recognition of these Supreme Court decisions, most state corporate income tax laws make a distinction between the share of a corporation's total profit that is "business income" — which is apportioned by formula among all of the states in which the corporation is taxable — and the share that is "nonbusiness income" — which is allocated to one state for taxation.

The District's corporate income tax includes a broad definition of "non-business" income, which has given aggressive multi-state corporations based outside the District a loophole that allows them to deny DC its fair share of tax on corporate profits.  (Many other states suffer from using similar definitions of business income.)  These corporations have defined a large share of their income as non-business income, which means it is taxed in the company's home state but not in DC.  If the company's home state has no or only limited corporate taxation, this move allows corporations to escape taxation on a large share of its profits.  As an example, companies may be able to avoid paying DC corporate income tax on capital gains realized when they sell a building, even though the company had been deducting the depreciation expenses from its DC taxable income for years while the building was in use.

A 1992 U.S. Supreme Court decision made clear that DC and other states could define "business" income to include many income sources that corporations assert to be "nonbusiness" income under the traditional state law definition.  Accordingly, leading state tax scholar Walter Hellerstein recently has advised states to bring their corporate tax laws into alignment with this Supreme Court decision through the simple device of amending the definition of  business income to read: "'Business income' means all income which is apportionable under the Constitution of  the United States."5

Some 18 states — including Virginia and Maryland —  have statutes that define apportionable business income broadly to include all income that may be apportioned under U.S. Supreme Court standards, and define allocable nonbusiness income as all other income of a corporation.6  These states are maximizing their ability to tax their fair share of profits earned by companies that are headquartered outside the state.  The District could do so as well.

Broadening the Base of the Sales Tax

The sales tax is intended to tax consumer purchases.  In general, the tax should be applied broadly to cover as many purchases as possible (with the exception of basic necessities such as food and medicines).  A broad sales tax base helps maintain a low sales tax rate: raising a given amount of revenue with a sales tax that covers a wide range of retail sales can be done with a lower tax rate than if the sales tax applies to only a narrow set of purchases.  In addition, a broad-based sales tax helps ensure that sales tax collections will grow in tandem with growth in consumer purchases. 

In at least two key ways, however, the District's sales tax fails to cover a broad base.

Taxation of Services

The District's sales tax, like the sales tax in many states, was adopted decades ago at a time when most purchases were of goods.  Because there has been a long-term shift in the U.S. economy toward use of services, goods-based sales taxes cover a shrinking share of consumer purchases.  District policymakers have attempted to adapt to this shift by applying the sales tax to some services — such as dry cleaning — but a number of services remain untaxed.  The District's sales tax does not apply, for example, to health club memberships or car towing.  It also does not apply to a variety of professional services, such as tax preparation and financial planning.

Beyond the adverse impact on DC tax revenues, the failure to tax services also creates inequities in DC's tax system, in that some transactions are taxed while other similar activities are not.  For example, movie tickets and admission to circuses are subject to DC’s sales tax, but theater tickets are not.  In another example, purchases of disposable diapers are taxable while use of a diaper service is not.

The District could consider broadening its sales tax to include more services.  In deciding which services are most appropriate to tax, policy makers should consider a number of factors, including the ease of administering the tax and the likely revenue that would be generated.

It is likely that some officials will argue that newly applying the tax to services may encourage consumers to purchase the service in Maryland and Virginia if it is not taxed there.  While this concern has some merit, it is worth noting that there already are some services that are taxed in DC, Maryland, or Virginia that are not taxed in all three jurisdictions.  Nevertheless, one way to address this concern is to concentrate on services that residents must buy or usually buy in the District.  This includes home-based services, such as carpet cleaning, or telephone answering services.

Some services that are not taxed now in the District but are taxed in some states are:

  • Home repairs (such as plumbing or electrical work)
  • Dating services
  • Health clubs
  • Tanning salons and day spas
  • Massage services
  • Diaper services
  • Car towing
  • Membership in private clubs
  • Security services
  • Admission to museums and cultural events
  • Live theater and concert tickets
  • Coin-operated video games
  • Tax Preparation
  • Investment Counseling
  • Pet grooming
  • Test preparation

Applying the Sales Tax to Purchases at Smithsonian Museums

The District’s sales tax currently gives the city authority to collect sales tax on sales made by the federal government and federal entities such as the Smithsonian Institution, as long as the sale is made to an individual or organization that is not exempt from sales tax.7  Yet the District currently does not enforce this right.  Tourists who purchase items at a gift shop in a Smithsonian museum, for example, do not pay sales tax.  This robs the District of tax revenue and of its ability to benefit fully from the area’s substantial tourist industry.

In 1998, the DC Tax Revision Commission recommended that the District enforce its authority to collect sales tax on sales by the federal government or federal entities.8  DC’s policy makers should consider implementing this recommendation now.

Limiting the Cap on Property Tax Increases

In recent years, many DC homeowners have faced substantial increases in their property tax assessments.  The jumps reflected both the extremely strong real estate market and the recent elimination of a “triennial” assessment system that had caused assessments to fall well below actual market values.

In response to concerns over rising assessments, the DC Council enacted a cap that limits property tax increases to 25 percent per year.  While this may seem like a reasonable response to the transition to a new assessment system, the cap has proven to be both costly and inequitable.

  •  A January 2003 report by the DC Fiscal Policy Institute found that more than nine of 10 homeowners in DC’s most affluent neighborhoods, such as Georgetown and Cleveland Park, are benefiting from the cap.9
  •  At the same time, almost no homeowners in less affluent neighborhoods, such as Anacostia and Congress Heights, are benefiting from the cap.  While assessments in many neighborhoods are rising 10 percent or more, the increases are not large enough to trigger the cap.

This means that owners of the most valuable homes in DC are paying taxes on less than the full value of their home, while owners of more modest homes in less well-off areas are paying tax on the full value of their home.  Not surprisingly, most of the cost of the property tax cap — which will reach $20 million in 2003 — reflects benefits to owners of the most expensive homes.

  • The average tax break for homes worth $750,000 or more is $1,900.
  • Some 54 percent of the benefit of the property tax cap is going to owners of homes worth $500,000 or more, even though they account for just eight percent of DC homes.

Given the significant costs and inequities created by DC’s property tax cap, policy makers should consider limiting the cap in one or more ways.

  • The property tax cap should be considered a temporary measure as DC fully implements its new assessment system.  Eligibility for the cap should be limited to one or two years.
  • The cap should be available only to homes below a specified value, such as $500,000.
  • When the District’s overall fiscal conditions improve in the future, District officials should consider reducing the property tax rate to respond to rapidly rising assessments, rather than maintaining a cap.

These steps would improve the equity of the District's property tax system, by ensuring that all homeowners pay tax on the full value of their home, and would raise revenues in an equitable manner to address DC's serious revenue shortfall.

Income Tax Changes

In 1999, the DC Council enacted a package of tax reductions — the Tax Parity Act — to be phased in through fiscal year 2004.  Income tax reductions under the Tax Parity Act were implemented through 2001 but were suspended in both 2002 and 2003 due to poor economic and budget conditions.

The deficit projections for 2004 prepared by the CFO assume, however, that the Tax Parity Act will resume and that $24 million of income tax relief will be implemented. The largest benefits from these tax reductions would go to DC's highest income residents.  The tax break for a family of four with income of $50,000 would be roughly $80, while a family with income of $150,000 would receive a tax break of more than $400.

Because the District is facing a projected budget deficit, District officials should consider suspending the income tax reductions in 2004.  This would be consistent with statements made by supporters of the Tax Parity Act when it was enacted.  The sponsors of the legislation agreed that the tax cuts should be suspended if the District's fiscal conditions became weak.10   Suspending the tax cuts also would be consistent with budget legislation enacted in 2002.  That legislation included a provision requiring the suspension of the Tax Parity Act in 2004 if the "proposed budget will not be balanced … if the scheduled tax rate decrease … takes effect."11

In addition to suspending scheduled income taxes, District officials also could consider an increase in income taxes for upper-income residents, either on a permanent or temporary basis.  Some states have taken this step or have proposed doing so in recent years.

  • North Carolina, Nebraska, and Oklahoma raised income taxes on high-income residents in 2002.
  • The governors of California, Connecticut, and Missouri have proposed income tax increases this year.  In California, the proposed increases would come from adding two new tax brackets — 10 percent and 11 percent — for its highest income residents.

As noted above, income tax liabilities have fallen in the District since 1999 as a result of the Tax Parity Act.  This means that an increase in income taxes could be designed to offset a portion of the tax reductions implemented in recent years — so that most families would retain some benefit of the income tax reductions.

Under a five percent income tax surcharge for families with incomes above $100,000, a family of four with income of $150,000 still would pay $313 less in income taxes than it did in 1999.

A five percent income tax surcharge would leave all families with incomes under $260,000 with a lower tax burden than in 1999.

Impact of a 5% Income Tax Surcharge on High-Income DC Residents


Income Level for Family of Four




Income Tax in 1999




Income Tax in 2004 with a 5% Surcharge








One advantage to raising revenues in this manner is that most high-income families facing increases in DC income taxes would experience a reduction in their federal income taxes that would offset a significant share of their DC tax increase.  This is because residents who itemize deductions on their federal income tax are allowed to deduct the full amount of DC income taxes from their federal taxable income.  The tax savings from this deduction can be significant — equal to more than one-third of the DC income taxes paid.  A $500 income tax increase for a high-income family in the District, for example would be offset by a reduction of up nearly $200 in their federal income tax liability.

End Notes:

1. See DCFPI’s recent report, “Dealing with the Deficit: Eliminating DC’s $323 million Budget Shortfall for 2003 Has Meant Substantial Spending Cuts, Notable Revenue Increases” (http://www.dcfpi.org/2-11-03bud.htm)

2. Center on Budget and Policy Priorities, “Closing Three Common Corporate Income Tax Loopholes Could Raise Additional Revenue for Many States,” 2002, p. 1. (http://www.cbpp.org/4-9-02sfp.htm)

3. Delaware has a special income tax exemption for corporations whose activities are limited to owning and collecting income from intangible assets.   Nevada does not have a corporate income tax.   Some other states also offer favorable tax treatment of intangible income.

4. Center on Budget and Policy Priorities, op cit., p. 7.

5. Walter Hellerstein, "The Business-Nonbusiness Income Distinction and the Case for Its Abolition," State Tax Notes, August 22, 2001.

6. The 18 states are Connecticut, Delaware, Florida, Georgia, Iowa, Maine, Maryland, Minnesota, Massachusetts, Nebraska, New Hampshire, Oklahoma, Pennsylvania, Rhode Island, South Carolina, Texas, Vermont, and Virginia.

7. See District of Columbia Tax Revision Commission, Taxing Simply, Taxing Fairly, 1998, p. 95.

8. Ibid., p. 95.

9. DC Fiscal Policy Institute, “DC’s Property Tax Cap: High Costs, Uneven Benefits,” January 2003.

10. For example, Council member Jack Evans stated that "David [Catania] and I have said all along that if there were any sign of a revenue shortfall, we would stop the tax cut and reverse it if necessary." Washington Post, April 29, 1999, page E3.

11 Fiscal Year 2003 Budget Support Act of 2002, Section 802 (b).

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