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Chapter 2. Recommendations for Changing CourseSimplicity and fairness for businessesThe Commission recommends abolishing four existing business taxes--corporate income tax, unincorporated business tax, tangible personal property tax, and business and professional licensing tax--and replacing them with a broad-based general business activities tax at a rate of 1.50 percent. This tax will raise the same amount of revenue as the taxes it replaces (Figure 17). Figure 17
The business activities tax is the cornerstone of a fundamental change in the way the District taxes business organizations. Current business taxes have high tax rates, are inequitable, contain confusing and complex administrative provisions, and do not provide stable revenue for the government. The business activities tax, in contrast, is fair, inclusive, and easy to administer. It will be imposed on a base that includes three elements: compensation, interest, and dividends. These elements represent the business enterprise's outlays for the use of capital and labor in the District, i.e., the value added. Because the business activities tax includes compensation in its base, some may suggest that it violates the Home Rule Act (the federal law that serves as a city charter for the District). The Home Rule Act prohibits taxing any portion of personal income, "either directly or at the source thereof, of any individual not a resident of the District." The Commission, however, believes that a legal challenge to the tax is unlikely to succeed. (See Appendix F for more information about the legal issues that may pertain to the business activities tax.) Back to top of page — Back to Table of Contents Recommendation: Abolish the four existing business taxesThe District's four existing business taxes — corporate income, unincorporated business, tangible personal property, and professional license fee — do not tax businesses uniformly. The taxes have comparatively high rates, provide unstable revenues, and do not provide for revenue growth that reflects growth in the economy. In addition, they are administratively complex for both taxpayers and administrators. The District currently imposes a 9.975 percent rate on corporate and unincorporated profits, the fourth highest among states that impose this tax. The 3.40 percent rate on personal property values, coupled with the District's conservative depreciation allowances, is higher than all of Maryland's and most of Virginia's neighboring jurisdictions. The tax is also shown to have a negative effect on District job growth. In contrast, the recommended business activities tax on all businesses will have a low rate, 1.50 percent of a firm's value added. Revenues from the profit-based corporate income taxes are unstable because they fluctuate with the economy and drop dramatically during economic downturns. In the recession of the early 1990s, the corporate income tax revenue declined about 50 percent, from $125 million in 1989 to $63 million in 1992. It then rebounded to $114 million in 1994. The recommended business activities base would have increased each year over the same period, except for a 3 percent decline in 1991 and a 1.5 percent decline in 1994 (Figure 18). Figure 18
Finally, the existing business taxes cannot provide for adequate revenue growth, largely because the fastest-growing component of the District economy, the service sector, can easily and legally avoid paying these taxes. More than half of all those who work in the service sector work for professional service-based firms. In addition, from 1984 to 1994, all growth in the District's economy occurred in the private sector, and within the private-sector economy, all growth was in the service sector (Figure 19). Many service-sector establishments do not pay taxes on the income of incorporated or unincorporated businesses. They will, however, be required to pay the new tax, and its broad base will provide for a tax that keeps pace with the economy. Figure 19
Back to top of page — Back to Table of Contents Abolishing the profit-based corporate income taxThe corporate income tax on net income is based on the "ability to pay" philosophy. It taxes profits, the portion of a firm's revenues that remain after providing payments to labor, suppliers, and creditors. While basing taxation on ability to pay can be an important component of tax fairness, in practice this principle cannot be equitably applied to District businesses. A large proportion of profitable District businesses are structured in ways that allow them to manipulate their profits to avoid the tax. This is particularly characteristic of moderate-size corporations in a range of service industries in which profits can be converted easily to salaries or other personal service payments. This conversion poses greater problems for the District than for other jurisdictions throughout the country. In most states, higher personal income tax payments on the salaries or personal service income would offset the lower business taxes, but federal restrictions prevent the District from taxing much of this income. As a result, the corporate income tax falls inequitably on a narrow segment of District businesses. Because the ability-to-pay principle cannot equitably be applied to District businesses, the proposed business activities tax will be based on the benefit principle, which holds that burdens should be distributed according to the benefits that taxpayers receive from public goods and services provided by the government. The benefits a business derives from public services depend on factors such as the nature and scale of production — not the amount of profit that is earned. While both profitable and unprofitable businesses in the same industry are likely to derive similar benefits from public services, only the profitable businesses are taxable under a profits-based income tax. As a result, corporate and unincorporated taxes paid by various types of firms are inequitable when compared to the business activities of, and services consumed by, these firms (Figure 20). Figure 20
Back to top of page — Back to Table of Contents Abolishing the unincorporated business taxThe District's unincorporated business tax does not tax many unincorporated businesses, and its structure is unfair. In contrast with the District, few states impose a separate tax on unincorporated businesses. Instead, under the tax system in most states and the federal government, the income passes through to owners and then is taxed through personal income taxes at the individual level. The case is quite different in the District. The District is unable to tax many unincorporated business owners through their personal income tax because of the ban on taxing nonresident income. Instead, it levies a tax on unincorporated businesses with gross receipts over $12,000; then, to avoid double taxation, the District allows residents to exclude such income (specifically the portion that originates in the District) from income at the personal level. The District also provides a 30 percent salary allowance for owners and a $5,000 exemption in determining unincorporated net business income. Aside from these provisions, determination of taxable income and apportionment of taxable income to the District follow the same tax rules that govern the corporate income tax. The decision to create this complicated, separate tax for unincorporated business was prompted by a desire to maintain neutrality in the taxation of different forms of business organizations. But efforts to maintain uniform taxes have not been successful, primarily because individual income and corporate income taxes are not integrated. As a result, the tax burden for a firm depends more on how it is organized — as a corporation with shareholders or an unincorporated business with an owner — than on how much value it adds to the District or how many District resources it consumes. In addition, the prohibition against taxing nonresidents' income led the courts to rule in Bishop v. District of Columbia that the Home Rule Act prohibits the District from taxing income of unincorporated businesses owned by nonresidents that provide professional services. In response to this ruling, the District has foregone collecting the tax from any unincorporated business providing professional services, regardless of where the business's owners reside. To do this, the District has had to devise exceedingly complex rules for separating firms that are taxable from those that are not. The inability to tax unincorporated businesses that provide professional services is particularly damaging because the service sector is a large part of the District's economy (Figure 21). Figure 21
Back to top of page — Back to Table of Contents Eliminating the tangible personal property taxThe District's tax on personal property does not uniformly apply to all personal property, has a complex and obsolete approach to estimating depreciation, and is difficult to administer. In addition, it does not appear to relate to either ability to pay or benefits received from government services. Some problems with the tangible personal property tax--the unrealistic five-year depreciation of personal computers, for example — can be corrected, but require constant adjustment as conditions change. Other problems, however, are more complex. Consider the narrow tax base. It does not meet the test of uniform taxation because it is so limited, yet the Commission found reasonable justification for many of the existing exemptions, including exemptions for inventories, motor vehicles, and household furnishings. In addition, the tangible personal property tax places a heavy burden on tax administrators, who must discover business personal property, audit returns, and maintain realistic depreciation schedules. Businesses, in turn, must keep detailed records on the purchase costs and age of all taxable property. Back to top of page — Back to Table of Contents Eliminating the professional license feeThe professional license fee is a charge of $250 for individuals who hold occupational licenses, such as attorneys, physicians, and accountants who are licensed to practice in the District. The tax was first imposed in 1992 and adopted as an alternative to a proposed 2 percent gross receipts tax on professionals. The fee was designed to tax professionals who are not subject to the unincorporated business tax. Total revenue from this tax is less than $10 million annually. The Commission recommends repealing this tax because under the proposed business activities tax, professional firms will be taxed in the same manner as other businesses and the tax no longer will be needed. Back to top of page — Back to Table of Contents Recommendation: Enact a broad-based business activities tax at a rate of 1.50 percentThe Commission recommends a business activities tax that will tax all enterprises alike. It is equitable, has a low rate and broad base, provides revenue predictability and stability, and is likely to produce growing revenues without statutory rate changes. It also is simple for both administrators and taxpayers. The business activities tax achieves these attributes by assessing business activity value, which is common to all businesses operating in the District. Its 1.50 percent rate is significantly lower than the current 9.975 percent corporate income tax and the 3.40 percent personal property tax. The business activities tax can have a far lower tax rate than the taxes it replaces and still raise the same amount of revenue because of a broader base (Figure 22). Figure 22
Why tax businessesA principal reason for taxing businesses is to ensure that nonresidents support government services by bearing a share of the tax burden in the jurisdiction. A business firm is an organizational vehicle through which individuals derive benefits of economic activity in their roles as consumers, suppliers, workers, or shareholders. Given this principle, the question arises as to whether there is justification for taxing business. The answer is "yes" for a jurisdiction such as the District that operates in an open economy in which goods and services flow freely across borders. Nonresident individuals owning all or part of a resident business enterprise cannot effectively be taxed directly on their income, wealth, or wealth transfers which are derived from the business activity. Similarly, resident individuals can engage in spending outside the District and therefore avoid direct payments under conventional sales taxes. Thus, employing the business enterprise as a tax-collecting intermediary is the only procedure available for assessing individuals, wherever they may reside, for the benefit of public services which accrue to them indirectly through the business entity. There are several ways to tax businesses. The District's current system, like those of 46 states, is based on net income. The state of Washington taxes gross receipts from sales of goods and services instead of corporate income. Texas taxes capital stock, and Michigan and New Hampshire tax value added. The Commission concluded that the best alternative for the District is a business activities tax, which taxes the value added from economic activity that takes place within the District's borders. All businesses directly or indirectly depend on a range of tax-financed goods and services, such as a judicial system, police and fire protection, roads, and schools. Business taxes serve as a form of payment for public services. Even businesses operating at a loss consume government services. In looking for a broad uniform business tax, the Commission considered and rejected a tax on gross sales. Taxes on gross sales do not directly relate to business activities in the District because much of the value of what is sold is added outside the District. A gross receipts tax also permits pyramiding of taxes, or taxing purchases for resale two or more times. For example, a wholesaler pays the tax on its sales to retailers; retailers, in turn, pay the tax on the same goods and services when they are resold at the retail level. In addition, a gross receipts tax is not equitable unless it has multiple rates. Without multiple rates, high-volume, low-margin vendors are penalized relative to high-profit vendors. For example, a food wholesaler may operate on a profit margin of less than 5 percent, while retail jewelers may have profit margins of 50 percent or higher, but have fewer sales. If both vendors were subject to the same gross receipts tax rate, the wholesaler would have a significantly higher tax. Thus, a gross receipts tax cannot be equitable unless low-profit vendors can have a lower tax rate than high-profit vendors. These multiple rates, however, would result in complex administration and difficulties in defining sales subject to the different rates. For these reasons, the Commission believes that a tax directed at the value added in the District by businesses is a better tax. Back to top of page — Back to Table of Contents Summing up the benefits of the business activities taxEnacting a tax on business activities to replace the corporate income taxes and the personal property tax will have the following advantages:
Design of the business activities taxMichigan and New Hampshire currently impose taxes on business activity. While both states reach a similar end point of taxing the value added by firms, there are significant differences in the approaches used to do so. Michigan starts with a firm's federal taxable income, adds labor compensation, depreciation, net interest paid, and subtracts capital expenditures. New Hampshire uses a simpler approach by merely adding three factors: compensation, interest, and dividends. Because of its simplicity, the Commission used the New Hampshire model to develop its recommendation. The specific elements are as follows:
Calculating the baseThe business activities tax base is the sum of: (1) all compensation paid in wages, salaries, bonuses, commissions, or other payments paid on behalf of or for the benefit of the employees, officers, or directors of the business enterprise; (2) interest paid for the use of money or property, excluding interest on borrowings to fund financial assets; and (3) dividends or other distributions paid to the owners of the enterprise. Wages and benefits in the tax base include all payments to persons that are made pursuant to an employer-employee relationship. The definitions of employer and employee are the same as those used for federal tax withholding purposes. Amounts reported as self-employment income for federal tax purposes are considered compensation paid to the proprietor or partner and should be included in the base. The interest element of the tax base is designed to measure the value of borrowed or debt capital employed by the enterprise. This definition is intended to exclude interest paid to depositors in the case of banks or other financial institutions and interest on borrowings to fund financial assets. Interest paid or credited by insurers to fulfill policy and contractual responsibilities to policyholders also should be exempted from the tax base. Dividends from an affiliated subsidiary that previously have been included in the payer corporation's taxable base should be deducted to avoid double taxation. A subsidiary is "affiliated" when the taxpayer owns at least 80 percent of its total voting power and 80 percent of the value of its stock. Back to top of page — Back to Table of Contents Tax nexusAny proposed tax must address whether, and to what extent, the District can tax enterprises that operate outside the District but perform business activities within the District. Constitutionally, the District can tax an entity only if it has a legal nexus, or presence, in the District, and it can only tax activities occurring within the District. The Commission's broad definitions of business enterprise and business activity should create a taxable nexus for just about any activity carried on in the District. Although Public Law 86-272 (15 U.S.C. Sec. 381) prohibits taxing personal income of individuals whose only presence in a state is soliciting, a Michigan court in Gillette v. Department of Treasury ruled that a business activities tax is not an income tax and not subject to Public Law 86-272. Therefore, the District's nexus for purposes of taxing business activities should be broad and inclusive. ApportionmentA business with activities that are taxable both within and outside the District should apportion its business activities tax base so as to allocate to the District a fair and equitable proportion of such base. The tax is not a separable series of several smaller taxes on compensation, interest, and dividends, but an indivisible tax on business activity. Therefore, taxpayers must determine their apportioned District tax base. Apportionment is calculated by multiplying the total business activity tax base of the enterprise in all states — compensation, interest, and dividends — by the portion of its business activities attributable to the District. Taxpayers use the average of three ratios to calculate apportionment, just as the corporate income tax is apportioned under the existing system. The ratios are: (1) District payroll to total payroll; (2) District property to total property; and (3) District sales to total sales. Back to top of page — Back to Table of Contents Recommendation: Introduce a single commercial property tax rateThe District currently has five real property tax classes, two for residential, two for commercial, and one for vacant property. The highest rate, the one on vacant property, is 5 percent, compared to a 0.96 percent residential rate. Both Maryland and Virginia, in contrast, have a single uniform tax rate of about 1 percent on all properties. The Commission recommends eliminating the multiple classes and having a two-tier system with one commercial rate and one residential rate. Moreover, the rate on commercial property should be no more than double the residential rate. The recommended commercial rate, which assumes that the residential rate is maintained at 0.96 percent, is 1.92 percent (Figure 23). (For more information on residential real property tax rate recommendations, see page 69.) Figure 23
Back to top of page — Back to Table of Contents A growing discrepancyIn 1978, the District had one uniform tax rate on all types of property, a system that still is used by all the adjoining suburbs. A separate tax rate on commercial property was introduced in 1979 with a rate that was a modest 119 percent of the residential rate. In 1986, a separate lower commercial rate for hotels was enacted, and in 1991, a higher rate was established on vacant properties. In addition, the general commercial rate has been changed four times since 1980. The current general commercial rate is 224 percent of the owner-occupied residential rate (Figure 24). This 224 percent difference is among the highest in the country — the fifth highest of the 32 states that permit separate rates on commercial property. Figure 24
Back to top of page — Back to Table of Contents Effects of inflated property taxesToday's 2.15 percent general commercial rate is almost double the next highest rate on commercial property in the Washington area. This differential endangers commercial space development and leasing, and statistical evidence also shows that the classified property tax reduces net District employment. The Commission concludes that the high rate and uncertainty caused by the growing increase in the gap with the residential rate have had a damaging effect on the value of commercial real estate. The lower rate for hotel properties was justified at a time when commercial development was generally robust, but hotel development was lagging. In recent years, however, hotels have been doing well compared to other commercial properties, and the Commission does not believe a separate rate is justified for economic reasons. Any problems with inequities in the way that hotels are valued should be addressed as an assessment issue. The separate, higher rate on vacant properties was expected to act as an incentive to their development or rehabilitation. It also was expected to address concerns that vacant properties would become neighborhood centers for illegal activities. There is no evidence that the higher rate has been successful in changing the situation. In addition, it has created severe problems of fair administration and compliance. The Commission believes that the goal of turning vacant properties from community liabilities to assets has merit, but that the property tax structure is an inappropriate instrument for achieving this end. Back to top of page — Back to Table of Contents Achieving equity for real property taxesThe Commission considered returning to a single uniform property tax rate for both commercial and residential properties, but rejected this option for two reasons. First, reducing the commercial rate to the current residential rate would create a major revenue loss. The only other path to a single rate — increasing the residential rate — is unfair to residents. Second, the high commercial rate reflects the District's need to overcome its inability to tax income at its source. One of the few ways that the District has to assess nonresidents — those who use District services but pay no District income taxes — is to tax the properties where they work. If the District is allowed full access to its tax base, a single, uniform property tax rate should be enacted. The Commission recommends a commercial rate that is no more than twice the base residential rate, or a rate of 1.92 percent, assuming the residential rate is maintained at 0.96 percent. The estimated net cost of lowering the general commercial and vacant property rates, while slightly increasing the hotel rate, is about $48 million. The Commission has not identified a source to offset this lost revenue, but recommends that this change be made as soon as the fiscal situation permits. (For more information, see Tax Reductions, page 85.) Back to top of page — Back to Table of Contents Simplicity and fairness for individualsThe Commission's recommended changes for individual taxpayers include simplifying District income tax filing, introducing a single 0.96 percent residential real property tax rate, and replacing current real property tax relief measures with a generous circuit breaker. Other Commission recommendations, such as the new business activities tax, also will affect individual taxpayers. These Commission recommendations, when fully enacted, will affect individuals' total tax burden. For the poorest 20 percent of taxpayers, taxes as a share of income will decrease by 1.9 percentage points. Those in the top 20 percent of taxpayers, however, will see an increase of 0.5 to 0.7 percentage points in their taxes as a share of income (Figure 25). Figure 25
Back to top of page — Back to Table of Contents Recommendation: Reduce complexity by conforming the District income tax to federal net taxable incomeDistrict residents use the same adjusted gross income to calculate their federal and District income taxes. The net taxable income, however, is different because the District has lower personal exemptions and standard deductions and allows different itemized deductions. The Commission recommends that District residents calculate their District income tax liability using the net taxable income amount from their federal tax returns. This change will simplify the process of calculating District tax liability and remove income filing requirements for poor families. The higher personal exemption and standard deduction used in calculating the federal taxable income will increase the income level at which tax is first owed — and eliminate the requirement that up to 40,000 District residents file tax returns. As a result, no District taxpayer with income below the poverty level would have to file a tax return, and the District's current low income tax credit would no longer be required to protect low income households from the income tax. Tax administration will be made simpler by having fewer returns to process and having fewer District tax calculations on the return. Back to top of page — Back to Table of Contents Changes in exemptions, deductions, and filing statusUnder the Commission's recommendation, both personal exemptions and standard deductions will increase in allowable amount, and each year, they automatically will be adjusted for inflation. Indexing the personal exemption and standard deduction for inflation ensures that taxes do not increase when the buying power of a family's income remains stagnant. The District's current personal exemption is $1,370, and the standard deduction is $2,000. The federal personal exemption for 1997 is $2,650, and the standard deduction is $4,150 for a single filer, $6,050 for a head of household, $6,900 for married filing jointly, and half that level ($3,450) for married filing separately. The federal personal exemption and standard deduction are adjusted administratively each year to account for inflation, but the District's exemption and standard deduction only change when the Council passes new legislation. If inflation adjustments had been made since the last Council action, in 1997 the personal exemption would have been $1,602 and the standard deduction would have been $2,795. Under the Commission's recommendation, interest on obligations of the federal government and income received while not a District resident will still need to be subtracted out of federal taxable income, and the federal deduction for District taxes paid will need to be added back. Some income currently not taxed under District law will become taxable, including portions of Social Security income, disability income, and pension and annuity income. However, some District residents who are 65 years of age or older may benefit from the higher federal standard deduction for senior citizens. Some federal reductions in income currently taxed by District law no longer will be subject to the District tax, including deductions for contributions to Individual Retirement Accounts. Finally, the recommended change generally will require taxpayers to file District returns using the same filing status used in the federal return. The federal tax code allows for four categories: single, head of household, married filing jointly, and married filing separately. The District allows for an additional status, married filing combined separate, which would be eliminated. Most District taxpayers who currently file married-filing-combined-separate in the District would change their filing status to married-filing-jointly. The District's married-filing-combined-separate status allows married couples to avoid paying the highest marginal tax rate on all of one spouse's income. Those who use this status benefit because both spouses can have earnings taxed at less than the top marginal rate. The Commission addresses this concern by proposing tax rates that provide income brackets that are twice as wide for those who file married-filing-jointly than for those who file singly. Thus, a single person will face a marginal rate of 8 percent on the first $10,000 of income; a married couple will face the same 8 percent rate on the first $20,000 of income. A single person will pay the top marginal rate on taxable income over $25,000; married couples will face the same rate on taxable income over $50,000. This proposal also benefits married households with only one wage earner. Back to top of page — Back to Table of Contents Effect on rates and liabilityDistrict personal income tax rates will be changed to make the new tax base produce revenue that equals revenue from the current rates. The new tax rates should preserve the current top marginal rate of 9.5 percent and should be designed to parallel existing tax burdens among income classes. One proposal that will accomplish these goals — rates and income levels at which these rates would apply — is shown in Figure 26. While the proposed rates may appear to be higher than some of the comparable existing rates, the income levels at which the rates first apply are higher, so the higher brackets affect income at higher levels (Figure 27). Figure 26
Figure 27
Using these rates, it is estimated that the poorest 60 percent of taxpayers as a group would experience a small tax reduction. The next highest 20 percent would have no increase, and the highest 20 percent would have a slight increase (Figure 28). Of course, some individual taxpayers whose returns have unusual financial characteristics could experience changes in liability outside the average effects. Figure 28
The change in calculating net taxable income--from the current District tax code to conformity with the federal tax code — will account for most shifts in tax liability within income classes. As noted earlier, some forms of income currently are not taxable in the District, but would be under a policy of conformity. These income sources include Social Security income subject to federal tax, pension and annuity income up to the $3,000 cap now excluded, and distributions from unincorporated businesses. Under current law, distributions from some unincorporated businesses are taxed as profits at the business level, and this gross income is not included in the gross personal income of District residents. However, the Commission proposes to abolish the unincorporated business tax, so all personal income will now be taxed at the individual level, regardless of source. Back to top of page — Back to Table of Contents Making residential property taxes more equitableThe Commission recommends taxing all residential property at a uniform effective rate and providing property-tax relief through a single program that is based on ability to pay as measured by current income. To achieve this goal, the Commission recommends: (1) consolidating the 0.96 percent owner-occupied rate and the 1.54 percent rate on rental properties into one 0.96 percent tax rate; (2) repealing the $288 homestead exemption for owner-occupied properties and the 50 percent tax reduction programs for senior citizens with incomes less than $100,000; and (3) consolidating the two programs that provide relief based on property-tax liability related to income into a single more generous program. These changes are recommended to provide equity among residents of the District and to remove the administrative confusion and complexity that accompany the existing residential tax system. The existing tax relief programs result in substantial differences in effective residential tax rates. Under the current system, properties occupied by owners who pay District income taxes are taxed at rates less than the 0.96 percent rate; some are taxed as low as 0.18 percent. These rates contrast with a 1.54 percent rate for rental residential properties (Figure 29). Current rates do not provide appropriate relief based on ability to pay for either homeowners or renters. The rates cause administrative problems and taxpayer confusion. For example, all homeowners must certify their status as both homeowners and District income tax payers to receive the exemption. Failure to file the required form results in disallowance of the exemption. Figure 29
Back to top of page — Back to Table of Contents Recommendation: Introduce a single 0.96 percent residential property tax rateThe Commission recognizes that establishing a single residential property tax rate will be difficult. A single rate will require either increasing the lower rate paid by homeowners or incurring the revenue loss of a decrease in the rate on rental properties. Because repealing the $288 homestead exemption and the senior citizen reduction will increase the effective property tax rate on homeowners from an average 0.73 percent to the stated rate of 0.96 percent, the Commission does not recommend increasing the 0.96 percent rate. Instead, the Commission recommends reducing the 1.54 percent rate to 0.96 percent. This decrease will result in an estimated $41 million loss in revenues for which the Commission is unable to identify a revenue-neutral source within the District's current resources. Therefore, it recommends establishing a single residential rate as a long-term goal to be achieved as rapidly as the city's improving fiscal situation permits or the federal government begins to meet its financial obligation to the District, consistent with the Commission's recommendations (discussed in the next section of the report). Back to top of page — Back to Table of Contents Recommendation: Replace current property relief measures with a generous low-income tax credit (circuit breaker)The District currently provides lower property taxes to homeowners for a variety of reasons, including age, physical condition, and owner occupancy of residences. The Commission believes, however, that all residents of the District receive the benefits of government services and are entitled to equal treatment, regardless of whether they rent or own, or are old or young. Therefore, the Commission recommends repealing the $288 homestead exemption, which is based solely on home ownership, and the senior citizen reduction, which is based on age. Reduction of property taxes should go only to those who need the most help paying their taxes. It should be noted that the Commission supports home ownership, but concludes that other incentives--the ability to deduct property taxes and home mortgage interest from personal income taxes, and the first-time federal homebuyer credit of $5,000 — are more appropriate than property tax incentives to encourage homeownership. The two existing circuit breakers, which the Commission recommends consolidating into one, are specifically designed to provide relief through the personal income tax to both renters and homeowners based on the relationship between income and the amount of property tax liability. They provide relief in hardship cases without providing relief to high income homeowners. The elderly, blind, and disabled circuit breaker is more generous than the all-ages circuit breaker. Both relief programs provide relief to homeowners with a maximum of $20,000 in income. The maximum relief is $750. The formulas used in both circuit breaker programs are quite complex in that they use both a threshold and a sliding scale, and they must be claimed on the income tax form. The complexity of these circuit breakers no doubt contributes to the low number of taxpayers who use them. In 1996, 115,633 District taxpayers, or 43 percent of the total, had incomes below the $20,000 ceiling for use of the circuit breaker. Among these relatively low-income taxpayers, only 14,450, or 12.5 percent of all low-income taxpayers claimed this exemption (Figure 30). Figure 30
The Commission therefore recommends a single relief measure in the form of a generous, revised circuit breaker. This revised circuit breaker should be simple and have only one criterion for eligibility: ability to pay. The circuit breaker should have the following characteristics:
The Commission's proposed property tax relief through the new circuit breaker should be accomplished on a revenue-neutral basis so the total amount of relief is the same, but the basis for allocating it is more equitable. The homestead exemption, consisting of a $30,000 reduction in assessed value for owner occupied properties that creates a $288 savings for each homeowner, has a revenue cost of about $27 million. The tax reduction of 50 percent of the tax liability for taxpayers over 65 who own and occupy their property and have less than $100,000 of household income has a revenue cost of about $13.6 million. The two circuit breakers together cost about $9 million. Thus, repealing all four of these programs will make approximately $49.6 million available for a new means-tested tax relief program. A sample circuit breaker with these characteristics could provide relief starting at 85 percent of tax liability for household gross income under $5,000, with decreases in relief of 5 percentage points for each additional $5,000 of income (Figure 31). The Commission believes such a program will be revenue neutral but was unable to obtain from the city the information needed to test this premise. Some adjustments may be necessary when additional information is available. Figure 31
Because of the differences among taxpayers in the relationship between incomes and house values, it is difficult to determine how each taxpayer would fare under the new program relative to the prior relief programs, but two results are apparent. First, many homeowners will receive a greater benefit from the Commission's proposed relief measure, but homeowners with incomes over $85,000 will no longer receive the $288 in tax relief now given to them by the homestead exemption (Figure 32). The Commission does not believe this creates a hardship. Figure 32
Second, taxpayers whose 50 percent senior citizen reduction in liability was more than $1,000 will get reduced relief because of the $1,000 limit on relief under the new program, and some with higher incomes and high-value properties will experience substantial percentage increases in their tax liabilities (Figure 33). For example, a senior citizen with a $70,000 income and a $180,000 home would see tax relief reduced from $1,008 to $346. Therefore, the Commission recommends that the senior citizen reduction be phased out over several years. Figure 33
Back to top of page — Back to Table of Contents Recommendations for the federal governmentA history of federal assistanceThe District's relationship with the federal government is unique. Over the years, the two governments have had various financial arrangements, including the 41-year period from 1879 to 1920, when the federal government paid for half of all District expenditures. The history and equity of these arrangements have been the subject of numerous studies. Most of them, including recent ones by the Commission on Budget and Financial Priorities (Rivlin Commission), D.C. Appleseed Center, Carol O'Cleireacain (Brookings Institution), and McKinsey and Company, conclude that the District has been given inadequate compensation to offset its special costs and restricted revenue-raising capacity. The federal government prohibits the District from taxing nonresident incomes, federally owned properties and other properties specified in federal law, federal purchases of goods and services, and profits of some District corporations. Historically, these federal tax limitations have been offset to a degree by a direct federal payment to the District. This payment in fiscal year 1997 was $665.7 million, or about 20 percent of all locally raised revenues. During 1997, the traditional arrangement of federal support in the form of a federal payment was dramatically altered by the federal government's assuming direct responsibility for some District costs by a federal "contribution," and by the creation of federal tax incentives available only in the District. As a result of these actions, there no longer will be a federal payment. The net result of these changes is that in fiscal 1998, the District will receive a little more than $900 million in direct assistance, which is roughly $236 million more in direct assistance than it received in fiscal 1997 (Figure 34); $190 million of this additional assistance, however, is in the form of a one-time contribution that may or may not be renewed in future years. Figure 34
Uncertainty notwithstanding, the changes provide important long-term benefits because they relieve the District of its financial responsibility for adult corrections (jails and prisons) and the unfunded local retirement systems, and reduce the local responsibility for Medicaid by 40 percent. Over the period from 1991 through 1996, costs of the retirement systems alone grew from $224 million to $336 million, a 50 percent increase. The federal tax incentives provided in 1997 are expected to provide $1.2 billion in benefits over the next 10 years (see Appendix C), although the amount will depend on how extensively the incentives are used. While the benefits will go to private firms and individuals and only indirectly to the District government, they may provide a significant advantage to the District in its efforts to encourage businesses and people to locate in the city. Despite the federal 1997 initiatives, additional actions are required to ensure that the District will have stable revenues to support its needs. The District must have access to reliable revenues, not just discretionary appropriations for annual budgets, such as the current "contribution." The federal government can provide revenue certainty to the District through a variety of actions. These include the three principal provisions that have long been sought by the District: (1) permitting the District to impose a tax on nonresident earnings; (2) making a payment in lieu of taxes for federally owned buildings; or (3) adopting a formula federal payment or contribution. Concerned parties have discussed all three options over the years, and the District has made a strong case for each of them. Back to top of page — Back to Table of Contents Recommendation: Allow the District to tax income at its sourceThe Commission's highest priority for help from the federal government is lifting the ban on the District's ability to tax all income at its source. No state government is prohibited from taxing revenue earned within its borders. If this ban were lifted, the District could assess everyone who uses its services. Some of the distorted tax arrangements now used to make up for the ban on nonresident taxes could be eliminated. For example, the top marginal personal income tax rate, which is the highest in the area, could be reduced. Of course, the District will have to exercise discretion in how it taxes nonresident earnings to avoid making the District noncompetitive with the suburbs. However, this is a judgment that is appropriately made by District officials in the same way that all taxes imposed must be evaluated. Back to top of page — Back to Table of Contents Recommendation: Make a payment in lieu of taxes for federally owned propertyThe Commission recommends that the federal government make an annual payment in lieu of property taxes to the District. Other properties that the federal government has exempted, such as the World Bank, the International Monetary Fund, and other international organizations, should make in lieu payments, or the federal government should make in lieu payments on their behalf. There are adequate legal and policy precedents for such payments because the federal government already makes payments in lieu of taxes in other parts of the country and pays sewer and water charges to the District. In addition, the federal government already pays imputed property taxes on space it leases in the District, and it has agreed to make payments to the new business improvement districts when federal buildings are located in these areas. It is difficult for the Commission to understand why the federal government will pay its share for street sweepers hired by the improvement district but will pay nothing for those hired by the District government. If the federal government were to acknowledge its property tax responsibilities, the District could substantially reduce its commercial property tax levy and make it competitive with nearby jurisdictions (Figure 35). Figure 35
Payments in lieu of taxes should be made as payments from the General Services Administration building services revolving fund and should not be the subject of a separate annual appropriation to the District. This approach will make accounting for the tax payments in the federal budget the same as accounting for lease payments. Property owned by the federal government that qualifies for tax exemption under District property tax laws, e.g., the Mall, Rock Creek Park, the museum portion of the Smithsonian Institution, should not be subject to federal payments. Back to top of page — Back to Table of Contents Recommendation: Adopt a formula federal paymentIf the federal government neither lifts the ban on taxing nonresident income nor makes a payment in lieu of property taxes, it should make a formula payment to the District. The Commission is not recommending a specific formula because many others already have completed extensive work on the justification and design of a formula federal payment. A wealth of suggested solutions is available. For example, in a 1980 report, Federal Payment Formula, the House of Representatives Committee on the District of Columbia noted that "the legitimacy of a federal obligation to compensate the District for the extraordinary impact of the federal presence has been accepted by the majority of both Houses." This 904-page report discusses the problem of finding the proper means for meeting the federal obligation. It found that "over 150 [formula] Federal Payment bills have been introduced in the past 40 years alone." Not one of them passed. The problem has not been finding an appropriate federal payment formula. The problem has been getting such a formula approved. Back to top of page — Back to Table of Contents Recommendation: Ensure that the District is compensated for GSEs' federal exemption from District business taxesGovernment Sponsored Enterprises (GSEs) provide secondary markets for mortgage loans. GSEs operate under federal charters that exempt them from state business taxes. This exemption results in a loss of revenue in the states where GSEs do business. The Commission concluded that if Congress believes the exemption for GSEs has merit, the federal government should make payments to the states to compensate for this exemption. Back to top of page — Back to Table of Contents — Forward to next section |
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