D.C. Tax Revision Commission Recommends Major Tax Changes

On January 5, the D.C. TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Revision Commission published a “chairman’s mark” previewing recommendations that would make sweeping changes to certain business taxes, introduce several new taxes—including a business activity tax and a data excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. —and significantly alter various income, property, and excise tax provisions. This is not the final word on the Commission’s recommendations, but it likely reflects members’ current thinking.

While some recommendations follow the principles of sound tax policy and may improve the District’s tax climate, some proposals make the tax code more complex and less neutral, potentially disincentivizing investment and business activity.

Business Activity Tax: GRT, VAT, or Something Else?

The chairman’s mark defines the new business activity tax (BAT) as “a low-rate, broad base ‘value-added tax’ on gross receipts minus the sum of purchases from other businesses, rent, and capital expenditures.” The proposed tax rate is 1.4 percent, and it is fully creditable against other income taxes imposed by D.C. (i.e., the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. and the corporate franchise tax).

Essentially, the formula for calculating one’s tax liability is as follows:

BAT=1.4%*(Gross Receipts-Business Purchases-Rent-Capital Expenditures)

While neither a gross receipts taxA gross receipts tax, also known as a turnover tax, is applied to a company’s gross sales, without deductions for a firm’s business expenses, like costs of goods sold and compensation. Unlike a sales tax, a gross receipts tax is assessed on businesses and apply to business-to-business transactions in addition to final consumer purchases, leading to tax pyramiding. nor a value-added tax, the BAT is much closer to the former than the latter because it taxes income, not consumption. However, gross receipts taxes, such as Washington’s business and occupation tax or Ohio’s commercial activity tax, typically do not allow corporations to subtract business purchases or investment costs from the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , which makes them one of the most harmful and nonneutral taxes. The BAT thus has a much narrower base than gross receipts taxes and is much less distortive. It is, however, different from a typical corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. because it does not require the corporation to be profitable in a given year to have a tax liability. In the case of D.C., corporations with no corporate franchise tax liability may still be required to pay the BAT.

Transparency and stability are the biggest problems with the BAT. The ultimate tax liability for any corporation or partnership is unpredictable and depends on several different factors, including capital intensity, tax status, and the total amount of other income taxes owed to D.C. For instance, a partnership owned by nonresidents (untaxable in D.C. given federal restrictions on the District taxing nonresident income) with little to no capital expenditures and rent payments can face a high BAT bill. In contrast, a profitable corporation with a significant corporate franchise tax liability and high capital investment activity may face a very small BAT bill, or none at all.

The Commission estimates that this new tax has the potential to generate $275 million in the first year of implementation (FY 2025), which would constitute about 2.5 percent of general fund revenues. Although revenue projections may change, one thing is clear: indirect transaction costs, including implementation and compliance, will be high for D.C. residents and nonresidents alike.

Repealing the Personal Property TaxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services.

Currently, D.C. taxes business personal property (machinery, equipment, fixtures, and other tangible property) but provides an exemption for small businesses: the first $225,000 of taxable value is not subject to tax. The District is not alone; 36 states tax business personal property and 10 states provide exemptions for small enterprises.

The biggest problem for D.C. is the fact that all businesses must file a personal property tax return (FP-31). According to the chairman’s mark, about 60,000 returns were filed during FY 2023, out of which only about 1,500 were non-zero returns. Notably, more than 90 percent of personal property tax revenue came from just 300 returns.

Repealing the tax would cost the District $77 million a year, which is just about 0.5 percent of general fund revenues. At the same time, this would significantly improve administrative simplicity and reduce compliance costs for small and medium-sized businesses operating in D.C. By eliminating this tax, the District would join the list of 14 states that do not tax business personal property, which includes New York, Illinois, and Pennsylvania.

Data Excise Tax: Small but Harmful

Concerned with online platforms’ use of D.C. residents’ personal data, the Commission considered several mechanisms for taxing “data mining” and digital services. Acknowledging legal challenges that Maryland’s notorious digital advertising tax currently faces, the Commission proposed to abstain from imposing a broad digital services tax. Instead, it suggested introducing a data excise tax, which would be a “tax on businesses that are extracting data from D.C. residents at an annual rate of $4 per participant.” The tax is inspired by New York’s proposed excise tax on the collection of consumer data, introduced in 2021 but never brought to the floor.

The projected revenue from the tax is estimated to be a mere $7 million. While raising relatively little revenue, this tax would be hard to administer and enforce, subject to future court challenges, and, as correctly pointed out by the Commission itself, perceived as “tech-unfriendly.” It could apply not only to companies collecting data for marketing purposes, but also to companies keeping customer sales records or maintaining loyalty rewards accounts. Instead of creating a separate tax, the District may consider broadening the sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. base to include some additional digital services used for personal consumption (Governor Youngkin has recently made a similar proposal in Virginia).

Other Proposals

The Commission’s recommendations include several other proposals that constitute sound tax policy. In particular, repealing basic business license fees and the unincorporated business franchise tax reduces administrative burdens for many businesses without losing much revenue. It is projected that eliminating these revenue sources would result in a loss of $97 million, which is less than 1 percent of general fund revenues.

Indexing individual income tax brackets for inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. prevents unlegislated tax increases, mostly for low- and medium-income taxpayers, at a trivial annual cost of less than $10 million. This is another step in the right direction.

Reducing real commercial property tax rates by 0.1 percentage points (from 1.65-1.89 percent to 1.55-1.79 percent, depending on the property’s assessed value) and eliminating tax recapture provisions where top rates are not marginal but are rather applied to the entire assessed value of the property would make the District somewhat more competitive with its neighbors. Commercial property tax rates are significantly lower both in Virginia and Maryland.

Applying the unified property tax assessment limit to all homestead properties and eliminating a special 2 percent limit for seniors would reduce the distortions caused by differential rates and make the tax system more neutral.

To raise an additional $41 million for the District’s budget, the Commission proposes either to increase the top residential property tax rate for properties with assessed value of above $2 million from 0.85 percent to 1.04 percent or to raise the tax rate for all properties to 0.95 percent and simultaneously increase the homestead deduction to $225,000. Both proposals have significant disadvantages: the first essentially makes the residential property tax progressive, adding complexity and potentially incentivizing affluent individuals to relocate (at which point they will no longer pay D.C. income taxes even if they continue to work in D.C.), while the second makes the tax base significantly narrower and thereby violates the “broad base, low rate” maxim of tax policy.

Some other proposals made by the Commission are relatively minor from the revenue adequacy perspective but reflect major trends in state taxation. They include raising the cigarette excise tax to $5.50 (second highest in the country after New York City, with neighboring Virginia at $0.60), expanding certain income tax credits, taxing electric vehicles at the same rate as other cars and trucks, and transitioning from the Joyce rule to the Finnigan rule as a method of applying corporate franchise tax to multistate corporations.

Conclusion

While some of the D.C. Tax Revision Commission’s proposals would clearly improve D.C.’s tax competitiveness, others would increase complexity and reduce neutrality. When finalizing the draft of its comprehensive recommendations, the Commission should consider the principles of sound tax policy and the effects of proposed tax changes on various groups of individuals, corporations, and pass-through entities.

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