The District of Columbia Considers Impressive Tax Reform Options

Download FISCAL FACT No. 427: The District of Columbia Considers Impressive Tax Reform Options

Executive Summary

On February 12, 2014, the District of Columbia 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 submitted its recommendations for overhauling the District’s tax system. The Commission, established in September 2011, had conducted dozens of meetings and hearings to develop its package of reforms, and the package as a whole received unanimous support from the Commission’s members.[1]

The Commission concluded that the District’s current tax system has three major shortcomings: (1) middle-class residents pay a relatively large share of their income in District taxes; (2) business taxes are too high; and (3) the District’s tax base is too narrow. The Commission’s recommendations seek to address these issues with reforms to 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. , business taxes, sales tax, and estate tax. Taken together, the recommendations balance competing priorities to improve the simplicity, fairness, neutrality, and economic competitiveness of the District’s tax system.

On April 3, D.C. Mayor Vincent Gray presented a budget proposal to the D.C. Council which includes two of the Commission’s recommendations (adopting single sales factor apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. and unifying tobacco taxes) and modified versions of two others (adding a 7.5 percent middle-income tax bracket and a business tax reduction from 9.975 percent to 9.4 percent) but did not include the rest.

Individual Income Tax

The Commission makes nine recommendations for reforming the District’s individual income tax:

• Filing Statuses: Consolidate the District’s eight filing statuses into five, matching the federal government.
• Joint Filers: Reduce the marriage penaltyA marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples. by creating separate tax bracketsA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. for married filers.
• Middle-Income Rate Cut: Add a 6.5 percent income tax bracket, reducing tax for those earning more than $40,000.
• Top Income Tax Rate: Reduce the top income tax rate from 8.95 percent to 8.75 percent in 2016 instead of the currently scheduled 8.5 percent.
• Tax-Free Income: Increase the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and personal exemption and adjust them annually 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. .
• EITC: Increase the Earned Income Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. (EITC) to 100 percent of the federal EITC for childless workers.
• PEP: Adopt a personal exemption phaseout (PEP) for high-income taxpayers.
• Remove unused credits: Eliminate the low income tax credit, District employee homebuyer tax credit, long-term care insurance deduction, and government pension exclusion.

Table 1 provides more detail on the Commission’s recommended changes to tax rates and brackets, the standard deduction, and the personal exemption.

Table 1: DC Tax Revision Commission Recommended Individual Income Tax Changes

	Current Tax System	Commission Recommendation
Tax Brackets and Rates	4% for income above $0 6% for income above $10,000 8.5% for income above $40,000 8.95% for income above $350,000	For single filers: 4% for income above $0 6% for income above $10,000 6.5% for income above $40,000 8.5% for income above $60,000 8.75% for income above $200,000 For married filers: 4% for income above $0 6% for income above $10,000 6.5% for income above $40,000 8.5% for income above $80,000 8.75% for income above $350,000
Standard Deduction	$4,100 Itemized deductions phased out for taxpayers with income over $200,000 by 5% of AGI over threshold	$6,100 (single), $12,200 (married), adjust annually for inflation Itemized deductions phased out for taxpayers with income over $200,000 by 5% of AGI over threshold
Personal Exemption	$1,675	$3,900, adjusted annually for inflation Phase out for taxpayers with income over $150,000 (single) or $200,000 (married) by 2% for each $2,500 above threshold

Source: District of Columbia; D.C. Tax Revision Commission.

The District’s income tax currently consists of four brackets: an initial bracket of 4 percent, with income over $10,000 subject to a 6 percent tax, income over $40,000 subject to an 8.5 percent tax, and income over $350,000 subject to an 8.95 percent tax. The rates apply to all tax filers, resulting in a significant marriage penalty for married couples. Neighboring Virginia imposes a top tax rate of 5.75 percent on income over $17,000 and middle-income taxpayers in neighboring Maryland counties pay a tax rate of 7.95 percent. Maryland and Virginia also have marriage penalties, although Virginia offers a credit designed to mitigate much of it.

Currently, income tax payers can itemize deductions or take a $4,100 standard deduction, plus exempt $1,675 of income per household member:

• A married couple with two children pays no tax on their first $10,800 in income.
• A single person with one child pays no tax on his or her first $9,125 in income

Under the Commission’s recommended system, the standard deduction will be raised to $6,100 for singles and $12,200 for married filers, matching the federal government. Additionally, the personal exemption will be raised to $3,900 per household member, again matching the federal government. Thus:

• A married couple with two children pays no tax on their first $27,800 in income.
• A single person with one child pays no tax on his or her first $13,900 in income.

This change, along with the new middle-income tax bracket and the reduction in the top tax rate, would result in almost all taxpayers seeing lower income tax bills. Table 2 reviews the change in income tax liability by seven hypothetical taxpayers. The most significant reductions occur for low-income workers and middle-income married taxpayers.

Table 2: Income Tax Liability for Seven Hypothetical Taxpayers under Proposed D.C. Tax Reform

	Van	Max	Jason & Nicole	Danielle	Laura & Jeremy	Sam & Ellen	Heidi & Bret
Filing Status	Single	Head of Household	Married	Single	Married	Married	Married
Income	$11,960	$23,920	$66,000	$75,000	$108,000	$360,000	$2,700,000
Children	0	1	2	0	1	0	2
Current D.C. Tax Bill	$175	($103)	$3,492	$4,650	$6,084	$26,429	$238,275
Proposed D.C. Tax Bill	($487)	($490)	$2,092	$4,061	$4,736	$25,914	$233,375
Dollar Change	($662)	($387)	($1,400)	($589)	($1,348)	($515)	($4,900)
Percentage Change	(378%)	(376%)	(40%)	(13%)	(22%)	(2%)	(2%)
Maryland Tax Bill	$354	$68	$3,859	$5,298	$6,397	$25,548	$221,607
Virginia Tax Bill	$236	$393	$2,979	$3,743	$4,798	$18,059	$143,911

Source: Tax Foundation calculations for tax year 2013. Assumes taxpayers with income below $75,000 take the standard deduction and taxpayers with income above $75,000 itemize at amounts based on IRS data: Danielle itemizes 6 percent of her income, Laura & Jeremy 16 percent, Sam & Ellen 11 percent, and Heidi & Bret 7 percent. Maryland taxpayer lives in Montgomery County and tax bill includes 3.2 percent local income tax. Proposed D.C. tax bill incorporates recommended changes to middle tax bracket, top tax rate of 8.75%, increased standard deduction and personal exemption, phaseouts of deductions and exemptions for high-income taxpayers, and increased EITC for childless workers.

The Commission considered but rejected a number of income tax proposals. A proposal to add more high-income tax brackets was rejected because they would exceed those of neighboring Maryland and widen the gap with Virginia. A proposal to further reduce the top income tax rate was rejected due to high revenue loss. A proposal to tax non-D.C. state bonds was rejected because the D.C. Council had recently voted against that approach.

Business Taxes

The Commission made four recommendations with respect to the District’s business taxes:

• Reduce the District’s franchise taxes (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. and tax on unincorporated businesses) from 9.975 percent to 8.25 percent, equal to Maryland’s 8.25 percent rate and closer to Virginia’s 6 percent rate.
• Expand the unincorporated businesses tax’s current personal services exemption to include investment funds, which are effectively nonexistent in the District due to the tax.
• Adopt single-sales factor apportionment.
• Impose a “local services fee” of $100 per employee per year on all non-governmental employers with five or more employees, to collect some revenue from commuting employees exempt from D.C. tax.

A proposal to eliminate business taxes was rejected due to high revenue cost, as was a proposal to adopt a gross receipts tax due to a high rate being needed and the likelihood of negative economic distortions. Proposals for targeted business tax incentives were also rejected.

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.

The Commission made four recommendations with respect to the District’s sales tax:

• Raise the sales tax rate from 5.75 percent to 6 percent, returning the rate to where it stood prior to October 2013 and matching the 6 percent sales tax rates in Maryland and northern Virginia.
• Expand the sales tax to consumer purchases of certain services: construction contractors and other construction-related services, storage of household goods and mini-storage, water for consumption at home, barber and beautician services, carpet and upholstery cleaning, health clubs and tanning studios, car washes, and bowling alleys and billiard parlors.
• Instruct taxpayers to pay use tax—a tax on the purchase of an item upon which sales tax has not been paid—on the income tax return, including an estimated use tax table to simplify recordkeeping.
• Replace an array of taxes on non-cigarette tobacco products (chewing tobacco, smokeless tobacco, snuff, and roll-your-own tobacco) with a single 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. of 80 percent of the wholesale price, equivalent to the $2.50 per pack cigarette tax rate if it were expressed as a percentage of wholesale price.

The Commission rejected further increases in taxes aimed at non-residents (18 percent parking tax, 14.5 percent hotel tax, 10 percent rental car tax, and 10 percent meals tax), as they would discourage business growth and job creation. The Commission also rejected a proposal to tax groceries and prescription drugs, citing other states’ practices. A proposal to adopt an “Amazon tax” on online sellers was also rejected as likely to be challenged in court and unlikely to produce much revenue.

Estate TaxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs.

The Commission recommended recoupling the District’s estate tax exemption level with the federal government exemption level, thus increasing the estate exemption from $1 million to $5.25 million and adjusting it annually for inflation. The Commission also recommended a simplified rate structure that maintains the top rate of 16 percent while reducing the number of brackets from 21 to three. Maryland and New York this year passed similar laws recoupling to the federal estate tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. .

The Commission rejected a proposal to eliminate the estate tax, citing revenue loss and skepticism about whether elimination would impact migration. Virginia does not impose a state-level estate tax, although Maryland does.

Property Tax

The Commission rejected a number of 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. proposals. A proposal to reduce residential property tax rates was rejected because they are already the lowest in the region. A proposal to reduce high commercial property taxes ($1.85 per $100 in value, compared with $1.22 to $1.42 in Maryland and $1.00 in Virginia) was rejected due to high revenue loss and because a franchise tax reduction would have greater impact. A proposal to tax land at a higher rate than buildings was rejected because no other major city does so. A proposal to reduce the District’s deed and recordation taxes (which range from 2.2 percent to 2.9 percent) was rejected due to skepticism that it would have an effect on transactions.

Revenue Impact

Table 3 illustrates the revenue impact of the Commission’s recommendations, which would reduce annual revenue by approximately $52 million to $74 million out of the District’s $7 billion annual budget.

Table 3: Projected Revenue Impact of D.C. Tax Revision Commission Recommendations

(millions of dollars)

Recommendation	FY 2015	FY 2016	FY 2017	FY 2018
Income tax changes (create middle-class tax bracket, increase standard deduction, increase personal exemption, expand EITC, and other changes)	-$124.8	-$103.7	-$109.0	-$111.8
Reduce business tax rate from 9.975 percent to 8.25 percent	-$57.0	-$59.9	-$62.6	-$65.4
Adopt single-sales factor apportionment	+$20.0	+$21.0	+$22.0	+$22.9
Impose $100-per-employee local services fee on non-governmental employers	+$45.0	+$45.5	+$45.9	+$46.2
Raise sales tax rate from 5.75 percent to 6 percent	+$20.5	+$21.3	+$22.1	+$23.0
Expand sales tax to select services	+$28.2	+$29.3	+$30.4	+$31.5
Add use tax collection to income tax form	+$1.0	+$1.0	+$1.1	+$1.1
Unify taxation of tobacco products	+$7.0	+$6.9	+$6.8	+$6.6
Total Revenue Impact	-$74.0	-$52.5	-$57.3	-$59.6

Source: D.C. Tax Revision Commission.

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