How to fix Washington, DC’s, tax system

An advisory commission has recommended some interesting changes to the District of Columbia’s tax system. The commission’s proposals may provide some useful lessons for other states looking to reform their tax codes.

In some ways, of course, DC is unique. While it is a city, it functions much like a state. However, because of its odd status, DC’s ability to tax is constrained by Congress. Economically, DC is booming and the city escaped relatively unscathed from the Great Recession. Its enormous federal presence provides a powerful employment base, but it also means a huge chunk of the city’s economy is excluded from taxation.

For all of that, the commission had to address many of the same problems faced by other state tax reform initiatives: How to make its individual tax code simpler and more progressive, how to design a stable business tax, and how to broaden its sales tax base.

The DC tax reform proposal was developed with the help of several of my Tax Policy Center colleagues. Kim Rueben served on the commission, Steve Rosenthal was its staff director, and Norton Francis provided technical support.

On the individual tax side, the panel suggested several steps to lower income taxes for middle-income households. The city currently has four brackets, but its second highest, 8.5 percent, is extremely wide and applies to taxable income from $40,000 to $350,000. The top rate, currently 8.95 percent but scheduled to drop to 8.5 percent in 2016, applies to taxable income in excess of $350,000.

The proposal would create a new 6.5 percent bracket for income between $40,000 and $80,000. It would also set a top rate of 8.75 percent, slightly lower than the current rate but higher than the scheduled 8.5 rate.

The panel also suggested several changes to conform the DC code to federal law, including raising both the standard deduction and personal exemption to federal levels, creating separate rate structures for singles and individuals, and boosting the estate tax threshold to $5.25 million. Unfortunately, the panel also adopted the federal gimmick of phasing out the personal exemption for some high-income taxpayers (which is a hidden tax rate surcharge).

For businesses, the panel proposed lowering the city’s franchise tax to 8.25 percent from 9.975 percent, making the levy more competitive with the surrounding suburbs. At the same time, it would create a $100 per employee local services fee. The government would not pay it, but non-profits would. This levy may be a clever way to circumvent the congressional prohibition against a commuter tax.

Finally, the panel suggested raising the city’s sales tax rate to 6 percent from 5.75 percent and somewhat broadening the base to include services such as home improvement contractors, barber shops, and health clubs. However, it did not suggest expanding sales taxes to include other services such as accounting and legal. It also left at current double-digit rates special taxes on hotels, restaurant meals, car rentals and other services that shift the tax burden to visitors.

The package would cut individual income taxes by about $450 million over the next four years, raise sales taxes by about $240million, and boost business taxes by about $20 million. The panel did not address property taxes at all. Including some other smaller changes, the overall proposal would cut taxes by about $240 million over four years.

For 2015, that’s a tax cut of a bit more than 1 percent and certainly manageable. It may be more problematic, however, should the federal presence shrink in coming years.

The package is itself a political compromise, and it will certainly face more revisions when it goes to the DC city council. However, it looks like a sensible set of reforms that anticipates a changing city with a more diverse economy.