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June 23, 1999

Why Cutting Taxes in the District of Columbia Will Lead to Economic Growth

By

Testimony before the District of Columbia Subcommittee / Appropriations Committee - United States House of Representatives

On June 1, 1999, Mayor Anthony Williams transmitted the District of Columbia's fiscal year 2000 operating budget and financial plan to President Clinton and Alice Rivlin (Chair of the District of Columbia Financial Responsibility and Management Assistance Authority, "the Control Board"). This important budget contains one of the most dramatic tax reduction initiatives in the District's long history. If approved by Congress, District taxpayers will save $892 million between FY 2000 and FY 2004 as the District reduces individual tax rates and business taxes to levels more like those taxpayers face in Maryland and Virginia.

The long economic expansion and wise tax policy changes in the last two Congresses account in part for the District's stunning decision to cut taxes. The tax policy changes of the 1980s and prudent fiscal stewardship in the 1990s produced the economic setting for what the District now proposes. On the one hand, the environment for entrepreneurship that tax cuts in the last decade enhanced led to vast improvements in economic efficiency and productivity that we now see bearing abundant fruit. On the other hand, the prudent management of state and federal budgets and our money supply led to lower interest rates and greater financial stability, especially as Congress and the Administration delivered on their promise to balance the federal budget. Congress's recent tax policy changes have only brightened the economic setting: Lower capital gains tax rates, expanded access to tax sheltered savings plans, and, yes, the child tax credit have clearly signaled to taxpayers that the federal policymakers want to accommodate continued economic expansion.

Additionally, the Taxpayer's Relief Act of 1997 contained some important elements of Delegate Norton's innovative District of Columbia Economic Recovery Act. While the Congress did not adopt Delegate Norton's call for a District-wide capital gains tax of zero, it did permit certain especially distressed sections of the District to enjoy lower capital taxes. While the Administration resisted the Delegate's wise call for a flat tax in the District, the President did sign the legislation that gave all first-time homebuyers a federal income tax credit of $5,000. Evidence now streams into the District's economic development offices that the tax credit and other Congressional tax actions have made the District of Columbia one of the fastest growing cities for new and previously owned home sales. Who would have thought that possible just a few years ago?

Now the District owns a handsome fund balance that is in surplus from its own revenue sources. Its fiscal health appears real, and its management team (aided by an energetic and talented Control Board) seems up to the important task of long-term economic recovery.

With these factors in hand, the District Council adopted the Tax Parity Act of 1999 to address one of the most harmful legacies of D.C.'s past mismanagement: the high District tax rates.

The District's three individual income tax rates (6, 8, and 9.5 percent) are all higher than the highest tax rates in Maryland and Virginia (5 and 5.75 percent, respectively). Business taxes in the District are also higher than in the surrounding states. D.C. businesses pay a franchise tax of 9.975 percent compared to corporate tax rates in Maryland and Virginia of 7 and 6 percent, respectively. Personal and business property taxes also are steeper in the District than in Maryland and Virginia. The Washington Post reported in February that D.C.'s own Office of Tax and Revenue found that a typical middle-class D.C. family paid 50 percent more in taxes than it would do in the Virginia suburbs.

In short, D.C. residents pay a substantial tax premium to live and work in the District, and many residents have found this premium far too high. In 1970, the District of Columbia enjoyed a population of over 750,000. By 1997, however, the District's population had fallen to 525,000. If current trends continue, the District's resident population (and much of its tax base) will shrink even further. According to WEFA (an internationally recognized economic forecasting firm in Philadelphia), current trends imply a population of 487,800 by the end of 2004 and 471,900 by the end of 2009. At the same time, the populations of the surrounding Virginia and Maryland counties are expected to continue growing at near double-digit rates.

This downward drift in resident population is mirrored by declines in total District employment. District employment stood at about 248,000 at the beginning of 1999. If trends do not soon reverse themselves, the end of 2004 will see total employment fall to 219,000. By the end of 2009, the Council could be trying to collect taxes from only 212,000 workers. That number would represent a 15 percent drop in total employment in a mere ten years.

Obviously, the District's school system and historically higher rates of crime have played a part in the hollowing out of the D.C. tax base, but high tax rates also matter. If the District is to avoid a 40 percent fall in its population by 2009, the Council should take action on all of these fronts. The District's Council argues that now is the time to begin work on the tax leg of the District's set of problems. Certainly, with budget analysts forecasting general fund surpluses over the next four years and many economists expecting a continuation of the current economic expansion, it is hard to argue with their timing.

Every good idea, however, has its critics. While the general public reacted to the Tax Parity Act of 1999 with enthusiasm, some in the District fear that proposed tax cuts will benefit only high-income taxpayers and that the "productivity savings" that pay for a portion of the cuts will be unrealized. The Council's decision to cut the lowest tax rate most and the highest least addressed apprehensions about who would benefit from the tax savings. Also, the jobs this policy change should produce would benefit those who currently do not have work as well as those D.C. residents looking to improve their economic position.

The concern about productivity offsets also is misplaced. The District just passed through a financial crisis that focused the attention of the Mayor's Office as well as the Control Board on numerous opportunities for reducing government's cost while improving its services. In the FY 2000 budget, for example, the Mayor proposes implementing simple but proven management tools for bidding and administering contracts. This "managed competition" initiative may save the District $20 million in FY 2003. Additional "productivity savings" are expected as the District finds old practices that high technology and ordinary common sense can correct. We know, however, from the efforts of large corporations to realize such productivity savings that their achievement requires significant and substantial attention: significant in the sense that the CEO must play a central role in driving the process of change and substantial in the hours spent by senior management on attaining higher quality at lower cost. The Mayor also projects $15.7 million in "general supply schedule savings" in FY 2003. This figure stems from growing already realized supply savings in FY 1999 by no more than the rate of inflation. In other words, if the District did no more than hold the current line, it would meet this spending reduction target.

Criticisms about the District's tax cut plan ran aground on the strength of the District's current and near-term economy and on Congress's clear intent to support economic growth in the nation's capital. Critics likewise ran against the continued and pressing need to bring greater prosperity to District residents. If declining population and employment are not enough to spur critics of tax reduction to think again, then they should contemplate a District unemployment rate that is still nearly twice the national average. While most of the country has succeeded in bringing the economic boom to Hispanics and African-Americans, Washington remains a "neverland" of employment if you are young, black, and hold a high-school degree.

Delegate Eleanor Holmes Norton heard these same arguments against tax cuts when she attempted to secure Congressional passage of the District of Columbia Economic Recovery Act in 1997, a measure specifically designed to jump start the District's then-sluggish economy. She wisely denounced them. Delegate Norton and her colleagues Senators Joseph Lieberman (D-CT), Sam Brownback (R-KS), and Connie Mack (R-FL) called for federal tax law changes that would have created a flat tax for the District, eliminated federal capital gains taxes in D.C., and given all first-time home buyers a $5,000 tax credit. Then, as now, the critics of this innovative proposal were more concerned with income maintenance programs than with jobs, with funds for emergency food programs than with micro enterprises. Despite a showing that D.C.'s own revenues would rise with lower federal taxes, that thousands of new jobs would be created, and that the suburbs as well as the central city benefited from new economic life in Washington, the critics prevailed and much of Delegate Norton's plan failed.

But not all of it. President Clinton signed the Taxpayer's Relief Act of 1997 that contained the District of Columbia tax credit for first-time homebuyers and a limited version of capital gains tax abatement. Many observers credit the tax credit with a significant portion of today's vibrant D.C. housing market and the special capital gains treatment given certain Washington neighborhoods with stimulating new business development.

Indeed, these remnants of Norton's tax proposal in concert with the reduction in the federal capital gains tax rates from 28 to 20 percent and from 15 to 10 percent may have a great deal to do the District's improved economy and its current budget surplus. As the Center for Budget and Policy Priorities correctly notes, budget surpluses bless the balance sheets of nearly every state and most major municipalities in large part because of unexpectedly high capital gains tax revenues. Reductions in the after-tax cost of capital, which stem in part from the lower taxes on capital gains, have stimulated housing construction and purchases. Taxes from these activities also fill the coffers of the District and other governments.

It is just these kinds of positive economic effects that the Council can expect from its proposed tax cuts. The WEFA/Heritage analysis of Delegate Norton's Economic Recovery Act (which saved taxpayers almost as much as the Council's plan) showed that disposable incomes throughout the metropolitan area would rise by a total of $115 billion over a ten-year period, and 15 percent of that increase would go to District residents. This analysis also showed that employment would rise by 112,600, with the District reversing its downward drift and gaining 24 percent of this increase. Likewise, District wage and salary income (upon which the District raises most of its income tax) would expand by $6.3 billion above its growth without the tax changes. Perhaps the most telling result of all from this analysis of the Norton plan was our finding that nearly all of the revenue decrease came back to the District over a ten-year period in the form of new taxes from new jobs and higher wages.

Tax policy stands at the center of our effort to get public policy right for economic growth. Tax policy mirrors our view of the role of government in everyday life and parallels the level of spending and the diversion of resources to the state. It reflects as well our opinions about the social worth of achievement and financial prudence and shapes our practice of the principle of equality before the law and equal access to due process.

Tax policy matters, whether it is in faraway places or the District of Columbia. We know from our study of over 130 other countries that those with low tax rates on labor and capital relative to the average have adopted other public policies that promote growth: free trade, minimal restrictions on the import and export of capital and labor, rule of law, stable money, and light regulations on the use of one's private property in production. We know as well that those countries with below-average tax rates on labor and capital have long-term growth rates that are about 0.6 of a percentage point higher than those countries at or above the average.

Numerous studies conducted over the past four years by The Heritage Foundation and by other think tanks with economic specialization show that reductions in tax rates on labor or capital--or both--lead to higher levels of economic activity. Tax policy changes that provide credits or deductions for some and not for others, however, have little effect on the overall level of economic growth, even though they may achieve greater equity in tax law. In fact, it is commonplace for economists to give low economic growth scores to tax policy proposals that reduce the tax burden on targeted classes of taxpayers. For example, the recently enacted child tax credit, although important for reversing the growing inequity in the code stemming from allowing the personal exemption for children to lag behind inflation and the exemptions for adults, hardly causes the standard economic models to stop for breath. Drop the taxes on capital gains or reduce marginal tax rates on ordinary taxable income, however, and these same economic models register significant increases in economic activity and long-term growth rates.

Getting tax policy right is a task that knows no particular season. This year's opportunity for redirecting tax policy down the seldom-trodden road to righteousness, however, happens at a time of unexpected, rather large budget surpluses. This bounty, however, raises a troubling question: Once the revenue requirements of government have been determined in our constitutional system of representative decision-making, must tax revenues above the needs of government be returned to taxpayers immediately; or does the national legislature have an expansive authority to seize taxpayer income beyond the budget law it has enacted?

Members of Congress and, indeed, the general public may not see the important connection between how this question is answered and future economic performance. If Congress and the District get policy right, then District residents are on the verge of unprecedented prosperity. If this opportunity is missed, they may find themselves the subject of endless academic essays diagnosing their failure to grab the chance for greater well-being when the fortunes of economic events offered it.

William W. Beach is Director of The Center for Data Analysis and John M. Olin Senior Fellow in Economics of The Heritage Foundation,

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