January marks the beginning of the preparations for the District’s Fiscal Year 2019 budget—the budget that would go into effect in October of 2018. The Mayor will send her budget bills to the Council at the end of March; the Council will hold hearings in April and pass the budget, with its own modifications, sometime in late June or early July.
One key step in this process is the Chief Financial Officer’s February revenue certification. This is the most important one of the District’s quarterly revenue estimates, as it provides the baseline revenues, on which the Mayor will build her budget. This year’s February estimate is even more important because it would be the first estimate that incorporates the impacts of the Tax Cuts and Jobs Act of 2017 on the District’s revenue base and revenue collections.
The federal tax law changes, on balance, should boost District income tax revenue. These changes will expand the base for income tax collections, and because D.C. has adopted the federal definitions of income, the base expansion will result in automatic revenue increases for the city.
The District is not alone. Every state that conforms to federal tax definitions will be affected, albeit in different ways, and each will respond differently. A recent Hill article notes that Maryland projects an annual revenue increase of $750 million in combined state and local income tax revenues as a result of the federal tax law changes. Governor Larry Hogan has already promised to cut the tax rates to hold taxpayers harmless, at least at the state level. Michigan, likewise, is considering a cut to its state level income tax rates. Minnesota projects an increase of $800 million in 2019, but will likely adjust its tax rates down. Colorado, on the other hand, is planning to spend its projected $220 million revenue increase.
Why do federal tax law changes affect D.C. revenue?
Most states adopt federal definitions of income to make tax administration easier. In these states, income taxable at the federal level is also taxable at the state level. And if an exemption exists at the federal level, it also exists at the state level. States can choose their own tax rates, of course, but if the federal definitions of income change (as they do with the federal tax bill), then these changes will have an automatic revenue impact at the state level.
The District has rolling conformity to federal descriptions of both personal and corporate income. That is, changes to the federal income definitions will at once affect the District unless the city takes legislative action to decouple from federal rules and write its own definitions of income. Virginia, in contrast, has static conformity. They had in the past chosen to follow federal definitions, but the federal changes are not automatically adopted: the the legislature must pass a bill to update the Virginia tax definitions.
What are some of the revenue implications of the 2017 Tax Act?
The federal tax bill makes significant changes to how income is defined. These changes will impact District’s income tax revenues in the following ways:
Elimination of personal exemptions will increase local revenue. In February of 2017, the large increase in the District’s projected revenues triggered the last ten of the 17 tax provisions that were adopted as a part of District’s Tax Reform Package in fiscal year 2014. This last batch included five provisions that increased District’s personal exemptions gradually from $1,775 to $4,000. The 17th and the very last provision conformed the District’s tax laws to the federal definition of personal exemptions, effective January 2018.
The federal tax bill eliminates the federal exemptions, and with that, the District’s now-higher personal exemptions are also gone—at least through 2025. That is, the federal tax bill broadened the federal income tax base and lowered the federal tax rate, yet D.C. is now left with a similarly broader base, but the same District tax rate. The federal bill inadvertently reversed of the provisions of the D.C.’s own Tax Reform that reduced income tax burdens on residents.
The scoring of the District’s Tax Reform Package in the February 2017 revenue estimates showed a combined revenue reduction of $52 million for fiscal year 2018 attributable to the District’s planned five-step increases to personal exemptions. But this was only for the nine months of the fiscal year. The full year impact, scored for fiscal year 2019, was $73 million. We should at least see a similar change in the opposite direction with the elimination of personal exemptions. However, these gains, will be tempered by increases in the standard deduction, which we turn to next.
Limitations in itemized deductions and doubling of the standard deduction will reduce local revenue. When filing their returns, taxpayers can take a standard deduction or can choose to itemize, writing off various expenses to calculate their taxable income. Taxpayers are more likely to itemize if they own a home and have a mortgage, live in a high tax state (because they can write off state and local taxes), contribute substantial amounts to charity, have large medical expenses, or have large losses from theft or natural disasters. District residents, when filing their District income taxes, must follow what they did on their federal tax returns. If they have claimed the standard deduction on their federal tax returns, they must do the same for their D.C. taxes. If they have itemized in their federal returns, they must itemize in D.C.
The federal bill doubles standard deductions to $12,000 for single filers, $18,000 for heads of household, and $24,000 for married couples. It also limits to $10,000 the state and local tax (SALT) deductions a taxpayer can itemize, and caps the mortgage interest they can write off loan amounts up to $750,000.
Changes in standard deductions impact District’s tax base because the District’s standard deduction amounts follow the federal amounts (9th item in the District’s Tax Reform Package). Taxpayers who take the standard deduction will have lower taxable incomes and therefore lower taxes. Taxpayers who are now itemizing, and will continue to itemize, will not see a change in their D.C. tax liability. This is because the District requires taxpayers to add back SALT deductions to their D.C. taxable incomes. Finally, some taxpayers will switch from itemizing at the federal level to claim the new expanded standard deduction, if it exceeds their itemized deductions. For these taxpayers, DC income taxes will likely decline.
The Joint Committee on Taxation projects that at the federal level the negative revenue impact of higher standard deductions will be about half of the positive revenue impact of eliminating exemptions. If this also holds for D.C., then the changes to the personal exemptions and the standard deduction, combined, will likely increase revenue in the $40 million to $50 million range. But these changes will be temporary, expiring in 2025.
Higher estate tax exemptions will reduce local revenue. The 2017 Tax Act doubles the estate tax exemption from $5.6 million per estate to $11.2 million through 2025. This will directly affect the District, as our exemption amount conforms to the federal level (13th item in the District’s Tax Reform Package). The most recent estate tax revenue estimate is about $19 million for fiscal year 2019. With the federal tax law changes, the estate tax revenue estimate for D.C. will go down, but it is difficult to know by how much. The OCFO revenue estimators tend to be very conservative with estate tax estimates because it is very difficult to reliably project how many estates will become taxable, and how large these estates will be. Given that conservative projections are already baked in the cake, changes in the exemptions should not reduce the tax collections drastically. We must wait until February, however, to know for certain. To undo this impact, the District would have to pass a law decoupling from the federal law, reversing its decisions under the District’s Tax Reform Package, and implementing its own exemption amounts (and we had done that, too, after the first Bush tax cuts in 2001).
Pass-through provisions will not impact local revenue. The federal tax bill includes a 20 percent deduction for nonservice business income so long as the deduction is not greater than half the wages earned by the pass-throughs’ employees. This change is not going to alter how federal AGI is calculated, and therefore will not change the income tax base in the District and will not have any impact.
Switching to chained-CPI will slightly increase future growth in local revenue. The federal tax bill permanently discards the use of consumer price index calculated for urban areas (CPI-U), and adopts the use of chained CPI, which tends to grow slower. Chained CPI grows slower because the calculations allow for substitutions in the consumption basket. If, for example, the price of beef goes up, then consumers are likely to buy more chicken or pork—items that are also in the consumption basket used to calculate the CPI. The CPI-U ignores this type of substitution, providing an upper-limit of consumer price increases. Chained CPI allows for these substitutions, curbing the increases in prices by allocating a larger consumption share for cheaper products. The federal Earned Income Tax Credit, standard deductions, and phase-in and phase-out thresholds for standard deductions will now use chained CPI, allowing for a slower growth in these credits and deductions. As the District conforms to these definitions, the city’s allowable growth in these tax credits and deductions will also diminish.
The local impact of federal corporate income tax changes is hard to estimate, but will likely increase franchise tax collections. On the plus side, the federal tax bill imposes a one-time tax on accumulated foreign profits. This is a one-time revenue raiser for states, but its impacts on D.C. will likely be small. Again, on the plus side, federal bill limits how corporations can carry forward or carry back Net Operating Losses (NOL), applying them to a future or previous year to minimize tax liability. This could potentially increase revenue in D.C., but the impacts are hard to estimate: The District had eliminated carry-backs in 1999 so the federal elimination of carry-backs in the tax bill does not matter. And because of the combined reporting rules, the District tracks net operating losses in a way that is different from how the federal government tracks them. The limitations on carry forwards will still apply but the net impacts are hard to know.
The federal tax bill changes depreciation rules to allow for full expensing of the cost of property acquired. This a revenue reduction for states that conform, but does not matter for the District, since the city has already decoupled from federal depreciation rules. The federal bill counters the changes to depreciation rules by limiting interest deductions—a provision that would affect D.C. as we fully conform to interest deduction rules. This is a revenue raiser, and we are curious to see how the CFO would score it.
What do we do with the “windfall?”
The CFO’s February revenue estimates will incorporate more than the impact of the federal tax bill. The baseline estimates could grow even faster if the revenue estimators see additional positive signs along with the federal tax law changes. So far, the national economy is strong, and despite higher unemployment figures in D.C., personal incomes appear to be growing. However, there are also risks to the D.C. economy, especially related to federal employment and federal budget actions. These risks have not changed much since the end of December (the last time the CFO released revenue estimates), but if these negative pressures increase, they could curtail the positive revenue impact of the federal tax bill.
It is too early to make definitive statements on what the city should be doing with this unexpected revenue. If the amount is small, this discussion will not be important. We hope that the CFO’s revenue estimates will separately tally the impacts of the federal tax bill from any other adjustments to the revenue estimates because of changing economic conditions. This way, we can see how the federal tax law changes affect tax burdens in the city.
Following on this line of thinking, the question on what to do with the “windfall” is an intellectually important one to ponder. This is because any attempts to fill fiscal gaps with the new revenue from federal tax reform will come at the expense of the District’s own tax reform.
Two of the most pressing issues on the District are metro funding shortfalls and infrastructure needs. In addition, the District might have to expand its health care spending in response to the federal tax bill provision that eliminates the penalty for not obtaining health insurance.
- Metro Needs. WMATA projects that it needs an additional $500 million in capital investments. The District’s CFO Jeff DeWitt and his team estimate that the District’s unfunded commitment to a fully funded Metro would be $2.3 billion over the next 10 years. Even without a grand bargain to solve Metro’s fiscal woes, the District’s contributions will increase. The proposed 2019 WMATA budget seeks an additional $136 million in capital contributions, $49 million of which would come from the District.The best long-term solution for Metro is a regional tax on a tax base that is projected to grow (such as sales tax or property) and can be used to raise funds through the capital markets. This goal can be reached if the Metro can reform its governance structure. The District can temporarily park its additional revenue from the federal tax law changes in the Metro, and even ask Maryland to do the same. Virginia cannot be asked to reciprocate on the same grounds, however, as it has static conformity with federal tax laws and will not see a similar income tax revenue unless it changes its laws.
- Infrastructure Needs. The District’s Capital Improvement Program funds $6.7 billion of capital needs, but the CFO estimates that the city has $4.2 billion in additional unfunded capital needs. Of this amount, $1.9 billion is for maintaining existing infrastructure. The remaining $2.3 billion is for new projects the city added to its wish list, but has not funded. This amount—about $700 million per year on average—is above and beyond what the city needs to invest in Metro.The District passed legislation in 2018 to require that starting fiscal year 2020, the District sets aside at least $58.95 million of current revenue in its capital improvement program each year, and increase this amount by 25 percent of any revenue growth above and beyond the fiscal year 2020 revenues. The District’s financial plan already incorporates these amounts for fiscal years 2020 and 2021. Additionally, the CFO notes that the District will have enough debt capacity to cover the bulk of the remaining capital needs, and can find more resources through public-private partnerships. So long as the city manages its budget prudently, and legislators do not add more things to the unfunded capital projects list, there seems to be a way meet infrastructure needs.
- Healthcare spending. The federal tax bill repeals the health care mandate by eliminating the penalty associated with not buying insurance. The expectation is that without a penalty many healthy young people will skip buying insurance. This will worsen the risk structure of the health care insurance markets and therefore increase premiums (by about 10 percent each year according to the Congressional Budget Office scoring) pushing even more people out of healthcare insurance markets. The District had its own insurance before the Affordable Health Care Act was enacted, and the city might be compelled to provide subsidies to keep its health exchange affordable and accessible.
A case for (temporary) tax cuts
Every budget starts with a shortfall, and some priorities go unfunded. This year is no different. Advocates of all stripes will push for increased spending for what they care about the most, pointing to the “windfall.” One must remember, however, that the revenue increase that results from federal tax law changes is a windfall only in the political sense, since no local lawmaker had to deplete political capital to increase taxes. The additional revenue will still come out of the pockets of the D.C. residents.
The Tax Cut and Jobs Act of 2017 will undo some of the income tax reforms the District implemented recently as a part of its Tax Reform Package. Overall, local tax burdens will increase for residents. Some residents will see higher federal tax bills too due to the elimination of the State and Local Tax deduction. And if Virginia does not pass legislation to conform to federal changes (or if Maryland reduces its tax rates, as intended by its governor), the income tax rate disparities between D.C. and its surrounding jurisdictions will widen.
The federal tax bill did not get much good press. Most coverage focused on its distributional impacts (despite the fact, according to Joint Committee on Taxation, that those distributional impacts are not particularly significant), as well as the deep corporate income tax cuts that came at the expense of permanent income tax reductions. But its provisions that broaden the income tax base are good tax policy. Since the District has chosen to conform to federal rules in defining its tax base, it should consider reducing personal income tax rates, even if temporarily, to ensure that the income tax burdens on its residents do not increase merely because of federal tax actions.
The District is facing significant fiscal pressures next year. But any attempts to fill fiscal gaps with the newfound revenue from the federal tax changes will rely on temporary money that increases tax burdens, and will come at the expense of the District’s own tax reform.
Yesim Sayin Taylor is the Executive Director of the D.C. Policy Center.
[budget bills] The two key bills that Mayor will send to the Council are the appropriations bill known as the Budget Request Act, and its companion, the Budget Support Act, which would include all changes to the D.C. laws necessary to executive the spending plan.
[quarterly revenue estimates] The CFO provides four revenue estimates every year—in February, June, September, and December. Among these, the February estimate is the most consequential one, since it determines the baseline revenue for the upcoming fiscal year and the three following years, for which the projected budget must be balanced.
[rolling conformity] Twenty-two states including the District of Columbia have rolling conformity. They automatically adopt changes in federal income descriptions. Seventeen states have static conformity and must vote to adopt federal tax law changes. States with rolling conformity must decouple, by legislative action, from a federal tax provision they do not like; states with static conformity must couple, by legislative action, to adopt a federal provision they like.
[income is defined] For personal income, D.C. uses the Federal Adjusted Gross Income (AGI) as a starting point. Federal AGI is the gross income adjusted for certain “above the line” expenditures. If you are making after-tax contributions to an Individual Retirement Account, you can take it out of your gross income at the federal level before you report your AGI. Thus, this amount is also never available for the D.C. Government to tax.
[at least through 2025] The impact will be slightly subdued for higher income residents, whose personal exemptions are phased out by 2 percent for each $2,500 above $150,000, with a complete phase out at $275,000 (6th item on the tax trigger list).
[nine months] The District’s fiscal year runs from October 1 to September 30, and most tax code changes are implemented at the beginning of a calendar year. Therefore, most tax changes, when they first take effect, cover 9 months of District’s fiscal year, from January 1 to September 30.
[what they did with their federal tax returns] District Code §47-1803.03 (c) states “Every individual who claims the standard deduction on his or her federal income tax return shall claim the applicable standard deduction specifed in District Code §47-1801.04 (44). Every individual who itemizes the deductions on his or her federal income tax return shall itemize the deductions permissible under this chapter.
[25 percent of any revenue growth] Paygo allocated in this manner cannot exceed the depreciation amount reported in the District’s Comprehensive Annual Financial Report.
D.C. Policy Center Fellows are independent writers, and we gladly encourage the expression of a variety of perspectives. The views of our Fellows, published here or elsewhere, do not reflect the views of the D.C. Policy Center.