The Reagan administration's proposal to eliminate state and local income taxes as deductible items on federal income tax returns would force the District of Columbia to restructure its tax system, according to local officials and municipal finance experts.
If the controversial deductibility provision is approved, several officials said, the District -- like New York City and other large urban centers of the Northeast -- will be under tremendous pressure to cut services drastically or to try to raise taxes in an environment that makes it much, much more difficult politically to do so.
Under the president's tax simplification plan unveiled last week, the federal government could be expected to raise about $34 billion in 1988 by eliminating the deduction for state and local income taxes. In jurisdictions such as the District where high-income taxpayers -- who are more likely to itemize -- pay relatively high state and local taxes, the federal tax write-off helps make the total burden of taxes more tolerable.
Approval of the provision eliminating the deduction could have a "devastating" effect on the District's ability to raise revenue, according to D.C. City Councilmember John A. Wilson (D-Ward 2), chairman of the council's commitee on finance and revenue.
"There is absolutely no question that the District will have to restructure its tax code totally," agreed Philip M. Dearborn, vice president of the Greater Washington Research Center and former financial counselor to D.C. Mayor Marion Barry.
D.C. officials declined to speculate on the need to raise taxes if the proposal is approved. Officials have begun to assess the city's options under several scenerios, however.
While eliminating the state-tax deduction would badly hurt the District by widening the tax gap between the city and the suburbs, other tax-reform provisions could harm Maryland and Virginia as well. The services industry -- increasingly important to the local economy -- would be particularly hard hit. The tax-reform proposals:
Could push down long-run residential and commercial property values in the city by giving new arrivees in the area added incentive to buy property in the suburbs.
Would reduce tax revenue from hotels and restaurants -- a large source of local funds -- by limiting the deduction for business entertainment and meal expenses.
Would hamper cash flow at law firms, medical organizations and other service providers by requiring many companies to use the "accrual basis" of accounting, which reports and taxes income when earned instead of when actually received.
District residents with high incomes generally pay higher federal and local income taxes than suburban residents, and with the loss of deductibility, Dearborn predicted, "there will be a greater incentive for those people to relocate" to the Maryland and Virginia suburbs. And, he said, any significant flight of D.C. residents to avoid higher taxes will lower the demand for property in affluent areas of the city and, thus, depress values and reduce the real property tax base, reducing the city's tax base by another notch.
"I'm more worried about the migration than anything else, frankly," Wilson said. "The problem is, we're already in a terrible competitive position with Maryland and Virginia, and if you drop the deductible, we're really in trouble."
Wilson predicts the loss of deductibility -- which, in effect, is a subsidy for states -- "will make local officials all over the country make some hard decisions.
"I would assume that New York City and Washington would find it very difficult" to manage without deductibility, Wilson speculated, because "we're surrounded by suburban jurisdictions which tax less because they don't have to do as much. We have more poor. We have more police, a complicated educational system, and all these things eat up money. The cities are basically trapped."
Similar stresses will be felt by cities across the country, even those in low-tax regions, according to economists and lobbyists concerned with the issue, because almost all cities impose higher taxes than surrounding jurisdictions.
"This is one of those issues where 90 percent of cities will say it will have an adverse impact, even in the Sun Belt," said one.
The plan would intensify not only city-suburb rivalry but also competition between adjacent high-tax and low-tax states for both jobs and tax-paying residents.
John Gunther, executive director of the U.S. Conference of Mayors, noted that, based on current tax burdens, the president's plan would set, for example, New York against Connecticut and New Jersey, Michigan against Indiana, and Ohio against Kentucky and West Virginia. With its very low taxes, "West Virginia would make out like a bandit," possibly drawing from Virginia, Ohio and Pennsylvania, he said.
Unlike most cities, however, the District has a narrow commercial base, "and that bothers me," Wilson acknowledged. "We can't go absolutely crazy on raising our commercial property taxes because they create the little bit of work we do have other than government."
In effect, eliminating the deduction for state and local taxes could create a relentless cycle for jurisdictions like the District with relatively progressive tax rates. Making local taxes more expensive by eliminating the deduction, if it forces high-income taxpayers out, shrinks the tax base and creates the need to raise taxes for those who are left.
"We would be in a position where we would almost have to raise taxes," Wilson said. But, he added, "It will be very difficult to convince people you have to raise taxes when they can't deduct them."
Upper-income taxpayers in high-spending cities or states with relatively progressive tax structures gain the most from deductibility, the Advisory Commission on Intergovernmental Relations noted in a 1984 report. In 1980, for example, D.C. taxpayers who itemized on their tax returns received the highest benefits from the deduction for state and local taxes -- an average of $917 in federal tax savings -- of any state, the commission said in a report entitled "Strengthening the Federal Revenue System: Implications for State and Local Taxing and Borrowing."
The commission added that voters who itemize are more likely to support or tolerate higher spending by local government than they might otherwise because deductibility has the effect of increasing their income and reducing the net prices they pay for state and local services. What's more, the commission said, elected officials "may be more apt" to propose tax hikes since they realize that, with deductibility, the net additional tax payment is less than the actual proposed increase for many voters.
The deductibility provision can either reduce the incentive for outmigration or encourage immigration into relatively high-spending and high-taxing jurisdictions, depending upon how taxpayers value the expenditures funded by state and local taxes, the commission said.
A study completed last month by the Congressional Research Service calculated that the average itemizing taxpayer in the District would lose $1,017 if his ability to deduct local taxes were lost. The impact of this tax increase is second only to New York's average loss of $1,168, and ranks well ahead of the $856 that would be lost by a Maryland taxpayer, and $679 by a Virginia taxpayer.
In addition, the study found that the average D.C. itemizer is in the 31 percent bracket, compared with 27 percent in both Virginia and Maryland.
The elimination of deductibility "would be a temptation for all state and local jurisdictions to increase taxes," observed Robert S. Statham, a local tax lawyer and former chairman of the Greater Washington Board of Trade's tax committee. By the same token, Statham added, "I think that if the District loses some people as a result of the loss of deductibility , it will wind up taxing those who stay."
But according to William R. Brown, director of finance for Prince George's County, the loss of deductibility may not necessarily mean a big outmigration and erosion of the District's tax base.
"On the other side of the coin, you have to look at the reduction in the federal tax rate," Brown said. "With a projected maximum tax rate of 35 percent, the deduction could wind up costing a taxpayer less. And there may be some cases where an individual might pay more, but I don't know if it's worth moving because it might take several years to recover the expenses of selling a house and moving to another jurisdiction."
On the other hand, Brown added, if real property taxes go up significantly over two to three years, taxpayers might have concern about the loss of deductibility and resist tax increases. And that, Brown added, has significant implications for elected officials.
The big concern Wilson and other D.C. officials have is that the individual income-tax burden in the District is the most progressive -- the higher one's income, the higher the relative tax burden -- in the area. As an example, in the District, the tax burden is 2.70 percent of income at the $10,000 income level, and 7.28 percent at the $75,000 income level. In Virginia, income at the $10,000 level is taxed at 1.75 percent, and 3.95 percent at $75,000. In Maryland, the least progressive of the three jurisdictions, the burdens are 3.23 percent and 5.44 percent at the $10,000 and $75,000 levels, respectively.
Should the loss of deductibility create an incentive for high-income taxpayers to move to jurisdictions with lower taxes, then the District will be put in the position of having to shift some of the tax burden from the higher income group to other taxpayers, Dearborn said.
Dearborn, coincidentally, is preparing a position paper on what the District needs to do about its "out-of-line" tax-rate schedule. "The end result, I think, is there will have to be a total restructuring of the District's taxes," he said. "And that's not a very pleasant prospect politically for District officials. But I don't think they will have much choice if the president's plan is approved."
The real estate industry in high-tax areas such as New York and the District also is beginning to worry about the impact of the proposal on property values, both residential and commercial. Several agents here, though reluctant to speak publicly of anything that might hurt house prices, said they fear that home buyers may become reluctant to look in the city.
"I don't see a great rush for the suburbs by people who are already here," said one. "You've got to remember that many of the better-off people who live in Northwest have been there a long time and have low-interest mortgages. Buying in the suburbs with a new loan might be more expensive than losing the deduction."
However, he added, when a new arrival is choosing among the local jurisdictions, the tax situation probably would be a major factor.
David Strachan, of the Washington Board of Realtors, said that while he has not analyzed the impact of the proposal, it would seem likely "to drive down values in the long run." He argued that "single-family homeowners are already subsidizing tenants" because rent control depresses the value of -- and thus tax collections from -- residential rental property. Loss of the deduction "would be another factor" raising homeowners' costs.
A decline in property values means a decline in a city's tax base, eroding the city's revenue. But raising taxes might simply increase the erosion in revenue by forcing people out.
"This isn't going to make life any easier," Gunther said.
Nor is life likely to get easier in other sectors of the local economy that could be significantly affected by other provisions in the president's proposal, several local business leaders said. However, businesses that don't require a lot of capital investment probably would fare better than those that do, said Stephen D. Harlan, managing director at Peat, Marwick, Mitchell & Co. "Washington is not a capital-intensive area, so we might fare better, simply because we have a higher percentage of the services industry than does the Midwest, for example," Harlan noted.
Indeed, the services sector has emerged as one of the mainstays -- along with government -- of the area's economy. The services sector accounted for almost 63 percent of the region's total employment growth between 1977 and 1981, according to a Greater Washington Research Center study.
But continued rapid growth in that sector could be adversely affected if certain provisions of the administration's tax reform proposal are approved, according to several local executives and tax experts.
Limiting deductions for business entertainment and meal expenses, for example, could have a rippling effect locally. "The hotel and restaurant industries are extraordinarily large segments of our economy and limiting those deductions could have some impact, but how much, I don't know," Harlan said.
"Certainly the expense-account restaurants will be hurt," said John Cockrell, executive vice president of the Restaurant Association of Metropolitan Washington. "Some restaurant operators are concerned they may have to lay off some employes."
Not only is there the potential for job losses but a decline in the restaurant industry's business-meal volume has some negative implications for the District's tax revenue. "It's a key industry and we have an 8 percent tax on meals," Dearborn pointed out.
In other segments of the service industry, cash flow could be affected by a provision that would require firms to use the so-called accrual basis of accounting when revenue exceeds $5 million. Under the accrual method, revenue would be reported and taxed when earned instead of when actually received. The impact of that could be extremely adverse for many law firms, accounting firms, medical service organizations, advertising agencies, and other service providers, according to local tax experts.
Using the accrual basis would have a dramatic effect, not only for the service industry locally, but for the entire country, according to Harry Linowes, managing partner at Leopold & Linowes, a Washington accounting firm.
"It means, in essence, that if you perform a service and bill a client and you aren't paid for six months or a year, you would actually have to pay taxes," Linowes said.
The bigger problem, Linowes said, is how a company should report work in progress. "You can realize the amount of hardship if you had to report income you haven't received and pay income tax on something you didn't receive.
"I would have to believe it will increase the need for borrowings, or a reduction in consumer spending, in that the partners in these firms will have less cash to spend for consumer items. That's going to have a significant effect on the economy."
Tax experts say the major local winner under tax reform could be the burgeoning high-tech industry concentrated in Northern Virginia and Montgomery County. High-tech firms now pay a much higher average corporate tax rate than other businesses -- something the administration proposals would change.
Furthermore, the plan gives a three-year extension to tax credits for research and development and actually cuts the top capital gains rate from 20 percent to 17.5 percent. Industry officials said, however, that it is not clear how much those benefits will compensate for the loss of investment tax credits and lengthening of the depreciation schedules for capital equipment investments -- changes that the tax plan also includes.