Should DC dump the sales tax?
DC should consider getting rid of the bottom tier of the sales tax and replacing it with a higher income tax. This could stimulate business, help the working poor by removing a regressive tax, and retain more money within the District by taking advantage of federal deduction rules.
Replacing this part of the sales tax with an income tax on higher earners would transform the bottom tier portion of the $973 million dollars DC residents currently pay in general sales tax, into a tax that is deductible from federal income tax.
This would return as much as $341 million dollars to the District's residents, serve as a tax break on the lower and middle class, and give DC businesses a competitive advantage over Maryland and Virginia, all while saving the District money.
There are five tiers to the DC sales tax. The 5.75% tier charged on tangible personal property is the bottom one. The others, on liquor, restaurant meals, parking, hotels, rental vehicles and sports tickets, represent luxury items or taxes on visitors and would not have the same effect if removed. When I talk about removing the sales tax, I'm talking about this bottom tier.
In 2009, the District raised $724,552,000 from its general sales tax, part of which came from the bottom tier. It is only tax-deductible from federal income tax by those who itemize, and only if they choose not to deduct their DC income tax. The sales tax deduction, which hasn't yet been extended this year, was designed for states without an income tax, primarily Texas, and is used rarely by DC residents, if at all. Thus, that entire sum of money is eligible for taxation by the federal government.
It is in the best interest of DC taxpayers as a whole to remove non-deductible taxes and replace them with deductible ones. By eliminated the sales tax and replacing it with a deductible tax, District residents could reduce their combined federal tax burden by up to 35%.
Those millions of dollars would stay in the hands of DC residents, much of which would be spent here, instead of going to the federal government. This would give a boost to local businesses.
Removing the sales tax would be good for local businesses in other ways as well. The District is surrounded by shoppers who would love to take advantage of sales-tax free spending, as would the 15 million annual visitors to the District. District tourist literature could promote DC as a place to see the sights "and shop tax-free."
Oregon has no sales tax and stores along the state line with Washington and California see a lot of business from out-of-state residents seeking a bargain. Unlike Oregon, DC's entire economy is a "border economy" so the impact would be even larger here. In addition, businesses would no longer need to collect, transfer and report sales tax, which would reduce overhead. Similarly, DC would no longer need the infrastructure to track, collect, audit and enforce sales taxes, thus allowing them to reduce costs.
DC would see other benefits too. While it would lose some sales tax that it currently earns from out-of-state shoppers, it would gain revenue from increased sales and the taxes, such as property and income, associated with profitable businesses. Stronger DC businesses would likely result in more jobs and so the District would also benefit from the taxes associated with workers, and reduced costs associated with lower unemployment.
As a further benefit, this would reduce taxes on those most in need of tax relief and make the system more fair. Sales taxes are paid by people across the economic spectrum, including those who can least afford to pay it. The top 1% of DC earners pay
5.8% 6.4% of their income in DC taxes. The bottom 20% pay 8.4%. The second and third 20% pay 11.0% and 10.8% respectively. So replacing the sales tax with a tax on high earners would make the tax system less regressive.
Cutting the sales tax will cut taxes for everyone. DC could then increase the income tax on those making more than $34,000 in taxable income (the start of the 25% bracket). Those making below $34,000 would pay no sales tax and would see no increase in income tax, which would represent about a 6.8% tax cut for them.
This tax cut would not be costly. In order to replace the revenue of the sales tax collected from the bottom 20%, the District would only need to increase the tax on the top 1% by 0.6%.
But that isn't necessary. By staggering the DC brackets to match the federal brackets, and tweaking the current rates, it could be arranged so that everyone pays less total tax, but the District gets the same amount of revenue, depending on the amount of state general sales tax that is paid by those out-of-state. This is done by taking money away from the federal government in the form of tax deductions. Those paying above $34,000 would pay an increased state income tax that could be more than offset by elimination of the state sales tax and a reduction of federal income tax.
Any fear that wealthy residents would choose to live just across the state line to take advantage of the reduced sales tax would be tempered by the fact that taxes in Maryland and Virginia are already higher than in DC. Maryland state income tax is 9.45% for those making more than $1 million, compared to 8.5% in DC, for example.
There are some possible drawbacks. A higher income does create a greater incentive to cheat, but with collection savings from removing the sales tax, DC could add enforcement staff for the income tax. Business gains for DC could spell loses for those just across the District line in MD or VA, but that is hardly DC's concern.
And by gaming the system to avoid federal taxes, DC runs the risk of Congressional intervention. But Congress created the system (without DC's input) and can hardly blame a state for gaming it. Further, the fear of Congressional intervention should not be a reason to avoid decisions that are best for DC residents.
A final drawback is that income tax revenues tend to be less stable, rising higher during good years and dropping farther during lean times. To make it work, DC needs to be more disciplined, setting aside more money in the rainy day fund during booms, so that it's available during busts.
None of these problems are so severe as to make this unmanageable. Five states, including nearby Delaware, have no sales tax, proving that whatever drawbacks there are, they are not insurmountable. For a jurisdiction with a strong border economy, numerous tourists, and an unbalanced tax rate among classes, getting rid of the sales tax is worth a look.
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