Current Economic Feasibility of Statehood

By Tim Cooper - August 2002

In recent discussions on the various political options available to remedy the long-standing disenfranchisement of DC residents, questions about whether or not the District of Columbia could financial maintain itself as a state have been raised.

This paper reviews two studies on the matter of the economic status of the District of Columbia. One addressed the financial impact of DC statehood and was published by the Commission on Budget and Financial Priorities of the District of Columbia in 1990.

The other study reviews the District's current economic situation and was published by the Federal City Council in March, 2002.

Both studies address financial impact on the District of a non-resident income tax and draw similar conclusions about their net benefit to the District.

Study One:

Study One, entitled The Budgetary Impact of Alternative Forms of Governance for the District of Columbia, drew the following conclusions about the impact of statehood on the District's financial position:

1) By eliminating Congressional review of the District's budgetary process, there would be an annual savings of $15 million;

2) By establishing a non-resident income tax at half the (then) current District rate, an additional $500 million would flow to the District each year;

3) By empowering two Senators and one Congressperson, the District's ability to lobby for an increase in federal grants would be enhanced. A 5% increase would net $32 million;

4) A 3% increase in taxes on privately owned properties heretofore exempted by Congress, such as George Washington University and Medical Center and National Geographic, would result in an additional $21 million in tax receipts;

5) An additional cost of $30 million would be incurred by the District assuming responsibility for the judiciary, marshal's office and prosecutor's office;

6) Half of the (then) $400 million annual federal payment, or $200 million, would presumably be reduced by Congress in light of the District's new taxing authority.

Thus, the report concluded that statehood, including a non-resident income tax, would provide the District of Columbia with a net gain of $338 million. By 1995, the city faced a $700 million budget deficit.

Study Two:

Study Two, commissioned by the Federal City Council and written by McKinsey & Co., addresses the District's current financial status in light of the changed relationship between the federal government and the District of Columbia as restructured under the 1997 DC Revitalization and Self-Improvement Act.

The Act provided, of course, for certain state-like functions to be paid for by the District government. These functions include the District's courts and prison system as well as a significant increase in the federal contribution to the city's Medicaid program.

The payment by the federal government of these costs have materially assisted the District government in turning around its local economy over the past several years. However, notwithstanding the city's improved financial standing, which includes the District's fifth consecutive operating surplus, the long-awaited termination of the Control Board, the city's improved credit rating, the retardation of urban flight, and the significant decrease in debt per capita, the study, entitled Assessing the District of Columbia's Financial Position , forecasts a "likely" $500 million budget deficit for the District by 2005.

Among other things, Study Two notes that the causes of the projected deficit stem from some familiar sources:

1) The recent downturn in the local economy (a projected revenue drop of up to $125 million to $150 million per year between 2002 and 2005);

2) The escalating costs of Medicaid (a projected $80 million to $90 million cost in unbudgeted Medicaid costs by 2005);

3) Improvement costs related to the city's public schools (a projected increase of $180 million in annual expenditures for public schools by 2005);

4) Rising Washington Metro Area Transit Authority (WMATA) expenditures (a projected $85 million annual increase in costs by 2005); and

5) Various costs associated with the lingering effects of September 11th and the subsequent anthrax attacks.

Study Two also warns that the economic impact of "an unforeseen event, such as a slow economic recovery, a cap on the city's debt level, or another major security event, could increase [the projected 2005 deficit] significantly." It notes that deficits as high as $700 million could loom by 2005 if a combination of any of these events take place.

Significantly, the report concludes that the failure of the city to grapple with these challenging financial issues "risks either the return of a control board or, more likely, substantial cuts in city services."

In light of the District's perilous financial predicament, the report makes the following recommendations:

1) The District should continue its management reforms that may afford "an annual cost reduction opportunity of $110 million to $160 million by 2005."

2) The District should defer its planned individual tax cuts for 2002 through 2004. Of course, these tax reductions were designed to bring individual income tax rates into rough parity with Maryland and Virgina rates, and attract much needed population growth to DC. The deferral of the tax cuts would "add $150 million to 2005 revenue, assuming that the deferral of these cuts does not lead to significant resident flight."

3) The District should seek supplementary financial relief from the federal government. The study notes that notwithstanding the implementation of the 1997 DC Revitalization and Self-improvement Act, the District continues to be burdened by "substantial structural constraints and burdens by virtue of its status as the nation's capital." They include: the large percentage of tax-exempt land in the District, the prohibition on a non-resident wage tax, and "arguably certain 'state' services that DC continues to provide."

Study Two notes that "[e]ven if the city is able to capture $110 million to $160 million in savings from management improvements and chooses to defer planned cuts in individual income tax rates for 2002 through 2004, increasing revenue by about $150 million per year by 2005, DC will still face a deficit of about $200 million to $250 million in 2005. This projected deficit would, of course, be even higher if one of the unforeseen events discussed earlier were to occur or if the city were to take on additional improvement projects (e.g., expanding Metro's reach to Dulles airport, revitalizing the city's waterfront) or increase service levels."

The report claims that the "annual opportunity cost of [the] structural challenges" noted above is at least $500 million. This sum includes a minimum of $400 million that would be generated from a non-resident income tax and "would be more than enough to avoid the projected shortfall," so long as the rising deficit does not exceed its projected minimal level of $500 million.

Conclusion:

As is evident then by Study Two's analysis of the District's current financial position, even if the city enjoyed a nonresident tax and received a fair payment by the federal government to compensate for the significant percentage of tax-exempt land in the District and "arguably certain 'state' services that DC continues to provide" the federal government, its current level of revenue is inadequate to pay for the reacquisition and long-term maintenance of all of its state functions-- namely the prison system and courts as well as a higher percentage of Medicaid costs commensurate with those paid for by states.

Furthermore, on an ancillary note, Stephen Fuller, a local economist at George Mason University, maintained in a February, 2001 phone interview that the District's long-term, fiscal forecast is "not rosy." He claims that the District's budget growth is "never going to be enough to reinvest in its capital structures", estimating that it will require $3 billion alone to revamp the DC public school system" to make [it] on a par with Arlington County's." Furthermore, he states, "[t]here are only 570,000 residents and the city is landlocked and has only a certain capacity to increase its tax base." In other words, the District needs additional revenue sources because "it has squeezed the maximum out of the [the revenue sources] it has."

As to whether or not the District will ever be able to reclaim its state functions given the current fiscal forecasts, Fuller answers the question with a question, "Any sober person might say, 'Why would it want to?'"

Lastly, in an August 27, 2002 phone interview with Dr. Andrew Brimmer, who wrote a financial report issued by the DC Statehood Commission in the mid-1980s on the economic impact of statehood which concluded that DC would be economically viable as a state, Dr. Brimmer refused to speculate about the financial viability of DC statehood at this time, claiming that he "had not thought about nor studied the issue since [the mid-1980s]." He said that the DC Statehood Commission report should be read from the perspective of what he thought about the proposition of DC statehood "at that time."

In light of these two studies and the current economic standing of the District of Columbia, economic viability as a state appears to be problematic.

Timothy Cooper
August 2002