A perennial issue for federal and District of Columbia officials has been determining the proper level of federal assistance to the District. Federal assistance historically has helped the District offset costs associated with its unique status and position. However, according to District officials, this assistance is inadequate. Based on the District’s most recent budget analysis, District officials claim that they will be unable to maintain the District’s current level of services into the future under its current revenue policies. District officials also point to a deeper structural imbalance, stating that they do not have sufficient revenue capacity to meet the high cost of providing residents and visitors with adequate public services. In addition, the District has experienced serious and longstanding management problems. In September 2002, we published an interim report that concluded that the District had not provided sufficient data and analysis for us to determine whether, or to what extent, the District is, in fact, facing a fiscal structural imbalance. To help inform this debate about the proper level of federal assistance, this report (1) assesses whether, or to what extent, the District faces a structural imbalance between its revenue capacity and the cost of providing residents and visitors with average levels of public services, (2) identifies significant constraints on the District’s revenue capacity, (3) examines cost conditions and management problems in key program areas, and (4) studies the effects of the District’s fiscal situation on its ability to fund infrastructure projects and repay related debt. While the District serves as the seat of the federal government, it also serves as home to over a half million people. The District is 61 square miles and had 9,316 residents per square mile in 2000. The District’s primary industry after the federal government is tourism. Other important industries include trade associations, as the District is home to more associations than any other U.S. city. Table 1 describes some of the demographic characteristics of the District and compares them to national averages in 2000. The fiscal relationship between the federal government and the District has been a subject of perennial debate. Although the U.S. Constitution gives the Congress exclusive legislative authority and control over the District as the seat of the federal government, the Constitution did not specifically define the fiscal relationship between the District and the federal government. Accordingly, tension has existed between maintaining some degree of federal control over the District and the desire to grant District residents a say in how they are governed. As a result, local autonomy and federal fiscal support for the District have evolved throughout the last 200 years. Through the 1870s to the present, the federal government has made financial contributions to the District’s operations. Table 2 briefly describes the evolution of this fiscal relationship by highlighting the important milestones since home rule in 1973. Several recent reports address some of the unique challenges the District faces as the nation’s capital, the status of its fiscal health, and the management inefficiencies that continue to affect its programs, costs, and service delivery. While these studies reach similar conclusions about the District’s unique costs associated with the federal presence, as well as its high demand for services, these studies also recognize that the District needs continued management improvements. Table 3 highlights the conclusions reached in several recent reports about the District. After the economic boom of the 1990s, all levels of government are now experiencing serious fiscal challenges and are likely to face even more fundamental ones in the future. The federal budget has moved from unprecedented federal surpluses in the late 1990s to deficits, with the Congressional Budget Office (CBO) now projecting the federal government to run deficits of $246 billion in fiscal year 2003 and $200 billion in fiscal year 2004. At the same time, spending demands are also on the rise, as the federal government deals with funding entitlement programs, such as Medicaid, Medicare, and Social Security, along with new and rapidly increasing health care costs and recent defense and homeland security needs. Similarly, states are experiencing significant, recurring revenue declines— estimates show state budget shortfalls of about $80 billion by 2004. States are not only facing a major decline in revenues—attributed to the recession, steep stock market declines and other factors—but also increased spending in areas like Medicaid due to increased enrollment and health care costs. This shortfall translated into reductions in aid to local governments, hiring and salary freezes, cuts in infrastructure projects and discretionary programs aimed at low-income individuals and families and even across the board spending reductions. Many states have also taken other actions like tapping “rainy day funds” or tobacco settlement money, or raising “sin” taxes. Like those of other state and local governments, the District’s finances have been adversely affected by the recent economic slowdown. The CFO’s office projects that total local source revenues for fiscal year 2003 will be $53.5 million (or 1.5 percent) lower in inflation-adjusted terms than they were in fiscal year 2000. The principal reason for this decline is a significant deterioration in individual income tax revenue. In fact, the decline of $214.1 million in the individual income tax far exceeds the decline in overall revenues. The CFO’s office attributes much of this decline to a steep drop-off in capital gains earned by residents, although the office does not have sufficiently detailed data to quantify the decline in this specific source of income. Sales tax and business franchise tax revenues have also declined, but in smaller absolute amounts compared to the individual income tax. In contrast, revenues from property taxes (the District’s second most important revenue source after the income tax), gross receipts, other taxes, and nontax sources have increased since fiscal year 2000. Table 4 shows the change in revenue from each principal source from fiscal year 2000 through fiscal year 2003. The District’s approved fiscal year 2003 budget was $5.6 billion. As of April 2003, District officials projected that over the long term, continuing current spending and tax policies would lead to increasingly large deficits, growing to $325 million dollars annually by 2007. The Ranking Minority Member of the Subcommittee on the District of Columbia, Committee on Appropriations, United States Senate, and the Honorable Eleanor Holmes Norton, House of Representatives, asked us to study the District’s fiscal position, including whether, or to what extent, the District faces a structural imbalance. To address our requesters’ questions, we used a body of evidence approach that combined quantitative and programmatic analyses to identify any possible structural imbalance. Our approach was not intended to provide a definitive point estimate of any imbalance, rather, it was expected to show whether the District’s ability to provide an average level of services with its given revenue capacity is substantially different from that of most jurisdictions. The approach was also designed to examine cost conditions in key program areas and to identify management problems that could lead to wasted resources. In addition, we attempted to identify the effects of the District’s fiscal situation on deferred infrastructure projects and debt capacity. Our methodology was vetted among key experts, including individuals who designed the underlying methodology and District economists. We revised our methodology based on expert consultation as appropriate. (See apps. I, II, and III for more detail on our overall approach.) Our methodology was based on previous efforts to define an objective measure of a fiscal system’s structural balance. No consensus exists regarding the appropriate level of services and taxation, and this issue has been a matter of perennial debate in every state. For this reason, when public finance analysts have, in the past, compared the underlying or “structural” fiscal position of jurisdictions, they have attempted to estimate objective measures of each jurisdiction’s spending that are independent of that jurisdiction’s particular preferences and policies. Similarly, analysts have estimated measures of revenue capacity that are independent of each jurisdiction’s decisions regarding tax rates and other tax policy choices. As we explain in more detail below, these objective benchmarks for levels of service and for revenue capacity are based on the national average spending and the national average tax rates for state fiscal systems. Consequently, the benchmarks are “representative” of the level of services that a typical fiscal system provides and the tax rates that it imposes on its tax bases. A fiscal system is said to be in structural balance if it is able to finance a representative basket of services by taxing its funding capacity at representative rates. Our use of an average level of services and average tax rates should not be interpreted as an indication that these are the levels of spending and taxation that jurisdictions should seek to provide. Each jurisdiction is an autonomous governmental entity responsible for providing the package of services and level of taxation desired by its citizens. Depending on the preferences of local citizens and their representatives, levels of taxation and the services they support may be higher in some jurisdictions and lower in others. The use of average levels in our analysis should only be thought of as a convenient benchmark against which to gauge relative differences in the cost of providing public services over which local officials have little direct control and as providing an indication of the potential availability of revenue sources from which to finance those costs. Because the District has all the fiscal responsibilities generally shared by state, city, county, and special district governments, we used two baskets of services as benchmarks. The first is a basket of services typically provided by state fiscal systems (the state and all of its local governments), and the second is a basket of services typically provided in more densely populated urban areas. Both baskets include such functions as elementary and secondary education, higher education, public welfare, health and hospitals, surface transportation, public safety, and other public service functions. For the basket of services provided by state fiscal systems, we combined our separate estimates by weighting each spending function by its proportionate share of total spending of the average state fiscal system. For the second basket of services provided by governments serving densely populated urban areas, we combined our separate estimates by weighting each spending function by its proportionate share of total spending of the average urban areas. To calculate the cost of providing an average, or representative, basket of public services, we used the national average per capita spending for each expenditure function as a benchmark for an average service level.