Brookings: Topics - Estate Tax

Taxing Privilege More Effectively: Replacing the Estate Tax with an Inheritance Tax

Lily L. Batchelder — Fri, 01 Jun 2007 00:00:00 -0400

Abstract

The repeal of the estate tax for one year only in 2010 creates vast uncertainty but also provides an opportunity to reconsider the taxation of gifts and bequests. This paper proposes replacing the estate tax with an inheritance tax. Heirs receiving lifetime inheritances greater than $2.3 million would include in income and pay a 15 percentage point surtax on the excess. The proposal would also replace stepped-up basis with carryover basis for bequests. As under the estate tax, the fraction of heirs affected would be miniscule, falling from three to two in 1,000.

The proposal has a number of advantages relative to the estate tax. It would reward donors who give more broadly. It would enhance efficiency and reduce compliance costs by curbing tax planning and the rules needed to contain it. Cross-national experience also suggests it would be administrable. Most importantly, the proposal would lower taxes on heirs receiving smaller inheritances and those with moderate incomes, making the tax system better attuned to unearned advantage and ability to pay. At an individual level, the distribution of tax burdens would change considerably: only 5 percent of the estate tax rate for an heir is accounted for by her inheritance tax rate, and vice versa, and each tax would raise 14 percent of revenue from heirs facing no tax burden under the other. The proposal is revenue-neutral relative to 2009 law. A lower exemption would raise more revenue and bring the tax rate on inherited income closer to the income tax rate on noninherited income, which is about three times higher.

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Authors

Lily L. Batchelder

Publication: Hamilton Project Discussion Paper, The Brookings Institution

'Death Tax' Repeal Unfair to Those Who Owe 'Birth Tax'

Diane Lim Rogers — Wed, 31 May 2006 00:00:00 -0400

Despite the political gridlock in Congress that has already stymied many tax and spending bills this spring, Senate Majority Leader Bill Frist, R-Tenn., has announced his intention to schedule a Senate vote on repealing or further cutting back the estate tax sometime in June. The House of Representatives already passed permanent repeal last spring.

Estate-tax legislation keeps coming up during each session of Congress, because the entirety of the 2001 tax cuts — including a gradual phase-down of the estate tax (to eventual repeal) — expire after 2010. Talk of a "compromise" coming out of the Senate has centered around how much estate-tax relief to maintain from here forward. There's been no talk of allowing the law to sunset and returning to the pre-2001 estate-tax levels. But some will keep insisting on permanent repeal.

Many members of Congress have taken to referring to the estate tax with the "populist" label, "death tax," and have suggested that all Americans should worry about facing this tax when they die.

Well, the estate tax may be appropriately called a "death tax" for the super rich, but for the vast majority of Americans, there is no tax due at death. The total U.S. population stands at nearly 300 million, and in recent years there have been around 2.4 million total deaths per year. The Urban-Brookings Tax Policy Center estimates that this year, with the estate-tax exemption level up to $2 million (or $4 million per married couple), there will be only 12,600 taxable estates. In other words, a mere one-half of 1 percent of deaths (or 1 in 200) will be assessed any estate tax. Calling this a "death tax" — as if it applies to all, or even many, Americans who die — is truly false advertising.

To put this in perspective, according to the National Center for Health Statistics, in recent years more than 18,000 people per year have died from an accidental fall. In other words, an American is 50 percent more likely to die from falling than to die owing a dime of estate tax.

So the estate tax actually affects a very small number of the wealthiest of families, just as it was intended to do. Under the law, it will affect a smaller and smaller number of families from now through 2009, when the exemption level reaches $3.5 million ($7 million per couple), and fewer than 1 in 300 of the deceased (only 7,200) will incur any estate-tax liability. Because the distribution of wealth is so highly skewed, however, the estate tax at its higher exemption level would still collect $16.3 billion for the government in 2009 — or almost 90 percent of this year's estate tax revenue — even though there would be fewer than 60 percent of this year's number of estate taxpayers.

So the difference between outright repeal and an higher exemption level than written into the law is small in terms of the number of households who will be relieved of the tax (everyone versus almost everyone), but huge in terms of lost revenue.

For almost all American families, repealing or reducing this tax would not provide any tax relief. Yet permanent repeal of the estate tax would cost the American people nearly $1 trillion in tax revenues, including interest, in the course of just the first 10 years of extension, from 2012 to 2021. Over several decades, this would add trillions of dollars to a total national debt that has already reached $8.5 trillion. (A compromise of establishing a higher exemption could cost much less than repeal, yet still could produce a substantial loss of revenue.) This is what all Americans should pay attention to when it comes to the subject of the "death tax." Repeal of the estate tax would only worsen the financial burden that our children and grandchildren will have to bear — a message that the U.S. Senate should hear.

The problem is that there is no such thing as a free tax cut, unless — ironically in this case — you die before the bill comes due. It is those born into our current fiscal quagmire who can't avoid the burden — an inherited share of the public debt that is, to date, $28,000 per American, and rising. However, this amount probably understates the burden on the youngest and yet-to-be-born Americans, because the commitments to programs such as Social Security and Medicare will rise over their lifetimes. By adding to the debt, estate-tax repeal would eventually raise this per-person burden — the "birth tax" — by thousands of dollars over their lifetime (including more than $3,000 from just the first 10 years after it would take effect).

This "birth tax" is a true cost imposed on all American babies. It cannot be repealed, no matter how upset Americans eventually get about it. Through the harmful effects of deficits on national saving, these future adults will be less likely to have the means to pay off these debts and are in danger of facing a lower standard of living than adult Americans today.

So repealing the estate tax would swap a "death tax," which affects hardly anyone and has been found to have little effect on economic decisions, for a higher "birth tax," which would be universal and seriously detrimental to future economic growth.

Authors

Diane Lim Rogers

Publication: San Francisco Chronicle

Options for Reforming the Estate Tax

Jeffrey Rohaly, Leonard E. Burman and William G. Gale — Mon, 18 Apr 2005 00:00:00 -0400

Under current law, the estate tax is reduced gradually through 2009, repealed in 2010, and then reinstated in full force in 2011. Few expect things to actually play out that way. President Bush and many members of Congress would like to repeal the tax permanently, and many would like to do so before 2010. Repeal would be expensive, however: Immediate repeal would reduce revenues by more than $400 billion over the next decade. Even making repeal permanent as of 2010 would cost $270 billion in the next 10 years. Repeal would also be regressive, would reduce charitable giving by more than $15 billion a year, and would invite significant tax sheltering activities. It would increase the concentration of wealth, and may also increase the political power of a wealthy elite.

Critics of the estate tax argue that it burdens small farms and businesses with confiscatory tax rates, discourages work and thrift, and retaxes money taxed under the income tax. In fact, few small farms and businesses appear to be subject to the estate tax although many families may undergo costly planning to avoid it. The empirical evidence on saving behavior is ambiguous: The tax may discourage work and saving for people subject to it, but it has the opposite effect on heirs who — expecting smaller bequests — choose to work harder and save more. And while it may "double-tax" income in some cases, much of the wealth subject to estate tax was earned through untaxed capital gains and so has never been subjected to the income tax.

In contrast to repealing the tax, retargeting the estate tax to very wealthy households and lowering its rates would blunt much of the criticism against it while retaining many of its advantages. This article explains how the estate tax works and examines who is affected by it under current law. It discusses how reform would affect tax revenues, the distribution of tax burdens, farms and small businesses, and charitable giving and bequests. A concluding section discusses ways to reduce the complexity of the tax.

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Jeffrey Rohaly
Leonard E. Burman
William G. Gale

Publication: Tax Break

Death by a Thousand Cuts: An Analysis of the Estate Tax's Demise

Thu, 24 Mar 2005 09:30:00 -0500

Event Information

March 24, 2005
9:30 AM - 11:00 AM EDT

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

In 2001, Congress enacted legislation to phase-out the estate tax by 2010. The repeal is effective for only one year, however. The estate tax—referred to by some as the "death tax"—affects the wealthiest 2 percent of the population and represents a progressive source of federal revenue and a key incentive for charitable giving. Prior to 2001, the movement to repeal the tax was a primary focus of reform debates, but its elimination seemed highly unlikely. How, then, did the legislation suddenly sail through Congress? And how did so many Americans become opposed to a tax that would never affect them?

At this Brookings briefing, Yale professors Michael J. Graetz and Ian Shapiro will discuss the history of the estate tax and analyze the reform movement through the philosophical arguments that framed it and the interests that drove it. They are the authors of a new book, Death by a Thousand Cuts (Princeton University Press, 2005), that is based on extensive interviews conducted with the relevant policymakers and political players. Following their presentation, a panel will discuss their findings and offer insights into the broader implications of the tax reform debate.

Participants

Moderator

Panelists

Leonard E. Burman

Senior Fellow, Urban Institute; Co-Director, Urban-Brookings Tax Policy Center

Ian Shapiro

William R. Kenan, Jr. Professor of Political Science, Yale University

Michael J. Graetz

Justus S. Hotchkiss Professor of Law, Yale University

Estate tax: Tax Needs Reform, But Repeal Would be a Giveaway to the Wealthy

William G. Gale — Sun, 27 Jul 2003 00:00:00 -0400

The estate tax plays an important role in our economy and society. It does have flaws, but it should be improved, not abolished. A sensible reform would bolster the strengths of the estate tax and reduce the problems.

The estate tax has numerous strengths. It is by far the most progressive source of federal revenue. Despite the perception that advocates of repeal have created, the vast majority of estates are not subject to the estate tax. Only 2 percent of deaths result in any estate payments at all. About half of all estate taxes are paid by the wealthiest 1 out of every 1,000 estates. By 2009, couples with less than $7 million in wealth will pay nothing at all. Repeal would be a massive giveaway to the nation's wealthiest dynasties.

The estate tax helps close what otherwise would be gaping loopholes in the income tax with respect to capital gains and other items. Repeal would create sheltering schemes that would drain massive amounts of income tax revenue from federal coffers.

The tax also helps support the nonprofit sector by providing incentives to give to charities at precisely the time when people are distributing large amounts of wealth. My own research indicates that repeal would reduce charitable giving at death and during life by about $10 billion per year. This represents 5 percent of all charitable giving and is equivalent to the annual grant-making of the nation's 100 largest foundations.

The estate tax helps provide equal opportunity by reducing the size of massive inheritances. It is hard to see why children of the rich should be allowed to inherit scads of money tax-free when other forms of income are taxed.

Opponents claim the tax raises very little revenue. But estate taxes were slated to raise about $400 billion over the next decade before being slashed in 2001. Let's put it another way: Retaining the estate tax, rather than repealing it, would pay for half of the entire Social Security shortfall over the next 75 years.

The alleged negatives of the tax have been grossly overstated. The vast majority of small businesses are too small to ever face the estate tax. Half of them go out of business within four years, so claims that the estate tax is a major cause of the breakup of family businesses simply are wrong.

Likewise, two major farm organizations were unable to point to a single family farm that had to be broken up due to the estate tax. Even if the tax were a serious problem for small businesses and farmers, those assets constitute less than 15 percent of all wealth subject to the estate tax.

Special provisions already allow family owned businesses and farms to shelter two to three times as much as others can and could be expanded. You don't need to repeal the estate tax to save the family business or farm.

The impact of the tax on wealth accumulation is unproven. But the impact of large inheritances on the behavior of recipients is quite clear: Inheriting a large estate causes people to work less and spend more. Those effects clearly reduce economic growth.

The hysteria in labeling it the "death tax" also is misplaced. About 98 percent of people who die receive a "death subsidy" -- their taxes on accumulated capital gains are forgiven, but they don't pay estate taxes. Furthermore, the estate tax need not actually be paid at the time of death. It can be prepaid with prudent estate planning devices such as life insurance, and for small businesses and farms, the payments can be stretched out over many years.

The easiest way to see that all the braying over the unfairness of taxing at the time of death is a red herring is to note that no one who objects to taxes at the time of death ever proposes equally progressive taxes imposed during life.

All taxes impose burdens, and the estate tax is no exception. The bigger question is whether the burden per dollar raised from a tax on someone who inherits millions of dollars is more or less than the burden of what will result if the estate tax is eliminated -- higher taxes on working families, less generous Medicare payments or some other unspecified alternative. All budgetary decisions reflect priorities, and eliminating the estate tax should be a lower priority than these and other claims on the national pocketbook.

For all of these reasons, abolishing the tax is a bad idea. After all, a tax that is progressive, closes loopholes, provides equality of opportunity and encourages charitable giving can't be all bad.

It should be saved and enhanced, reformed to emphasize its virtues and minimize its costs. This could be done by closing loopholes, reducing rates modestly, indexing the tax for inflation and letting the exemption rise as scheduled. This would focus the tax on the truly wealthy and at the same time make it simpler and fairer.

Authors

William G. Gale

Publication: Spartanburg Herald-Journal

Effects of Estate Tax Reform on Charitable Giving

Jon M. Bakija and William G. Gale — Tue, 17 Jun 2003 00:00:00 -0400

Since 1916, the United States has imposed a tax on the estates of the wealthiest individuals. The 2001 tax cut reduces the estate tax over time, and then repeals it as of 2010, only to reinstate it in 2011. Because politicians are unlikely to allow this pattern of changes to occur, estate tax reform will return to the policy agenda in the near future.

One of the most important issues in assessing reform options is the impact on charitable giving. The estate tax encourages charitable giving at death by allowing a deduction for charitable bequests. It also encourages giving during life, as explained below. But the tax reduces charitable gifts by reducing the amount of wealth decedents can allocate to various uses. The net impact of these effects is ambiguous in theory.

We find that estate tax repeal would reduce charitable bequests by between 22 and 37 percent, or between $3.6 billion and $6 billion per year. Previous studies are consistent with this finding, and also imply that repeal would reduce giving during life by a similar magnitude in dollar terms. To put this in perspective, a reduction in annual charitable donations in life and at death of $10 billion due to estate tax repeal implies that, each year, the nonprofit sector would lose resources equivalent to the total grants currently made by the largest 110 foundations in the United States.1 The qualitative conclusion that repeal would signifi- cantly reduce giving holds even if repeal raises aggregate pre-tax wealth and income by plausible amounts.

Background

In 2001, charitable contributions totaled $212 billion, of which living individuals gave 76 percent, bequests accounted for 8 percent, and foundations accounted for 12 percent (AAFRC Trust for Philanthropy 2002). Estate tax changes can plausibly affect giving through all of these channels.

The remaining 4 percent was donated by corporations. Charitable bequests figure most prominently as a source of gifts for educational institutions, medical research institutions, museums, and the creation and maintenance of private foundations.

The federal estate tax currently applies to net estates in excess of $1 million. The net estate equals gross assets at death less deductions for debts, spousal bequests, charitable bequests, expenses of administering the estate, and a few other miscellaneous items. The marginal estate tax rate varies between 41 and 49 percent, with the rate rising as wealth does. The exemption is scheduled to increase in steps, reaching $3.5 million by 2009, while the top marginal tax rate is scheduled to fall to 45 percent, before the tax is temporarily eliminated in 2010.

In recent years, about 2 percent of decedents have had to pay federal estate taxes. Table 1 provides information on charitable bequests and wealth reported on federal estate tax returns filed in 2001. Most of these returns represent people who died in 2000, for whom the effective exemption was $675,000. Charitable bequests appeared on one-sixth of estate tax returns, and amounted to $16.1 billion, or 7.5 percent of the value of gross assets.

Both the likelihood of giving and the share of estate given rise significantly with wealth. These patterns are consistent with the incentives created by tax rates that rise with wealth. Of course, people may be willing to give larger shares of wealth to charity as their wealth rises for reasons other than taxes. In any event, charitable bequests are heavily concentrated among the wealthiest estates. In 2001, 301 decedents with gross estates in excess of $20 million gave $6.8 billion to charity. These decedents represented fewer than 1 out of every 8,000 deaths in that year, but accounted for 42 percent of all charitable bequests and made average bequests of $23 million. Likewise, 64 percent of all charitable bequests came from roughly 1,900 gross estates above $5 million.

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Jon M. Bakija
William G. Gale

The Estate Tax: A Forum Featuring William H. Gates, Sr.

Tue, 14 Jan 2003 09:30:00 -0500

Event Information

January 14, 2003
9:30 AM - 11:30 AM EST

Katharine Graham Conference Center
The Urban Institute
2100 M Street, NW, 5th floor
Washington, DC

William H. Gates, Sr. is the co-author with Chuck Collins of a new book, Wealth and Our Commonwealth: Why America Should Tax Accumulated Fortunes.

Following Mr. Gates' presentation, a distinguished panel of experts will comment on the impact repeal of the estate tax would have on charitable giving, small businesses and family farms, state budgets, the nation's overall economic growth, and more.

The panel, which will be moderated by Robert Reischauer (president of the Urban Institute), includes:

Bruce Bartlett, National Center for Policy Analysis (former Treasury deputy assistant secretary)
Len Burman, Urban Institute (co-director, TPC and former Treasury deputy assistant secretary)
William Gale, Brookings Institution (co-director, TPC and former senior staff economist, Council of Economic Advisers)
Raymond Scheppach, National Governors Association (former deputy director, Congressional Budget Office)

More information is available on the Urban-Brookings Tax Policy Center website. Seating is limited. Please RSVP as soon as possible to Karen McKenzie, (202) 261-5709 or kmckenzi@ui.urban.org. A limited number of copies of the Gates book will be available at the forum.

Rhetoric and Economics in the Estate Tax Debate

Joel Slemrod and William G. Gale — Tue, 22 May 2001 00:00:00 -0400

In this paper, we evaluate and critique ten principal claims made in recent debates on the estate tax, distinguishing five types of statements: facts, rhetoric, value judgments, economic reasoning, and informed speculation. Economics can not fully resolve the debate because economic knowledge is inconclusive and because value judgments help determine optimal choices. Nevertheless, economic analysis can contribute substantially to informing these debates and we show that many of the claims on both sides are incorrect or incomplete, given what is known.

This paper was prepared for the National Tax Association Spring Symposium, Washington, DC, May 7-8, 2001.

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Joel Slemrod
William G. Gale

The Estate Tax Plays a Key Role

Joel Slemrod and William G. Gale — Sun, 01 Apr 2001 00:00:00 -0500

The estate tax plays a small but important role in our society. It is by far the most progressive federal tax. Over half of all estate taxes are paid by the wealthiest—1 out of every 1,000 estates—and only 2 percent of deaths result in any payment at all. Most couples with less than $1.35 million of wealth pay nothing at all. A variety of special provisions allow family-owned businesses and farms to shelter two to three times that amount.

The tax helps close what would otherwise be gaping loopholes in the income tax with respect to capital gains and other items. The tax helps support the nonprofit sector by providing incentives to give to charity at precisely the time when people are distributing large amounts of wealth. The tax also helps provide equal opportunity by reducing the extent of huge inheritances. And estate taxes are slated to raise about $400 billion over the next decade.

The alleged negatives of the tax—its effects on saving, small businesses and farms, and its high compliance costs—are often grossly overstated. The hysteria in labeling it the "death tax" is also misplaced. About 98 percent of deaths result in no estate taxes, its one-time burden at the time of death can be reduced with prudent estate planning devices such as life insurance and the tax is imposed on wealth, not on death itself.

All taxes impose burdens, and the estate tax is no exception. The bigger question is whether the burden per dollar raised from a tax on someone who inherits millions of dollars is more or less than the burden of what will result if the estate tax is eliminated—higher taxes on working families, less generous Medicare payments or some other unspecified alternative. All budgetary decisions reflect priorities, and eliminating the estate tax should be a lower priority than these and other claims on the national pocketbook.

For all of these reasons, abolishing the tax is a bad idea. A much better strategy would be to reform the tax to emphasize its virtues and minimize its costs. This could be done by raising the exemption, closing loopholes, reducing rates modestly, and indexing the tax for inflation. This would focus the tax on the truly wealthy and at the same time make it simpler and fairer.

Authors

Joel Slemrod
William G. Gale

Publication: AARP Bulletin

Rethinking the Estate and Gift Tax

Joel Slemrod and William G. Gale — Thu, 01 Mar 2001 00:00:00 -0500

Advocates of estate tax abolition see a morally repugnant tax that impairs economic growth, destroys small businesses and family farms, encourages spendthrift behavior, generates huge compliance costs, and leads to ingenious sheltering schemes. As an inefficient, inequitable, and complex levy, the so-called "death tax" is thought to violate every norm of good policy. Supporters of the tax believe the criticisms are overstated or wrong. They note that the tax is only levied on the estates of 2 percent of Americans who die—and only on those with substantial wealth. They believe that a highly progressive tax that patches loopholes, helps provide equality of opportunity, reduces the concentration of wealth, and encourages charitable giving cannot be all bad.

An intermediate strategy would be to reform the tax by raising the exemption, closing loopholes, reducing rates, and indexing for inflation. This strategy could resolve many of the problems that advocates of abolition perceive, while retaining the virtues raised by estate tax supporters.

The debates have increased in intensity and frequency, in part because of the stock market boom, an aging population, the budget surplus, and intensive lobbying, but also because the estate tax raises controversial issues. Besides its association with the rich and the dead, the estate tax epitomizes in extreme form the pervasive trade-off between equity and efficiency in the design of government policy. In addition, the tax raises issues as private as the nature of relationships between parents and their children, and as politically sensitive as the definition and implementation of equal opportunity and the limitations on the government's role in income redistribution.

Estate Tax Basics

Since 1976, federal law has imposed a linked set of taxes on estates, gifts, and generation-skipping transfers. Under current law, the executor of an estate must file a federal estate tax return within nine months of a person's death if the gross estate exceeds $675,000. Generally, the gross estate includes all of the decedent's assets, his or her share of jointly owned assets, life insurance proceeds from policies owned by the decedent, and gifts made during life in excess of an annual exemption that is currently set at $10,000 per donee per year. It is often possible to discount the valuation of assets by placing them in a mediated ownership form, such as a family limited partnership, rather than holding them on one's own account.

The tax allows deductions for transfers to a surviving spouse, charitable gifts, debts, funeral expenses, and administrative fees. Tax credits are given for gift taxes previously paid, for estate taxes that were recently paid on inherited wealth, and—to a limited degree—for state-levied inheritance and estate taxes. A unified credit currently exempts taxes on the first $675,000 of lifetime taxable transfers, a figure that will rise to $1 million by 2006. For estates above those amounts, the tax rate begins at 37 percent and rises to 55 percent on taxable transfers above $3 million. For estates with taxable wealth between $10 million and about $17.18 million, a 5 percent surtax takes back the benefit of a graduated rate structure and raises the effective marginal rate to 60 percent. Additional information on the history and structure of the tax, as well as the economic characteristics of decedents, may be found in the conference paper by Treasury Department economists Barry Johnson, Jackob Mikow, and Martha Britton Eller.

Transfer taxes raised about $28 billion in federal revenues in 1999 and are projected to raise over $400 billion between 2002 and 2011. Nearly all industrialized countries levy some kind of wealth transfer tax. But other than the United States, only the United Kingdom levies "pure" estate taxes; the others have an inheritance tax or a mixture of inheritance and estate taxes. In 1997, the United States ranked third highest among industrialized countries in terms of transfer taxes as a share of total revenues. But many industrialized countries have annual wealth taxes, which the United States does not.

Why Give Intergenerational Transfers?

An important theme to emerge from the conference is the simple but fundamental point that the effects of transfer taxes will depend on why people give transfers in the first place. Some bequests may be "accidents," in the sense that people accumulate assets to save for retirement, but they do not know how long they will live. Even if they do not plan or desire to give bequests, they may die before they expect to and end up bequeathing assets to descendants. Other bequests may be motivated by parental altruism toward their children. Some people may be motivated by the sheer joy of giving resources away. Finally, some bequests or transfers may represent a sort of payment by parents to their children in exchange for help and attention.

Equity

Half of all estate taxes are paid by the estates of decedents with $5 million or more in wealth, and all estate taxes are paid by wealthiest 2 percent of decedents. Thus, if the burden of the tax is borne by donors, the tax is extraordinarily progressive. Many people claim, however, that the burden is really borne by the people who receive inheritances. However, as William Gale and Joel Slemrod report in their introductory survey, the recipients of inheritances from estates subject to the estate tax typically have very high-pre-inheritance incomes. Thus, even if the tax is borne by recipients, it is still a very progressive tax.

Another possibility is that the burden is passed along to others in the economy. But the conference paper by University of Michigan economist John Laitner shows that the tax is progressive, even allowing for its economy-wide effects. The estate tax also serves as a backstop to the income tax, taxing components of income—such as unrealized capital gains—that otherwise go untaxed.

Transfer taxes raise difficult issues of horizontal equity. Among donors with the same wealth, the taxes discriminate on the basis of how resources are spent, violating the notion that those with equal means should pay equal taxes. But among recipients with the same (non-inheritance) wealth, transfer taxes reduce the inequality of inheritances and thus ameliorate unequal opportunity. These two perspectives create irreconcilable differences in views concerning whether taxes on transfers are fair in principle.

Another issue is whether taxing at death is appropriate. Death is neither necessary nor sufficient to trigger transfer taxes. It is unnecessary because transfers between living persons can trigger gift taxes. It is insufficient because 98 percent of people who die pay no estate tax. While death may be unpleasant to contemplate, the costs of taxing at death do not appear to be significant, relative to taxation during life. Thus, to the extent that it really is a problem, taxation at death could be avoided by replacing the estate tax with equally progressive taxes imposed during life.

Efficiency

In his conference paper, Harvard University law professor Louis Kaplow shows that whether an estate tax is part of an efficient tax system—one that minimizes the economic cost per dollar raised—depends crucially on several factors, most notably on why people give transfers. For example, to the extent that bequests are "accidental," the estate tax is highly efficient, because the donor had no intention of leaving a bequest in the first place. On the other hand, if parents are altruistic toward their children, Kaplow shows that there may even be a case for subsidizing transfers, rather than taxing them. However, if society desires an equitable tax system as well as an efficient one, the case for an estate tax is improved, because the tax is highly progressive, and hence can "buy" a lot of equity. This suggests that simple descriptions of optimal tax policy toward transfers are difficult to establish.

Tax Avoidance and Evasion

Critics argue that the estate tax spawns a host of avoidance schemes and label the levy "voluntary." But it is hard to believe that financially sophisticated, wealthy households voluntarily part with upwards of $30 billion per year. Duke University law professor Richard Schmalbeck surveys a wide range of estate tax avoidance techniques and shows that although it is possible to avoid a significant amount of estate taxes, doing so typically requires people to give up control of their assets, which they are not inclined to do.

Estimates of the costs of complying with the estate tax vary enormously—from 7 percent of revenues to 100 percent—partly because the data and methodologies are flawed; the more reliable estimates are at the lower end of the range. In their contribution to the conference, economists Martha Britton Eller, Brian Erard, and Chih Chin Ho estimate an estate tax evasion rate of about 13 percent, and suggest that the true value is likely to be higher.

Effects on Saving, Labor Supply, and Entrepreneurship

Critics argue that the estate tax significantly reduces the saving, labor supply, and entrepreneurship that are essential to economic prosperity, but little evidence has been available to evaluate this claim. A distinctive feature of the volume is the presence of the three papers on wealth accumulation and the taxation of estates.

The University of Michigan's Laitner provides the most sophisticated simulation model of the economic impact of estate taxes to date, embedding them in an overlapping generations model which features individuals with altruistic bequest motives. He finds that removing estate taxes would have a small positive effect on the long-term ratio of capital to labor. William Gale and Federal Reserve Board economist Maria Perozek show that the impact of transfer taxes on saving, like the efficiency effects, will depend critically on why people give transfers. If bequests are unintentional, for example, estate taxes will not affect saving by the donor. But the reduction in net-of-tax inheritances received will cause recipients to consume less and thus save more. If bequests are motivated by altruism, the effects are ambiguous, but simulations suggest that the estate tax could actually raise saving under many circumstances.

Wojciech Kopczuk and Joel Slemrod, of the University of Michigan, show that in years with high estate tax rates, the total value of reported estates is generally lower than in years with low estate tax rates, holding constant other influences. Using data on specific decedents, they find that the tax rates that prevailed at either age 45 or ten years before death are more clearly (negatively) associated with reported estates than the tax rate prevailing in the year of death. These results could reflect the impact of estate taxes on the donor's saving or avoidance, or both.

Other empirical work has shown that recipients of large inheritances increase their consumption spending and reduce their labor supply. By extension, if estate taxes reduce net-of-tax inheritances, they should reduce consumption—that is, raise saving—and raise labor supply by the recipient.

The impact of the estate tax on family-held businesses and farms has taken on a hugely disproportionate role in public policy debates. This issue is reviewed extensively in the introductory survey by Gale and Slemrod, but the basic points are straightforward. There is virtually no reliable evidence suggesting that the impact of estate taxes on businesses and farms is significant. Businesses and farms already receive substantial subsidies under the existing estate tax, not to mention subsidies under the income tax. The vast majority of estates have no business or farm assets, and only about 3 percent of estates have more than half of their wealth in businesses and farms. Most of the value of small businesses in estates consists of unrealized capital gains and would never be taxed were it not for the estate tax. These findings suggest that the case for existing business subsidies in the estate tax is weak, the case for expanding those subsidies is weaker still, and the notion that the estate tax should be abolished because of its alleged effect on businesses and farms is completely misguided.

Effects on Gift Giving and Charity

Although estate and gift taxes are said to be "unified," a number of features of the tax code favor gifts over bequests, and evidence suggests that changes in the tax treatment of gifts and bequests affect the composition and timing of transfers. In their paper at the conference, economists Jonathan Feinstein and Chih Chin Ho extend this work by showing that an individual's health status (and by extension, the likelihood of dying and facing estate taxes), has important effects on giving behavior. They document a series of patterns among saving, gift giving, and health that suggest that a significant amount of giving is tax-motivated.

Several analyses find that the estate tax deduction for charitable donations generates a significant increase in contributions at death. The estate tax may also encourage charitable giving during life, too, since this would reduce both income and estate taxes. David Joulfaian's contribution to the volume matches estate tax returns filed between 1996 and 1998 with income tax returns for the same people filed between 1987 and 1996. Joulfaian, a Treasury Department economist, finds that the magnitude of giving during life relative to giving at death changes markedly with wealth, with the extremely wealthy giving a much greater share of their contributions at death. His estimates also document that giving at death is sensitive to the marginal tax rates applied in the estate tax, and so indicate that abolishing the tax would lead to a significant decline in charitable bequests.

Proposals for Change

Policymakers have considered numerous changes to the estate tax in recent years. The most radical reform would be to abolish the tax. This removes the existing problems, but may create serious additional issues. It would eliminate what is by far the most progressive tax instrument in the federal tax arsenal, just after an extended period over which the distributions of income and wealth have become far more skewed. It could hurt non-profit organizations. It may not even raise saving, labor supply, or growth, as its advocates hope, and would probably reduce state tax revenues as well. Finally, abolition would expose a gaping loophole with regard to capital gains in the income tax and would open up other possibilities for tax avoidance—and resulting revenue loss—under the income tax.

Abolition could be coupled with the extension of the capital gains tax to the gains accrued but unrealized at death. This proposal, however, would raise only about a quarter of the revenue of the estate tax, and would be much less progressive, as economists James Poterba and Scott Weisbenner demonstrate. In addition, this option would contain many of the complexities of the estate tax, and so is neither attractive nor likely.

The bill that Congress passed in 2000 tied elimination of the estate tax to another significant change in the taxation of capital gains called "carryover basis." Under the provision, heirs would assume the decedent's basis for capital gains purposes. Exemptions would have applied to transfers below $1.3 million and to interspousal transfers of $3 million. This proposal, however, would raise almost no revenue, and it would be difficult to administer, in part because records would have to be kept for an even longer period of time and across generations. A similar item was passed in the late 1970s, but was repealed before it ever came into effect partly because of anticipated implementation problems.

Another reform would be to replace taxes on estates and gifts given with taxes on gifts and inheritances received, as is the practice in several U.S. states and many foreign countries. Under a progressive inheritance tax (but not under an estate tax), spreading a given bequest among more recipients reduces the total tax burden and thus encourages the splitting of estates. In addition, a unified tax system would tax all sources or all uses of income. Currently, the income tax imposes burdens on sources of income and the estate tax falls on a particular use of income. In contrast, the income tax, combined with a tax on inheritances and gifts received, would cover all major sources of income over the lifetime, and placing the statutory burden of the tax on recipients rather than the donor may reduce some of the moral outrage generated by estate taxes.

Perhaps the most plausible reform would be to follow the strategy invoked for income taxes in the Tax Reform Act of 1986: raise the exemption level, close loopholes, and cut rates. Raising the exemption would reduce the number of people paying the tax while still taxing the "truly wealthy," and chipping away at the concentration of wealth. It would also help smaller family-owned businesses, but without the horizontal equity problems that are involved in giving preferential treatment to business assets. Closing loopholes by treating different assets in a more similar fashion would reduce sheltering opportunities, and thus make the tax simpler and fairer. Modestly reducing rates would reduce the incentive to shelter or change behavior in the first place. In addition to these changes, indexing the effective exemption and the tax brackets for inflation would automatically keep the tax burden at any particular real wealth level constant over time.

Conclusion

The appropriate role and effects of transfer taxes are still open questions. Any conclusion about the appropriate taxation of intergenerational transfers must take into account transfer motives, the political and technical limitations on other tax instruments, the limited knowledge about such taxes that is currently available, and other factors.

In a real world filled with practical difficulties, political compromises, and economic uncertainties, it may take a variety of taxes to meet social goals, and the estate tax may well play a small but important role in the government's portfolio of tax instruments. It adds to progressivity in a way that the income tax cannot easily do because of capital gains issues, and that society may choose not to do via income taxes, because taxing at death may have smaller costs than taxing during life. The supposed negatives of the estate tax—its effects on saving, compliance costs, and small businesses—lack definitive supporting evidence and in some cases appear to be grossly overstated. Additionally, there are some presumed benefits from increased charitable contributions and improved equality of opportunity.

Nevertheless, it is equally clear that there is a problem. A tax with high rates and numerous opportunities for avoidance is ripe for reform. Even given the goals and constraints noted above, many people feel that transfer taxes could be better structured. Many others feel that having no transfer taxes would be preferable.

Economic analysis cannot fully resolve these issues. What it can do is clarify the various trade-offs involved in tax policy decisions, illuminate which value judgments—about which economics has no say—are involved, and identify the crucial conceptual and empirical issues. Compared to many tax questions, the tradeoffs that affect estate taxes are more difficult to analyze, because they involve more than one generation. The value judgments are more difficult, because they involve life-and-death and parent-child issues, about which people have strong opinions. Empirical analysis is more difficult, because the data are more elusive and the relevant behaviors span at least a lifetime.

The studies in the forthcoming conference volume address all of these issues and rethink the estate and gift tax in a rigorous way. It is our hope and expectation that the papers that emerged from the May conference will provide a solid base of knowledge to inform future policy discussions and a springboard to encourage continuing analysis of transfer tax issues.

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Joel Slemrod
William G. Gale

Resurrecting the Estate Tax

Joel Slemrod and William G. Gale — Wed, 21 Jun 2000 00:00:00 -0400

In June, the U.S. House of Representatives voted to phase out the estate and gift tax over the next 10 years. This is not a new idea: both the House and the Senate voted to dump the tax last year, but President Clinton vetoed the bill. What is new is that 65 Democrats joined Republicans in voting out the tax this year, enough to override a veto. This shift, along with an endorsement from presumptive Republican presidential nominee George W. Bush, makes the estate tax a live political issue.

Besides its association with the rich and the dead, the estate tax manages to touch on several other sensitive topics. The tax embodies in extreme form the trade-off between equity and efficiency that pervades government policy. It is only levied on the wealthiest households, but the tax base is linked to accumulated wealth and thus to the labor supply, effort, and saving that create wealth and are crucial to prosperity. In addition, the impact and proper role of estate taxes depends on issues as personal and sensitive as parents’ rights to provide for their offspring and the nature of relations between parents and children, and issues as controversial as the true meaning of equal opportunity.

Despite all this, the estate tax has received little public airing and even less reasoned discussion. Many arguments commonly made against the tax are demonstrably specious. To the extent that any of them are valid, they suggest reform rather than abolition. Many arguments made in favor of the tax actually support maintaining some sort of levy, but not necessarily the existing version.

POLICY BRIEF #62

Estate Tax Basics

Taxes on transfers of wealth were levied as far back as the 7th century B.C., in Egypt. The first American tax on wealth transfers dates to 1797 when, faced with the expenses of dealing with French attacks on American shipping, Congress imposed a stamp duty on receipts for legacies and probates for wills. The tax was eliminated in 1802. Similar, short-lived taxes were enacted during the Civil and Spanish-American Wars. The modern estate tax also originated in a time of war preparation, if not war itself, in 1916. However, this incarnation survived World War I because it fit the dominant view of the time that federal revenue from customs and excise taxes should be replaced by more progressive tax methods.

Nearly all industrialized countries levy some kind of a wealth transfer tax. But other than the United States, only New Zealand and the United Kingdom levy "pure" estate taxes; the others have an inheritance tax or a mixture of inheritance and estate taxes. Other than the U.S., only Japan and South Korea collect more than one percent of total tax revenues from wealth transfers, but many industrialized countries have annual wealth taxes, which the U.S. does not.

Under current U.S. law, the executor of an estate must file a federal estate tax return within nine months of a person's death if the gross estate exceeds $675,000. The tax base includes the decedent's gross assets plus any gifts made in excess of $10,000 per year per donee. The tax allows deductions for transfers to a surviving spouse, charitable gifts, debts, funeral expenses, and administrative fees. A tax credit exists for state-levied inheritance and estate taxes; most states now levy so-called "soak-up" taxes that fall within the credit limit, and so do not add to the total tax burden. A unified credit currently exempts taxes on the first $675,000 of lifetime taxable transfers, a figure that will rise to $1 million by 2006. For estates above those amounts, the tax rate begins at 37 percent and rises to 55 percent on taxable transfers above $3 million. In 1999, the federal estate and gift tax netted $28 billion—about 1.5 percent of federal revenue. By comparison, the gasoline tax raised $39 billion, the income tax $879 billion, and the corporate income tax $185 billion.

Estate tax liability is highly concentrated among rich families. Less than 2 percent of people who die owe any estate taxes at all. In 1997, estates with gross value over $5 million accounted for half of all estate and gift taxes, but only about 5 percent of all taxable estates and about 1 out of every 1,000 deaths. Estate taxes are much more progressive than the graduated income tax. Households in the top 5 percent of the income distribution bear 91 percent of estate taxes compared to 49 percent of income taxes. Those in the top 20 percent bear 99 percent of estate taxes and 77 percent of income taxes.

The Case Against the Estate Tax

1. Taxing at death is immoral

Opponents often view death as an illogical time to impose taxes at best, and a morally repugnant one at worst. Compounding the grief of a family with a tax, of all things, seems a bit heartless, and the mention of "death tax" evokes queasiness. As evocative as it is, this argument is seriously misleading. First, death is neither necessary nor sufficient to trigger the estate and gift tax. It is insufficient because over 98 percent of decedents pay no tax. It is unnecessary because gifts between living people can trigger a tax liability. More important, estate tax liabilities can be effectively prepaid via life insurance purchases tied to the expected tax liability or, in the case of qualified family businesses, can be delayed and paid over a 14-year period after the death of the owner. Thus, although death may trigger the tax liability, the payment can be remitted at any of a number of times.

Leaving the morality issue aside, death is very likely to be a convenient "tax handle." The public nature of the probate process reveals information about a family's level of affluence that is difficult to obtain in the course of enforcing the income tax, but that may be relevant for societal notions of the appropriate level of progressivity. This aspect of taxation at death likely explains why inheritance and estate taxes date back for millennia. Many economists have argued that taxes at death have smaller disincentive effects on lifetime labor supply and saving than do equivalent-revenue taxes imposed during life.

2. The estate tax stifles saving, labor supply, and economic growth

Combined with the income tax, the marginal tax disincentive to work and save created by the estate tax for the affluent can be so high as to seriously discourage work and saving. The top federal income tax rate of 39.6 percent combined with the top estate tax rate of 55 percent implies a tax penalty as high as 73 percent on a dollar earned with the intent to bequeath.

The impact of the estate tax on saving hinges on why people make bequests. For example, to the extent that bequests are unintentional, and arise out of people's unwillingness to convert their wealth to annuities, people would have wealth left over when they die, even if they would have liked to have consumed the wealth themselves. In that case, an estate tax would not discourage saving and would not be a burden to the bequeathor (although the donee would be less well off).

What if bequests are really payment for services rendered by children to parents in their later years? An estate tax, then, merely raises the purchase price of the services, so that the effect on saving depends on how responsive parents' purchases of services are to the price. Since people are likely motivated by a combination of factors in their bequests, the impact of estate taxes on saving by the estate owner is difficult to sort out.

Evidence is not much stronger than theory. The effects of income taxes on labor supply and savings appear to be relatively small. Estate taxes are levied at higher rates, which might suggest a larger effect, but they are also levied at more distant points in the future, suggesting a lesser impact. Direct evidence, however, is sparse. In years when the estate tax has been relatively high, reported estates as a fraction of national wealth were lower than other years, which is consistent with either a depressing effect on wealth accumulation and/or an encouraging effect on estate tax avoidance.

3. The estate tax hurts family-owned businesses and farms

Estate tax opponents claim that a large proportion of American businesses never make it to the second generation and assert that the estate tax is the reason why. This is surely a case of the tail wagging the dog. Farms and other small businesses represent a small fraction of estate taxes. In 1997, farm assets were reported on less than 6 percent of all taxable estates, and closely held stock on less than 10 percent. Farm assets totaled a microscopic 0.3 percent of taxable estates; closely held stock, limited partnerships, and "other noncorporate business assets" accounted for less than 10 percent. Only 3 percent of estates consist mainly of farms or small business. These figures imply that the vast majority of estate taxes are paid by people who own neither farms nor small businesses, and that scaling back or eliminating the estate tax is a very blunt instrument for dealing with the issue.

Family farms and businesses already receive special treatment under the estate tax. Taxpayers may calculate the value of family farms and businesses on the basis of the value to family proprietors rather than market value. This can reduce gross assets by as much as $775,000. In addition, the estate tax liability due to family farms and businesses can be paid in installments over a 14-year period, with only interest payments at below-market rates due during the first five years. Legislation enacted in 1997 permits a special deduction of up to $675,000 worth of family-owned farms and businesses when they constitute at least 50 percent of an estate in which heirs materially participate. Moreover, small businesses already receive numerous income tax subsidies.

4. The estate tax discriminates unfairly against savers

Opponents claim the tax inequitably burdens families that want to provide for their children and punishes those who fail to engage in sophisticated tax planning. It's true that the estate tax does not burden people who spend every penny on themselves or charity, but hurts those who pass their fortune to their children.

The perspective, however, is crucial to this argument. From the giver's viewpoint, the tax seems to single out the altruistic for taxation. But from the perspective of the next generation, inheritance provides an advantage to some rather than others. Supporters of the tax claim that advantages derived from inheritance are unearned, unfair, and reward the "skill" of choosing affluent parents. They argue that this seriously distorts notions of equality of opportunity, and is detrimental to a widely shared understanding of fair play. Supporters note that high estate taxes do not stop parents from passing on huge amounts of human capital, family reputation and values, and large amounts of tax-free financial wealth via gifts and bequests. They say that high estate taxes provide good incentives for young people to work hard, promote fair play, and do not seriously impinge on parents' ability to provide for their offspring.

5. The estate tax is easy to avoid and creates huge compliance costs

Opponents allege that the estate tax is inefficient because avoidance and compliance costs are so high and the tax is so easy to avoid. But how high are the costs? The widely-cited claim that the costs of complying with the estate tax laws are roughly the same magnitude as the revenue raised is extremely rough at best. More recent estimates based on consultations with tax professionals produce a cost of 7 percent of revenues, a number that in our view is likely to be closer to the truth. Moreover, an unknown fraction of this may be estate planning, inter alia about intergenerational succession of the business, that is unrelated to taxation and thus would likely be incurred regardless of whether there was an estate tax. If there are high compliance costs, it is not clear whether that would suggest that the tax should be cut back or, alternatively, be bolstered by broadening the base, eliminating loopholes and reducing tax rates.

6. The estate tax does't raise much revenue, anyway

Opponents argue that the estate tax raises very little revenue, so that abolishing it would make little difference to federal revenues. This assertion is factually incorrect. Over the long-term, eliminating the estate tax could cost over $50 billion per year. But even if it were right, it begs the relevant question: should taxes be cut in this way, some other way, or not at all? A more sophisticated version of the argument is that the next effect of estate taxes is close to zero because the sheltering schemes that reduce estate taxes also tend to reduce income taxes. If this were the case, the estate tax would be difficult to justify. But the findings are highly speculative, and opponents do not act as if they believe the tax imposes no net burdens.

The Case In Favor of Transfer Taxes

1. The estate and gift tax is progressive

Progressivity has always been the primary defense of estate taxes and remains so today. It's true that the standard liberal defense of the estate tax on progressivity grounds is in part a knee-jerk resistance to a tax cut for the rich. But the standard conservative attack is also partly a knee-jerk response to any tax that is progressive, as evidenced by recent support for the flat tax and criticism of the graduated income tax and capital gains taxes. Neither liberals nor conservatives are arguing for a low-exemption, flat-rate estate tax that almost everyone would pay when they die. Instead, the policy debate concerns a tax that applies only to the rich.

It would help if opponents of the estate tax clarified whether they are advocating a large reduction in the progressivity of the tax burden, or just a change from one progressive tax instrument to another (it is the former). Likewise, it would help if supporters of the estate tax clarified whether they would support an equally progressive alternative tax, or whether there is something about taxation of wealth transfers per se that is essential.

Ultimately, the progressivity of the tax depends on its impact on saving and labor supply. If the estate tax discourages significant amounts of wealth accumulation, it could drive wages down by reducing the amount of capital per worker. In this case, the impact of the tax would be felt (indirectly) by workers. Because the impacts on saving and labor supply appear to be relatively small but have not been firmly established, it is appropriate to maintain the view that the estate tax is progressive until new evidence is provided. Certainly, the alignment of forces pro and con is consistent with this view.

2. Transfer taxes serve as a backstop to the income tax

Supporters of the estate tax often note that it serves as a backstop for the income tax by imposing taxes at death on income that previously escaped taxation. One source of such income is capital gains that have never been realized. These gains elude the income tax net and are bequeathed to inheritors with a stepped-up basis, and so are never taxed under the income tax. (Basis step-up also occurs for transfers from one spouse to another, even though such transfers are deductible from the gross estate. As a result, the estate tax contains a potentially large marriage bonus that has received little attention.) To the extent that the estate tax is meant to collect on previously accrued but unrealized capital gains, the tax should apply only to unrealized capital gains and should be capped at the highest capital gains tax rate. Clearly, this is not how the estate tax is structured.

3. Transfer taxes reduce the concentration of wealth

Since its enactment, the estate tax has been viewed as a counterweight to an undue concentration of wealth. Today, some opponents claim that the estate tax fails to achieve this goal. Although the concentration of wealth may be lower now, in the era of high estate taxes, than it was before, the real question is whether concentration of wealth is lower than it would be without the tax. It is probably unrealistic to expect that a tax that in a typical year raises revenue equal to 0.3 percent of Gross Domestic Product (GDP) and 0.1 percent of household net worth would make a serious dent in overall wealth inequality. This reduces the scale of both costs and benefits, but does not resolve whether the benefits exceed the costs. In fact, the opponents' claim could be construed as an argument for increasing, rather than decreasing, the tax.

4. Transfer taxes help the non-profit sector

Supporters note that the deduction in the estate tax for charitable contributions generates a significant increase in contributions to the non-profit sector, especially among the wealthiest households. In 1997, of 329 taxable estates with gross assets above $20 million, 182 made charitable contributions, and those that did contributed an average of over $41 million! Transfer taxes may also encourage giving to charity during life, as a way to reduce gross estate values. Opponents say the deduction has a small effect relative to the overall funds raised by the non-profit sector, and that repealing the tax would raise wealth among the richest families, which would increase charitable contributions. This latter claim is inconsistent with their view that estate taxes do not affect the concentration of wealth.

Where Do We Go From Here?

The most radical reform would be to abolish the estate tax. This would eliminate existing problems, but may create a host of additional issues, including repealing what is by far the most progressive tax instrument in the federal tax arsenal, following a long period during which distributions of income and wealth have already become more skewed. A repeal could hurt non-profits. It would reduce federal revenues. It may not even raise saving, labor supply or growth, as its advocates hope, and it would create a gaping loophole for capital gains in the income tax. Moreover, the case for abolition appears to be backed largely by loose rhetoric about the immorality of taxing at death and the supposed impact on a tiny component of those who would benefit from it.

Elimination of the estate tax could be coupled with an extension of the capital gains tax to the gains accrued but unrealized at death. By itself, that is neither an attractive nor a likely option, as it would raise much less revenue from a quite different set of people, and would have many of the complexities of the estate tax. It would also not necessarily help small businesses and farms, since most of their wealth takes the form of unrealized capital gains.

The bill passed by the House in June tied elimination of the estate tax to another significant change in capital gains taxation, under which heirs would assume the decedent's basis for capital gains purposes—called the "carryover basis"—for transfers from estates valued at more than $1.3 million (plus a $3 million exemption on spousal transfers). This would raise even less revenue than taxing gains at death, and would be substantially more complicated, in part because records would have to be kept for longer periods of time. A similar provision passed in the late 1970s was repealed before it took effect because of anticipated implementation problems.

The best way to achieve more modest changes in the estate and gift taxes depends in large part on what the system aims to accomplish. If the goal is to help family-owned businesses and farms, the appropriate exemptions could be increased. But it may make more sense simply to raise the exempt amount for all assets, since doing so for selected forms of assets creates both horizontal equity problems and inefficient sheltering incentives.

If the goal is to chip away at an undue concentration of wealth, then the effective exemption could be raised substantially—since only the extremely wealthy are the target—and the high tax rates maintained. This could simplify the tax and greatly reduce the number of people who pay estate taxes, but it would also reduce revenues. If the goal is to improve equality of opportunity, then estate tax revenues could be earmarked for special education and training programs, or for means-tested asset accumulation subsidies.

Broadening the tax base, closing loopholes and reducing rates carried the day in the last comprehensive income tax reform in 1986 and could improve the equity, efficiency, and simplicity of the estate tax as well. Treating different assets similarly would reduce sheltering opportunities and make the tax simpler and fairer. For example, legislation could address unwarranted valuation discounts and abusive trust arrangements that abound. Reducing rates would reduce the incentive to shelter or change behavior.

The historical record shows that transfer taxes can play an important role in the tax system. While many arguments against the current estate and gift tax system are specious, they contain an important undercurrent of truth. At the same time, supporters of these taxes must distinguish between the potential benefits in principle and the design problems that arise in practice. A transfer tax system that couples effective marginal tax rates of up to 73 percent with substantial opportunities to shelter funds is asking for trouble. An income tax with similar features in the 1970s was swept out in favor of a broader-base, lower-rate system in the 1980s. In light of these considerations, a package of lower rates, a higher exemption level, a thorough reform of the tax base and perhaps a judicious earmarking of estate tax revenues may well be the lifeblood of a more effective transfer tax system for the future.

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Authors

Joel Slemrod
William G. Gale