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Is the Estate Tax a (Revenue) Loser?

7 min readBy: J. D. Foster, Ph.D.

In a stunning shift in taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policy, the federal estate and gift taxA gift tax is a tax on the transfer of property by a living individual, without payment or a valuable exchange in return. The donor, not the recipient of the gift, is typically liable for the tax. may soon land on the scrap heap of worn out tax policies. The 1999 tax cut vetoed by President Clinton included the complete phase-out of the “death tax.” Even though the President objected to the magnitude of the cuts, criticism of the estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. repeal was muted.

Governor Bush, the presumptive Republican nominee for the White House in 2000, has included the phase-out in his tax plan, while other Republican contenders support immediate repeal. The estate tax has become so unpopular that even liberal politicians are starting to call it the death tax. Parris Glendenning, Governor of Maryland, has suggested that Maryland pull the plug on its estate tax, though both Democratic contenders for the Presidency still support the federal estate tax.

Arguments for Repeal There are many good reasons to repeal the estate tax. It prevents small businesses and farmers from passing their businesses on to the next generation. It penalizes saving and capital formation. And it greatly discourages the creation of new wealth by America’s most innovative, productive entrepreneurs.

Another reason it has fallen out of favor is that its policy justification is invalid in our new, information economy. The estate tax enjoyed broad support on the grounds that it prevented an excessive concentration of wealth. The fear was that huge amounts of wealth would remain in the hands of the same few families, generation after generation. Fortunately, the economy each year is generating vast amounts of new wealth and large numbers of newly rich people. The economy has solved the concentration-of-wealth problem far better than the estate tax ever could.

The Misleading Estimates of Estate Tax Revenue With all this against it, the estate tax has one last remaining ally, and that is the belief, supported by official estimates, that it brings a lot of money into the U.S. Treasury. In fact, it certainly does not raise nearly the money that the official estimates show, and it may even lose money. There are five reasons why, and the first two come under the general heading of robbing the income tax to avoid the estate tax.

1. The estate tax reduces the effective income tax rate levied on billions of dollars in capital income.

Under current law a taxpayer may distribute up to $10,000 tax-free each year to any person he or she chooses. Typically, one would expect the donor’s personal income tax rate to be either 36 or 39.6 percent, whereas the children and grandchildren who are the recipients are more likely to be in the 0, 15, or 28 percent tax brackets. Thus, the income subsequently earned on these gifts is subject to a much lower tax rate as a result of the gift.

For example, suppose a donor distributes $10,000 in dividend-yielding stock to each of his ten children and grandchildren, for a total distribution of $100,000. The distribution would produce perhaps $8,000 in dividend income annually. If the donor had kept the money, he would have paid almost $2,900 in tax on this income, assuming a 36 percent income tax rate. Assuming the recipients pay tax at a 15 percent rate, the heirs collectively pay $1,200 in income tax. Thus, the U.S. Treasury loses about $1,700 in income tax in the first year following the transfer. If all net income is saved, reinvested, and continues to earn an 8 percent return, then over a 20-year period the Treasury loses over $48,000 in income tax revenue per $100,000 of distributed estate. And, of course, in this example there is no estate tax levied on the $100,000.

2. The estate tax erodes the income tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .

Perhaps of even greater consequence than number one, the estate tax may dramatically increase bequests to charities as taxpayers try to avoid paying up to 55 percent of their accumulated savings to the federal government. These assets end up producing capital income for tax-exempt charities instead of remaining in the estate where taxpaying recipients would have earned the money. Thus, charitable bequests made to reduce estate tax liability lower government revenue by reducing the income tax base. Of course, charitable organizations serve valuable social purposes, and not all such bequests are motivated by the estate tax. Nevertheless, the income tax consequences of tax-driven bequests are very significant and ought not be ignored.

Consider a $1 million charitable gift made to reduce estate tax liability. If the charity invests the gift and earns 8 percent annually, then it will earn $80,000 annually, tax free. Suppose there were no estate tax, and the donor, who pays income tax at the 36 percent rate, had held onto the asset. He would have paid $28,800 in tax the next year. Suppose all the after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. would have been reinvested, and suppose he would have lived for ten years at which time the asset would have passed on to his heirs who pay a 15 percent income tax rate. In the following 20 years, this $1 million would have generated over $650,000 in income tax revenue. This is revenue foregone to the Treasury because the estate tax motivated the donor to make a gift of the asset.

Suppose, instead, the $1 million gift was distributed from the estate to avoid estate tax. If the assets had remained in the family, they would have generated $12,000 in income tax in the first year. If the after-tax income from these assets had been saved, then over 20 years the assets would have produced over a half million dollars in income tax revenue. That’s $500,000 in income tax revenue foregone over 20 years because the estate tax drove the estate to make a charitable contribution instead.

The next three reasons could be called “supply-side” effects of the estate tax, which also have important effects on the revenue estimate.

3. The disincentive effects of the estate tax on entrepreneurial activity.

Some years ago the Tax Foundation studied the estate tax’s effect on entrepreneurial activity, and we found that the estate tax’s 55 percent rate had roughly the same incentive effect as doubling an entrepreneur’s top effective marginal income tax rate. Thus, an entrepreneur facing a 31 percent statutory income tax rate behaves as if he is facing an effective 62 percent income tax rate. As that rate rises and additional work yields less after-tax return, entrepreneurs become more likely to retire prematurely. Then they pay no income or payroll taxes on wages and create no new wealth.

4. Estate planning is phenomenally expensive. Official revenue estimates take no account of the enormous amounts of income tax-deductible expenses incurred by taxpayers engaged in estate planning.

Clearly someone facing the estate tax will incur such expenses until the expected amount of estate tax avoided is equal to the after-tax value of the expense itself. Since individuals worried about estate planning are likely to be in the upper-income tax brackets, the value of their estate tax planning deductions is great. Absent the estate tax, these individuals would likely shift the amounts spent on estate planning to non-deductible expenses, or they would save them. Either way, current or future income tax receipts would be higher.

5. Compliance costs for taxpayers and the IRS.

Finally, if the estimators produced a truly comprehensive estimate for estate tax repeal, they would also account for the savings to the IRS which spends millions of dollars each year attempting to collect estate tax revenue. The resources devoted to estate tax compliance would likely be redirected into other areas of tax collection, areas which the estimators have historically scored as increasing collections significantly.

Conclusion Even without considering the “supply-side” effects, the estate tax significantly reduces income tax receipts, first by encouraging donors to transfer assets to individuals whose personal income tax rates are likely to be below that of the donor. Second, by encouraging donors to transfer assets to tax-exempt entities, the estate tax removes the income produced by the assets from the income tax base. The official revenue estimates ignore these effects.

The estate tax is a levy without a mission. Its ill effects are legion, its social policy motivation obsolete, and even its revenue is an illusion. It should be repealed.