Why A Death Tax “Loophole” May Make Economic Sense

December 20, 2013

A Bloomberg story reports that some wealthy people are using a complicated legal arrangement to reduce the bite that the federal death tax will take out of their estates after they die. The procedure is called a grantor retained annuity trust (GRAT), and the U.S. Tax Court ruled in its favor in 2000 following an IRS challenge.

The Bloomberg article describes the arrangement as “exploiting a loophole that Congress unintentionally created” and says that neither Democrats nor Republicans on Capitol Hill are willing to prohibit the tax strategy because some of their largest campaign donors use it. According to the story, the tax strategy may have reduced federal estate and gift tax collections by $100 billion since 2000.

The article’s not-so-subtle messages are that the wealthy keep finding legal ways to pay lower taxes than they should, that the law ought to be changed, and that in the meantime the federal government is leaving billions of dollars of potential tax revenue on the table.

No attempt will be made here to divine congressional intent or provide a legal analysis, but it is worthwhile to offer some perspective regarding tax fairness, economic growth, and tax revenue.

First, the concern that the wealthy are failing to pay their fair share of federal estate and gift taxes is the opposite of reality in an important sense. Most people do not have to worry about the federal death tax because an exemption allows each of us to give or bequest up to $5.25 million (rising to $5.34 million in 2014) to our heirs without incurring the tax. In other words, while people who expect to give or bequest more than the exempt amount need to engage in costly and time-consuming tax planning to reduce, but probably not eliminate, the tax hit, everyone else effortlessly avoids the tax. For them and their heirs, death thankfully is not a taxable event at the federal level. Given that most people’s estates will never owe the federal death tax, it is not obvious that the relatively few people who must engage in careful tax planning to mitigate the tax’s bite are failing to pay their fair share.

A second fairness-related consideration is that all the money in an estate is derived from income that has already been taxed, often more than once, or that will be taxed in the future. Either the original saving was made with after-tax income (as with the initial deposits in the GRATs) or was tax-deferred in a pension arrangement, in which case the recipients will owe tax on it.

A subtle but important point is that although only a small number of large estates pay the tax directly, the estate and gift tax has indirect effects that are felt throughout the economy, by people at all levels of income. Because the tax is an assessment on accumulated savings transferred to heirs, it discourages people with potentially large estates from saving and investing as much or working as hard as otherwise. After all, working fewer hours, saving and investing less, and consuming more are sure-fire ways to minimize the death tax. Moreover, the saving and investment disincentive is strong because the tax rate is extremely high: 40 percent on each dollar above the exempt amount. The tax also pushes some saving and investment into relatively inefficient channels that nevertheless offer tax advantages. Additionally, saving and investment decline when the death tax comes due because some accumulated saving must be liquidated to pay the tax. With reduced saving and investment, economic growth slows and productivity suffers. The results are less economic output than otherwise, and lower wages and incomes for people throughout the income spectrum. (See this study, which looked specifically at the adverse effects on small businesses and the job losses there, and this study for a broader analysis of the estate and gift tax’s economic costs.)

A fourth point is that prohibiting the technique mentioned in the article would not add anything like $100 billion to federal coffers. The supposed revenue haul would not materialize both because other tax-reduction arrangements would spring up and because the revenues from other federal taxes, fees, and charges would fall short of expectations as the economy weakened. The adverse economic effects might be so large that federal revenue would actually fall. (For dynamic simulations indicating that cutting the death tax may sometimes raise federal revenue, see this study.)

In short, members of Congress on both sides of the aisle may be reluctant to close a death tax “loophole” not because they are in thrall to campaign donors but because prohibiting the arrangement might not improve tax fairness or increase federal revenue but would certainly hurt economic growth.

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