Most people don’t understand the difference between an estate tax and an inheritance tax. The distinction may not seem important but misunderstandings cloud public debate about such “death taxes” in general. Most people believe that such taxes affect far more estates than they actually do.
We have a federal estate tax that hits about one percent of all people who die. We have not had a federal inheritance tax for a century. Many states also have estate taxes, and about ten of them still have inheritance taxes.
The difference is simple. An estate tax is levied on the value of a person’s estate at death, before it is distributed to any heirs. (There are numerous exemptions and adjustments to the “gross estate” to arrive at the taxable amount.) The tax is paid before the estate is split up among the heirs according to a will or law for deaths without a will.
An inheritance tax is a tax on money an heir receives from someone else’s estate. It is paid by the recipient. Specifics of such state taxes vary widely. All exempt sums left to surviving spouses. Many have low rates for children. Amounts left to others rise as the degree of blood relation diminishes.
The estate-inheritance distinction may not seem important but it is. Suppose an unmarried uncle with a moderate estate dies in a state without an inheritance tax. Some nieces or nephews live in that state and others in a neighboring state with such a tax. No estate tax would be due to either the federal or state government as long as the estate is only a few hundred thousand dollars.
Those living in the first state get the money tax-free. Siblings or cousins across the state line have to pay tax.
Or someone may die in a state with an inheritance tax. Her heirs all live in states with no estate or inheritance taxes. But the state in which she lived will levy a tax on each of the separate inheritances, despite the fact that the heirs live in other states.
(This is not peculiar to inheritance taxes. States with income taxes usually tax the earnings of people who work in the state but live elsewhere. And some states with estate taxes levy it on any significant property, such as a farm, located in that state even if the deceased owner lived elsewhere.)
Both estate and inheritance taxes date from the Middle Ages. Both have what economists call a high “excess burden.” That means that costs to society from administering the tax and from the economic inefficiencies the tax causes are high relative to the amount of tax revenue produced. The second problem – inefficiencies resulting from people re-ordering their business affairs to minimize eventual taxes owed – is the greater problem.
Most economists would be glad to see these taxes abolished, especially that on inheritances. But the perennial question then arises. What other tax should we raise to get the money?
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.