The estate tax is one facet of this week’s fiscal cliff agreement that has gotten little attention. This is interesting, as the amounts of money potentially in play were at least as large as those for other issues.
The switch to a new version of the Consumer Price Index to calculate changes in Social Security benefits, tax brackets and so forth, for example, raised a fire storm of protest from liberals and senior citizens’ organizations and has been put off to a later round in this ongoing bout.
Yet, the estate tax measures agreed to will increase the deficit by about $40 billion dollars a year compared with what it would have been had these parameters reverted to the ones in effect prior to 2001. The measures leave the exempt amount at $5 million in 2012 and indexes it thereafter for inflation; it sets the marginal rate at 40 percent. Moving to a chained CPI would save only $20 billion a year.
So why was there no fuss about a tax reduction that was twice as large as the contentious benefit cut?
One answer is that, regardless of widespread public handwringing about deficit reduction, cutting taxes is popular and cutting benefits is not. But it also shows our collective ambivalence about “death taxes.”
Yes, that term is used demagogically by Republicans who want to see the federal estate tax eliminated or reduced to the point of insignificance. Surveys show the public reacts much more negatively to that phrasing than to “estate tax,” and the GOP has taken to heart Newt Gingrich’s insight that choosing rhetoric carefully means a lot.
But the terms “death duties” and “death taxes” have been used for centuries in British common law and hence in countries like ours that follow this system. It is a convenient term that encompasses both estate and inheritance taxes.
The two are different, although many journalists and even elected officials who should know better often used the terms interchangeably. An estate tax is imposed on the wealth of a person who has died, after certain statutory exclusions for spouses, charitable gifts and so forth. An inheritance tax is one imposed on sums that heirs receive from someone’s estate. We have had a federal estate tax since 1916. There has not been a federal inheritance tax since one imposed during the Civil War was repealed in 1870, but they once were common at the state level and seven states still levy them.
The distinctions may sound arcane; after all, both result in the government getting some money when someone dies and that person’s heirs getting less. But there are differences in terms of incentives for how people order their financial affairs in reaction to each of these taxes and in the economic distortions that result.
The federal estate tax has never affected many people. But the rates were set very high for World War II, and the threshold amounts were not indexed for inflation. So by the 1970s, it was a concern for a significant number of households, even if still a minority. A 1976 reform raised this threshold and lowered rates. After that, usually fewer than 1 percent of all estates owed any tax.
It did affect many other people, however. If one owned significant assets for a small business or farm, one might be exposed to the tax even if annual net income was not high. But there are also many ways to order one’s business affairs to avoid the tax. Many people put considerable effort into such “estate planning.” For every household that ends up paying any tax, five to 10 others spend resources on legally avoiding it.
This can have an economic cost when people allocate resources in a way that makes sense only because it minimizes taxes.
The degree to which this is true is debated. Many of the measures farms and small businesses usually take, including forming a small corporation or limited liability company, make good business sense for other reasons anyway.
But there clearly is some efficiency loss that may be proportionately greater than for other taxes.
Why even have the tax?
First, because government needs the revenue. Most people don’t like taxes, but they also want programs. One could eliminate the estate tax, but you would then have to raise individual or corporate income taxes or institute something new, like a value-added tax.
Second, some argue the estate tax constrains, at least marginally, the concentration of wealth, and hence power, in society.
At a time when income distribution is becoming markedly more unequal, that is a valid consideration. But the degree to which the estate tax accomplishes this is also debatable.
Some argue an estate tax creates a powerful incentive for wealthy people to donate to charity.
That certainly is a factor, and the hospitals, universities and other institutions that often get such bequests are a powerful lobby against abolishing the tax.
Third, while some argue the estate tax results in double-taxation of income, there is considerable income that does get around income taxation but that is caught, for very wealthy people at least, by the estate tax.
The primary reason for this is the “step-up basis” provision of the income tax. If you buy an asset and it increases in value, and then you sell it, you owe taxes on that “capital gain.”
But if you pass the asset on to heirs at death, the “basis” or cost of the asset “steps up” to whatever the market value was on the date of your death. Your estate does not owe any income tax on that gain, and any capital gain your heirs get applies only to the increase in value after they got the asset.
This sounds arcane, but the result is that at least a third of all the capital gains income in our country is never subject to the income tax.
If I died today, my heirs would get more than $1 million in a farm and a share of a wind project without me or anyone else ever having paid any income tax on it. Anyone else who earns money from wages, salaries or business profits has to pay income tax on anything accumulated for their heirs.
This is highly unjust and economically inefficient. Because my estate will be less than the minimum level that invokes the federal estate tax, it won’t owe anything. But for the Walton, Buffett and Gates families, the estate tax does take a bite out of wealth that escaped the income tax.