Last May, after several months of controversy and fierce debate, the Congress passed a series of changes to the U.S. estate tax as part of the federal budget. Given the political realities (in particular, the promise to keep total ten-year tax cuts under $1.35 trillion) and the intensity of feelings surrounding this issue, perhaps no one should be surprised that the resulting legislation was a major compromise. § The bill reduced the top estate tax rate, from 55 to 50 percent in 2002, and then to 45 percent in 2007. It increased the amount of assets that are exempt from tax, from $1 million in 2002 to $3.5 million in 2009. States will help compensate for the federal revenue loss by giving up their share of estate tax revenue as of 2005, even though federal revenue will continue to be collected until 2010. § In 2010, the estate tax is to be repealed entirely; instead, a capital gains tax will be levied on many types of inherited assets that now can be bequeathed at current market value (and effectively escape being taxed). Then, in 2011, all tax cuts in the budget bill (not just the estate tax provisions) will expire, a move necessary to keep the total cost of the bill under the agreed upon amount. § The legislation included something to make everyone unhappy. For those who want to abolish the estate tax permanently (“no taxation without respiration”), that the death of the “death tax” doesn’t occur for almost a decade is cause for concern—and its reinstatement one year later provides little added comfort. For those who feel strongly about using the estate tax as a way to redistribute wealth from richer to poorer, the changes, which disproportionately benefit the very richest Americans, were disheartening. Whatever their perspective, most agree that the bill’s provisions, especially the repeal followed by reinstatement a year later, virtually guarantee that both the country and the Congress will revisit the issue in the not-so-distant future.

How did we get here?

The first U.S. tax on the transfer of assets at death occurred in 1797, when faced with the expense of resisting French attacks on American ships, the Congress imposed a duty on receipts for legacies and probates for wills; the tax was repealed in 1802. Similar taxes were imposed in 1862 (to pay for the Civil War), 1894, and in 1898 (to pay for the Spanish-American War). These were also later repealed or declared unconstitutional.

It was only after 1916 that the modern estate tax became a permanent feature of the U.S. economy. Originally instituted to help pay for World War I, the tax was part of Progressive Era legislation that aimed to replace the federal custom and excise taxes, the main source of tax revenues, with, first, a federal income tax (1913), followed by the estate tax (1916). For those in favor of this change, estate and income taxes were preferable to excise taxes because the structure of tax rates made their impact “progressive”—that is, households with more wealth (income) paid a larger share of that wealth (income) in taxes. Yet, just as now, this was not everyone’s view. Opponents of the new estate tax called it a “fiscal crime” and a “project of confiscation.”

In the original 1916 law, the first $50,000 was exempt from tax, and rates ranged from 1 percent (on the first $50,000 transferred) to 10 percent (on assets over $5 million transferred). Many changes followed; tax rates reached as high as 77 percent (in 1977) and exemptions also were increased. By the time the 2001 budget bill passed, an estate had to be greater than $675,000 before owing any taxes. An estate of unlimited value could be left to a spouse without incurring tax (although when the spouse died, taxes would be owed on what was left). And, although many did not take full advantage of the rule, $10,000 per year could be given to each child and grandchild, which reduced the size of many otherwise taxable estates below the level where tax would be owed. Thus, only about 2 percent of estates paid any estate taxes.

The economic impact

The economic impact of changes in the estate tax is difficult to assess. First, one must be careful to separate timing changes, for example, the decision of when to give a gift or sell an asset, from “real” changes or actual changes in magnitudes. Second, impacts will depend on the specific provisions of the law that are changed. And third, the relationship of the tax system to the economy is enormously intricate, so untangling the effect of even a relatively simple tax change, especially over time, is extremely difficult. Having said that, it is useful to consider some of the more significant potential impacts.

TAX REVENUE. Estate tax revenues totaled about $25 billion in 1999, accounting for less than 1.5 percent of federal revenues. Many observers on both sides of the issue do not view this as a particularly large number. In making the case against the estate tax, members of the House Joint Economic Committee, observed, “The individual income tax raised more revenue in 1998 alone than the estate tax has during the entire 20th century.” William Gale of Brookings and Joel Slemrod of the University of Michigan, who generally favor an estate tax, find it “remarkable” that a tax that generates so little revenue can be the subject of such heated dispute.

Despite the relatively small collections, many proponents believe the estate tax is necessary to protect the “integrity” of the income tax. In this view, the estate tax functions as a backstop for income that would otherwise escape taxation. Under current rules, for example, heirs receive stock, antiques, and other real property at current market value (at a “stepped-up basis”) rather than at historical cost. Thus, no one pays income tax on any capital gains that accrued during the giver’s lifetime. Opponents suggest that this will be addressed by combining the elimination of the estate tax with an expanded capital gains tax, as the budget bill does. Proponents reply that an expanded capital gains tax imposes substantial paperwork and administrative requirements (such as keeping records, having to figure the value of assets that are difficult to value absent a sale) and may not ultimately prove viable.

Proponents also worry that permanent elimination of the estate tax will compromise the progressive nature of the income tax, by encouraging certain wealthy people to convert income into assets and thereby reduce their overall tax. They could, for example, load their portfolio with non-income-bearing assets that accrue returns in the form of capital gains rather than dividends on which they would pay income tax.

As it stands, the estate tax changes will have substantial revenue consequences for the states. Most states tie their estate tax to the federal estate tax, with taxpayers receiving a dollar-for-dollar credit against their federal liability. As of January 2001, 35 states had their estate tax structured to exactly equal this “pickup tax.” In effect, this sends a portion of federal estate tax revenues to the states without increasing the total tax paid. States are free to impose additional taxes. Connecticut and New Hampshire currently also have an inheritance tax (so-called because it is levied on the heirs, not on the estate), although Connecticut is phasing its inheritance tax out.

The elimination of the state credit, due to take effect in 2005, will reduce state tax coffers unless other sources of funds are found. Some states are more reliant on the federal credit than others. Florida gets more than 2.5 percent of revenues from its credit. New Hampshire, with no income or sales tax (at least for now), would be the hardest hit state on a percentage basis. It stands to lose about $25 million, or 4.6 percent of revenue. Vermont, Rhode Island, and Connecticut receive more than 2 percent of state revenue this way.

Even without the new law, federal revenue collections—and the share of estates that are large enough to owe estate tax—could grow over the next decade. Rising prices in the stock and housing markets increased the wealth of many Americans during the 1990s and put them within sight of owing tax. In addition, the 1976 legislation that established the unlimited deduction for spouses probably slowed revenue growth over the past 25 years. Now, as the second spouse of the couple dies and estate taxes come due, the share of estates that are taxable—and tax collections—may increase.

Perhaps that is why a recent survey found that 17 percent of Americans expect to owe estate tax, even though fewer than 2 percent currently do so. People may be concerned because they have watched the rising values of their home and stock portfolio. Or they may be overly optimistic about the likelihood of becoming wealthy. Perhaps they worry about the estate tax rather than face the low probability that they will ever become rich.

WORK, SAVING, AND INVESTMENT. Another concern is that the estate tax reduces the incentive to entrepreneurial energy, saving, and investment—and that this could hamper capital accumulation and economic growth. As an argument, this can cut both ways. On the one hand, net saving is quite concentrated among the wealthy. According to one study, the top 1 percent of wealth-holders in 1986 accounted for about half of all savings between 1983 and 1986; reducing the estate tax might further increase their incentive to save. On the other hand, if people “target” the size of their bequests, then eliminating the estate tax could decrease saving as people reach their target more quickly. And the very richest people, who pay the bulk of estate tax, seem to engage in saving and accumulating wealth for reasons that go beyond bequests. To the extent that they build wealth for other reasons—to attain status and power, for example—reducing the estate tax may have little or no impact.

The effect of the estate tax on capital accumulation, savings, and economic growth is surprisingly little studied, say William Gale of Brookings and Maria G. Perozek of the Federal Reserve Board of Governors. In part, this is because we need to understand the motives for bequests, especially the motives of the very rich about whom relatively little is known. Some people may leave an estate “accidentally” because they are not sure when they will die and cannot time their consumption to spend their last cent exactly as they take their last breath. Or, in the case of the super rich, simply because they cannot spend their billions. Reducing the estate tax would not have much impact on such unintended bequests.

But bequests may also be intentional, arising out of the desire to leave money to children or others. This is where a change in the estate tax might have its biggest impact on wealth accumulation and growth. By reducing the ability of a person to transfer income, the tax may discourage work effort and encourage consumption. Several studies find that reducing estate taxes would likely increase the economy’s ratio of capital to labor, although they do not agree on whether the effect would be small or large. Another study finds that inheritance may increase savings by parents but may reduce savings by heirs. Still another finds that the probability of starting a successful business increases with a large inheritance, suggesting that eliminating the estate tax may reduce business investment.

Finally, some parents may use bequests to encourage their children to attend college, care for them in old age, or act in otherwise desirable (to the parents) ways. They may even hope to influence actions from the grave. Senator Joseph Lieberman, as executor of his uncle’s $48 million estate, had to decide how to enforce his uncle’s wish that his cousins be disinherited if they did not marry within the Jewish faith. The impact of the estate tax, in these instances, depends on the cost of eliciting a child’s desired actions. If, for example, parents are willing to pay a high price (and their children require it), increased estate taxes will tend to raise the parent’s target bequest, and thus raise their incentive to save and accumulate wealth.

In the real world, motives for bequests are not easy to disentangle. And the evidence is mixed, and tricky to interpret. Research—and common sense—suggest that all motives probably coexist in the economy, even within a single individual. This makes it difficult to determine how much entrepreneurial energy, saving, and investment will be affected by a tax change. It also implies we should be careful about leaning too hard on such estimates when setting policy.

CHARITABLE GIVING. The proposed elimination of the estate tax has raised concern about its potential impact on the tax-exempt charities and nonprofits—museums, cultural groups, service organizations, educational and religious institutions, and hospitals—that depend on donations. Most studies find that the deductibility of charitable gifts generated a significant increase in contributions at death, and may even have increased gifts during the donor’s life, in anticipation of future taxes. Opponents question the size and significance of the impact.

EVASION, AVOIDANCE, COMPLIANCE, AND ADMINISTRATIVE COSTS. Where there are taxes, there is the incentive to avoid them. And the estate tax is so easy to avoid, say some critics, that it is essentially “voluntary.” One New York City attorney estimated in The Wall Street Journal that he could lose 75 percent of his practice if the estate tax were abolished. Opponents of the estate tax argue that resources put into rearranging assets to minimize taxes could be better spent on education, healthcare, or other consumption or investment. The costs to the taxpayer in paperwork and effort, and to the government in monitoring and enforcement could also be put to more productive use.

But measuring the extent of these costs is difficult. Estimates of compliance and administrative costs range widely, from 10 percent to 100 percent of the tax collected. Estimates of the costs of (legal) tax avoidance are sketchy and depend on relatively arbitrary assumptions. As for (illegal) tax evasion, consultant Brian Erard studied how estate taxes increased or decreased after an audit and estimated evasion to be about 13 percent of the potential tax base—a figure slightly lower than for the income tax.

FAIRNESS. Much of the heat over the estate tax is generated, not by its narrow economic impact, but by concerns about fairness. Many proponents believe that tax and spending policy should be used to help even up—not exacerbate—differences in opportunity. In this vein, George Soros, Warren Buffett, and Bill Gates, Sr., have likened eliminating the estate tax to choosing the U.S. Olympic team according to whether one’s parents had been Olympians. The decline in prospects for the less educated during the last quarter century has only underlined this concern.

Whether measured by the wealth of the person making the bequest or by the person receiving the inheritance, the estate tax is “progressive,” even more so than the income tax. Household wealth in the United States is very concentrated, far more concentrated than income, notes NYU Professor Edward Wolff, with the top 1 percent of households holding 36 percent of net worth. The U.S. Treasury estimates that households in the top 1 percent of the income distribution pay 25 percent of income taxes, but almost two-thirds of all estate taxes.

Even as measured by the income of heirs, the estate tax is highly progressive. In 1981, the average adjusted gross income was $47,400 for all households that received inheritances subject to estate tax. It was $123,000 for recipients of estates between $2.5 and $10 million, as compared to U.S. median family income of $23,800. Moreover, many proponents think that while it is possible to raise this revenue in an equally progressive manner with the income tax, it may be less efficient.

On the other hand, wealthy parents may transfer the most important assets to children before they die. Paying for college or professional school, providing access to contacts, or lending seed money for a new business, all are ways to give children a leg up that poor parents cannot match. The estate tax may hold only a limited ability to even the score.

Those who oppose the tax on grounds of fairness may take as fundamental the right of an individual to dispose of the fruits of his or her labor, and particularly the right to to leave them to one’s children. Others believe that it is an act of bad faith to impose a tax at a time when people are grieving. The prospect of filing forms and facing an audit can seem terribly unfair (although only estates equal to or greater than the exempt amount must file). Having to set a value on and divide property can exacerbate family tensions at a vulnerable time, although any will that distributes assets in percentage terms requires this, even in the absence of an estate tax.

Opponents also argue that the estate tax unfairly punishes frugal savers while encouraging wanton spenders. Leave children $2 million for their kids college education, and it will be subject to estate tax; throw a $2 million party in Morocco for 800 of your closest friends—as Malcolm Forbes did for his 70th birthday party— and the government doesn’t take an extra penny. Last year in an editorial, The Wall Street Journal called the estate tax “a tax on virtue.”

The impact on small businesses and family farms has also been a focus of considerable attention. In fact, small businesses received favorable treatment even prior to the new law. They could value assets at “use” rather than “market” value, and reduce the taxable worth of the estate by up to $770,000 (indexed for inflation). They could put assets, even publicly-traded assets, in limited family partnerships to further decrease the size of the estate. And they could stretch out tax payments for up to 14 years. One study found that almost 60 percent of small firms held liquid assets equal to the estate taxes owed. Alternatively, a firm’s owner can buy a life insurance policy with the proceeds to cover the expected tax so that heirs will not have to sell the business to cover it.

Nevertheless, compliance and tax planning can cause huge headaches. Despite the availability of insurance, and for reasons that are not clear, firms tend to be underinsured. And some end up in costly disputes with the IRS. Frederick’s of Hollywood just ended such a six-year battle. At issue: how to value a large block of stock that was in the owner’s estate—at a premium because the block conferred control of the company or at discount because selling the shares at one time would depress the price. By the time the family prevailed, Frederick’s was already in bankruptcy proceedings. “We lost the war before we won the battle,” said the estate’s co-executor to The Wall Street Journal. Yet, family members agree that some of the company’s woes were due to internal disputes over its future direction. Succession in a small business involves difficult and emotional decisions even in the absence of an estate tax. In the heat of the moment, the tax may feel like the culprit.

Death and taxes

Everyone in America wants to believe that he or she will eventually be rich. And so the estate tax is a tough story to sell. In a 1990 Gallup Poll, respondents said that they thought 21 percent of their fellow citizens were rich. When asked how much annual income that would take, their median response was $95,000—the income level of the top 4 percent of households.

Those who do make it into the upper brackets tend to underestimate their own wealth. Only 7 percent of respondents considered themselves “upper-income” and less than one-half of 1 percent admitted to being “rich.” What looks rich from afar, may not feel so rich once you arrive.

And while everyone wants to be rich, almost no one likes thinking about or planning for death. Maybe if we eliminate the estate tax, we won’t have to face our own mortality. It is only human nature to want to put off confronting the inevitable.

For further reading

“A Quarter Century of Estate Tax Reforms,” by David Joulfaian, Office of Tax Analysis, U.S. Department of the Treasury, National Tax Journal, Vol. 53, No. 3, pp. 343-360.

“Rethinking the Estate and Gift Tax: An Overview,” by William Gale and Joel Slemrod, The Brookings Institution, January 2001. http://www.brook.edu/views/papers/gale/20010126.pdf

The Economics of the Estate Tax, Joint Economic Committee, Jim Saxon, Chairman, December 1998. http://www.house.gov/jec/fiscal/tx-grwth/estattax/estattax.htm