Why the "Death Tax" Should Live

It may need reform, but not elimination. That would only increase financial inequality in a nation that claims to be egalitarian

By Christopher Farrell

I received many impassioned e-mail comments after I argued on National Public Radio toward the end of 2000 against eliminating the estate tax. One listener wrote: "No, the reason this [estate] tax should be repealed is very simple: The money has already been taxed! Have we really strayed so far from our founding principles as a nation as to cite things like 'Well, the effective tax rate isn't that high anyway,' or 'We'll deepen the economic divide if the tax is repealed,' or 'The tax only benefits a certain few' as valid reasons for keeping a tax on the books? The money that resides in the estate of a deceased person has already been subjected to income taxes and is likely subject to capital gains taxes as well. Is that not enough?"

Another said: "My opinion is, no matter how Mr. Farrell frames his argument, the estate tax is unfair. It is their money, and it should go to whoever the person wishes upon their death. It is none of our business."

With most forecasters alarmed that the economy is falling off a cliff and bipartisan sentiment on Capital Hill favoring a massive income tax cut, now is a good time to revisit the estate tax-controversy. Odds are, Congress will repeal the estate tax, considering legislators have voted twice to abolish it and President-elect George W. Bush campaigned against it, calling it the "death tax."


  The estate tax is targeted toward America's wealthiest households. It is imposed on fewer than 2% of Americans who die. The federal estate-tax rate can run as high as 55%, although the the tax is levied only on the portion of an estate that exceeds $675,000, after allowable deductions. The exemption is slated to rise to $1 million by 2006. Although these are generous figures, the enormous gains in financial and real estate wealth among middle- and upper-middle-class households in recent years, along with tax-equity considerations, argue for federal estate-tax reform. But repealing the estate tax would be a mistake, and would actually increase inequality by taxation for Americans.

Let's turn to the point made by my first e-mail critic cited above. In essence, many people believe the estate tax is unfair because the money has already been taxed. Yet economists note that much of the assets of the wealthiest households do escape taxation. Their portfolios typically include a healthy portion of unrealized capital gains. A large portion of the value of small businesses and farms is unrealized capital gains, too.

For instance, in a recent paper, economists Scott Weisbenner of the Federal Reserve and James Poterba of the Massachusetts Institute of Technology looked at household wealth in 1998. They applied a mortality rate to people in 1998 to generate numbers on potential estate-tax liability. In that set of "synthetic deaths" subject to the current estate tax, the scholars found that the total value of businesses and farms is $9.7 billion, and the unrealized gain is $7.8 billion -- or close to close to 80%. In other words, no taxes have been paid at all on these gains. To be sure, their study didn't include the entire universe of closely held businesses and farms, but their angel-of-death algorithm is suggestive. (Their paper, "The Distributional Burden of Taxing Estates and Unrealized Capital Gains at the Time of Death," is available at www.nber.org.)


  A more troubling issue is the charge that the estate tax hampers savings and capital accumulation. Yet the evidence is mixed. For instance, a high estate tax could limit the savings and work effort of an entrepreneur but increase the incentives for his heirs to save and work. It's extremely difficult to figure out the impact of estate taxes on savings, labor, and economic growth, say economists Joel B. Slemrod of the University of Michigan and William G. Gale of the Brookings Institution think tank. They say in a recent research paper, "we are still without any hard evidence that U.S. capital accumulation has been and continues to be held back by this tax." Besides, there are other options to consider if the goal is to increase wealth accumulation, such as paying down the national debt. (You can download a copy of the paper, "We Tax Dead People," at taxpolicyresearch.umich.edu/.)

The estate tax is a highly progressive tax. According to the Treasury Dept., households in the top 5% of the income distribution pay 91% of the estate taxes. That's opposed to the 49% that this bracket pays for total income taxes. Put somewhat differently, eliminating the estate tax is likely to increase inequality in a nation with a strong egalitarian tradition. For instance, a simulation by John Laitner of the University of Michigan calculated that the wealth of the top 1% of wealth holders would expand by 20% to 40% if the estate tax were eliminated. (The paper, "Simulating the Effects on Inequality and Wealth Accumulation of Eliminating the Federal Gift and Estate Tax," is at taxpolicyresearch.umich.edu/.)

Of course, as with all taxes, any perspective in favor of or against the estate tax does involve complex value trade-offs. It's intriguing to note that the traditional dividing line between liberals and conservatives doesn't always hold when it comes to this specific tax. Even though conservative politicians are leading the current assault on the estate tax in the 21st century, a long line of conservative thought, best identified with 19th century steel baron Andrew Carnegie, favors a steep estate tax.


  Instead of abolishing the estate tax, why not reform it? It's disturbing that the estate tax burden essentially often falls on the builders and creators of wealth. Perhaps it should be transformed into a progressive gift and inheritance tax? From an economic point of view, it doesn't matter who bears the tax burden. But billing the inheritor makes better sense in a society that values equality of opportunity and entrepreneurship. "Rather than tax the people who built the wealth up, if they give it to someone, the inheritor has to pay taxes on it," says William Gale, economist at the Brookings Institution. "To me, there is a much more compelling justification for taxing the inheritance."

Two other possible changes to the estate tax are sensible. The current exemption limits should be raised by a substantial margin. The estate tax is targeted toward the economy's plutocrats, but the aging of the population, along with the enormous appreciation in financial and real estate assets over the past decade, is pushing many upper-middle-class families above the current limits. Second, the high marginal estate-tax rate could be lowered substantially in return for eliminating many estate-tax shelters, especially in the complex world of trusts. But repeal the estate tax, no.

Farrell is contributing economics editor for Business Week. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online

Edited by Beth Belton

Before it's here, it's on the Bloomberg Terminal.