Straight Talk About the Estate and Gift Tax: Politics, Economics, and Morality (Part I)

Dennis J. VENTRY, Jr.

Perspectives, Vol. 2, No. 2

(Editor's Note: This is the first part of a two-part essay. Part II will be published in December. Notes and references of this essay, omitted here due to space limitation, are available from the author at dventry@brook.edu.)

In June, the U.S. House of Representatives passed H.R. 8, the Death Tax Elimination Act. In September, the Senate ratified the House bill. Days later, President Clinton vetoed the legislation. End of story? Not quite.

H.R. 8 represents the most recent initiative in a protracted and increasingly viable effort to abolish the U.S. federal estate and gift tax. In 1999, the Republicans made eliminating the estate tax a key component of their ill-fated $792 billion tax cut. Even before the ink dried on President Clinton's 1999 veto message, Republicans promised to abolish the so-called "death tax," placing it on their 2000 tax policy agenda, right behind marriage penalty relief.

Critics of the estate tax seemed poised for victory this summer. Most telling, the partisanship that characterized earlier proposals to eliminate the estate tax gave way to a bipartisan alliance. Democrats joined Republicans to repeal what Bill Archer (R-TX), Chairman of the House Ways and Means Committee, called "the wrecking ball of a life's worth of achievement and success." Sixty-five House Democrats helped pass H.R. 8, 279 to 136. And nine Senate Democrats co-sponsored the House bill, shuttling it to the President's desk by a vote of 59 to 39. Only the White House's concerted effort to shore up Democratic support prevented an override of the President's veto.

What's more, recent polling data indicate overwhelming public support for eliminating the estate and gift tax. A June 2000 Gallup Poll found that 60 percent of the respondents favored "eliminating all inheritance taxes on estates over $1 million." The latest numbers are even more damning. In surveys conducted in late August and early September this year, the Pew Research Center reported that 71 the percent of respondents favored "eliminating the inheritance tax." Indeed, the future of the estate tax, arguably the most progressive component of the federal tax system, appears uncertain.

Notwithstanding the widespread and bipartisan support for eliminating the estate and gift tax, the case against it does not withstand scrutiny. Its critics have conducted a campaign of misinformation characterized by scare tactics, misleading economic evidence, and ill-informed arguments that construe transfer taxes as immoral. Average American taxpayers have been frightened into believing that the big, bad federal tax system will take all their assets at death, and leave their children destitute. The very existence of family-owned farms and businesses are in peril, according to this campaign. Inheritance taxes penalize savers, encourage lavish consumption, raise no revenue on net, discourage capital formation, and threaten the competitiveness of the U.S. economy. Evidently, the campaign has worked. A majority of Americans, both private citizens and elected officials, demonstrate support for eliminating a federal tax provision that if repealed would benefit less than two percent of the population.

This article argues that the estate and gift tax serves several critical roles in the federal tax system: it generates not inconsequential federal revenues; it improves overall progressivity (an especially important role during a period of widening income and wealth distributions); it provides incentives for charitable donations; and it helps close the loophole in the federal income tax that allows basis step-up at death on appreciated capital assets. Moreover, under certain conditions transfer taxes might actually increase national savings, labor supply, and economic growth.

The defense of transfer taxes cannot rest on economic evidence alone. Equally important, transfer taxes fulfill moral imperatives that have been an integral part of U.S. public policymaking for over two hundred years. Contrary to recent arguments from politicians and academics, transfer taxes are not "immoral." Rather, from the very beginning of the republic, the founding fathers (and mothers and brothers and sisters, too) considered inheritances and bequests an entitlement defined by society, not by birth. They were civic benefits, not birthrights. As such, they were perceived in relation to an individual's moral responsibilities to society. In turn, these responsibilities, or what was more commonly known as republican values, comprised essential components of a free and virtuous republic. They mitigated aristocratic concentrations of wealth, and at the same time established a stable political and economic order in which capitalism and democracy could coexist. Abolishing the estate tax would jeopardize this balance, and repudiate longstanding notions of social justice.

Although this article debunks much of the case for eliminating the federal estate and gift tax, it does not suggest that the tax is beyond criticism. In fact, it proposes reforming the estate and gift tax, primarily through raising the effective exemption, broadening the tax base, and lowering rates. Admittedly, I make these suggestions with an eye towards preserving transfer taxes and their attendant social justice implications. But I also commend them in order to reconcile modern societal mores-particularly the evolving public perception of wealth accumulation as a public good-with more traditional norms regarding an individual's moral responsibility to society and the state. Transfer taxes and the beneficiaries of the "new economy" need not be adversaries.

Rhetoric versus Reality

Critics of the estate and gift tax talk as if they represent a popular uprising. "Ordinary citizens across America are calling for freedom from death taxation," law professors Edward McCaffery and Richard Wagner write. Congressman Jon Kyl (R-AZ), for his part, portends, "This is a dam about to burst." And the editors at The Wall Street Journal claim that "estate-tax repeal has rolled over the political class on a wave of grassroots support, notably from farmers and small business, but also from average folks who think it's unfair to confiscate the fruits of a lifetime of hard work."

Estate- and gift-tax critics, moreover, suggest that abolishing transfer taxes will benefit all Americans, from farmers to small businessmen, from retired old economy workers to new economy professionals. A vote against repeal is a vote against average citizens, the argument goes. In criticizing Bill Clinton's veto of H.R. 8, for example, Speaker of the House Dennis Hastert (R-IL) stated that the President "disappointed millions of Americans who worry that a lion's share of their life's work will be passed on to the Internal Revenue Service rather than left to families."

Although opponents decry transfer taxes in the name of all Americans, they have made small farmers and business owners their poster children. "Families who toil all their lives to build a business or family farm and diligently save and invest should not be penalized for their hard work when they die," Finance Committee Chairman, William Roth (R-DE) has argued. Preserving the estate and gift tax "will hit our nation's farmers and small business owners the hardest," Speaker Hastert concludes. "The death tax can take up to 55 percent of a farmer or small business owner's assets"; and it "prompts…children to sell off the family business to cover the tax." And Nydia Velazquez, Democratic Congresswoman from New York, has written, "the reality for family-owned small businesses is that one-third will be forced to sell or partially liquidate themselves to pay estate taxes on the owner's death."

To a certain, very limited extent, these claims ring true. Polling data, as we have seen, demonstrate that the majority of respondents support abolishing inheritance taxes. Transfer taxes certainly influence financial decisions within family-owned farms and businesses. An increasing number of Americans, moreover, are likely to feel the effects of the estate and gift tax under current laws. And in fact, some of these estates will pay marginal estate tax rates of 55 percent and even 60 percent.

But in a broader, more practical sense, the rhetoric far outpaces the reality.

First, polling data on this issue are not very reliable. Respondents demonstrate confusion, for example, over who would benefit from estate and gift tax repeal. Seventeen percent of those surveyed by Gallup in June indicated that they would "personally benefit" from the elimination of inheritance taxes. But less 2 percent of all estates passing to heirs in any given year pay transfer taxes. However, this evident confusion does not prevent the public from favoring repeal of inheritance taxes. Thirty-nine percent of those surveyed during the June Gallup Poll did not "know enough to say" whether repealing transfer taxes would help or hinder them, and 43 percent believed repeal "would not personally benefit" them. But 60 percent indicated a preference for eliminating inheritance taxes. Thus, if we assume that all respondents who believed they would benefit from estate-tax repeal also indicated a favorable response for repeal, we can deduce that a majority of those who did not know whether they would win or lose from eliminating transfer taxes still expressed support for the repeal.

Such reflexive opposition to the estate tax is hardly surprising. The public historically opposes all taxes. Asking whether or not they favor abolishing a particular tax invites a predictable response. Pollsters could control for this effect, scholars have noted, by replacing true-false questions, such as "Do you favor repealing inheritance taxes," with multiple-choice or open-ended questions, such as "Which one of the following tax cuts should be made first?" The recent polls indicating public approval for abolishing the estate and gift tax utilize the more predictable true-false structure, a format that does little to advance our understanding of public opinion on transfer taxation in particular.

Second, the anti-inheritance tax rhetoric grossly misrepresents the impact of inheritance taxes. This misrepresentation of the facts not only further invalidates polling data, but also begs the question, "Who stands to gain from repealing the estate and gift tax?"

The fact of the matter is that for the vast majority of Americans, transfer taxes are a "non-issue." In 1997, 42,901 estates-less than 2 percent of all estates passing to heirs that year-paid any federal estate tax. The other 98 percent of estates paid no tax. Estates valued at less than $5 million accounted for 94.5 percent of taxable returns (the number of estate tax returns that paid positive taxes), but only 56.3 percent of gross estate (the gross value of all taxable estates). By comparison, estates valued at more than $5 million represented just 5.5 percent of taxable returns, but nearly 47 percent of gross estate. And less than 1 percent of all estates-that is, those with gross estate exceeding $20 million-paid taxes on more than 25 percent of all gross estate. Repealing the estate tax would have given estates over $5 million an average tax cut of $3.47 million. For estates over $20 million, the average tax cut would have surpassed $10 million.

Thus it seems the campaign to abolish inheritance taxes has very little to do with helping "millions" of "hard-working" Americans pass on their "life's work" to their children.

Neither does it involve saving family-owned farms and businesses. In 1997, only 6 percent of all taxable estates included farm assets, and the value of farm assets amounted to a mere 0.3 percent of total taxable estate value. In addition, family-owned business assets (including closely-held stock, limited partnerships, and non-corporate business entities) accounted for 9.7 percent of all taxable assets. In total, farms and small businesses accounted for no more than 10 percent of all assets in taxable estates. If we limit the analysis to estates that reported more than 50 percent of their gross assets in family-owned farms and businesses (that is, those farms and small businesses that in theory might be forced to liquidate assets in order to meet rising estate tax obligations), the universe shrinks further: these 1,200 estates accounted for only 3 percent all taxable estates. "This is a crisis?" the editors at The Economist have appropriately asked.

Focusing more narrowly on family-owned farms and businesses with taxable estates valued below $5 million belies the existence of a crisis still further. According to a 1998 Treasury Department study, farms and family-owned business assets comprised less than 4 percent of all assets in these "smaller" estates. Of the 47,482 taxable estates in 1998, only 776 (or 1.6 percent of all taxable estates) claimed family-owned business assets amounting to at least half the gross estate. And only 642 estates (or 1.4 percent of all taxable estates) included farm assets comprising the majority of the estate. In combination these estates paid less than one percent of all estate taxes in 1998.

Only a fraction of all family-owned farms and businesses pay estate taxes, in part because they already enjoy considerable privileges under the estate tax. Closely-held farms and businesses are allowed to determine the value of estates on the basis of their net worth to family proprietors. Everyone else must base the calculation on market value. This privilege can result in lower estate tax liabilities by as much as $750,000, and on average, by one-third. They can result in even lower liabilities due to the fact that the subjective valuation of assets takes place outside liquid markets. In 1997, moreover, Congress allowed a special $675,000 deduction for estates that could demonstrate both that closely-held farms and businesses comprised at least half of the estate in question and that heirs contributed materially to the estate. In combination, these special tax breaks allow family-owned farms and businesses to avoid paying estate taxes until gross estate exceeds $3.9 million. If family enterprises manage to accumulate estate tax liability in spite of these myriad special provisions, Congress allows them to pay it off in installments spread out over 14 years with below-market interest only charged for the first five years.

In addition to the obviously troubling horizontal inequities created by these tax preferences, the evidence suggests that the beneficiaries do not necessarily need the tax relief. Families that own small businesses have been found to report annual incomes at nearly two times the typical U.S. family. And they own assets valued at more than five times the average family. The closely-held businesses and farms subject to the estate tax are even more wealthy. According to Charles Davenport, "Some run into the billions of dollars. We are not talking about mom-and-pop grocery stores on the corner or even the stereotypical family farm." Rather, "The owners are among the wealthiest one percent of people in the United States." Moreover, although the federal estate tax reaches a marginal rate of 60 percent, the average estate tax rate is considerably lower. In 1997, the average federal estate tax owed on all taxable estates amounted to just 17 percent. Even some of the largest estates, valued at between $3 and $20 million and subject to the highest marginal rates, paid average estate taxes of only 25 percent.

In light of these facts, it is difficult to argue that inheritance taxes should be abolished on the basis that they are breaking up farms or causing heirs to liquidate family businesses. It seems more likely that critics of the estate and gift tax have used farmers and small businessmen as "shells" to obscure the true winners of repealing federal transfer taxes.

The "true winners," as many commentators have pointed out, are extremely wealthy families. Philanthropist George Soros recently argued, "The truth is that repealing the estate tax would give a huge tax windfall to the wealthiest 2 percent of Americans…For the rest of the public, it is a cruel hoax." Regarding these inequitable effects, columnist Jane Bryant Quinn has written sardonically, "I'm trying really hard to feel sorry for the rich. When they die, their estates have to pay a 'death' tax, which means less for their heirs. Poor kids. All that heavy lifting in the stock market by Mom and Dad, and the kids don't' get to keep it all. Where's the justice? Who will stand up for the rights of the descendants of multimillionaires?" Not to fear, their rights are well represented. But not through any democratic, grass-roots movement, as opponents of inheritance taxes would have us believe. Rather, the rights of heirs to receive huge accumulations of wealth tax free is being represented by what economist Paul Krugman has called the simple "power law" that says, "money talks."

There is truth to Krugman's claim. An organization of small businesses, for example, calling itself Americans Against Unfair Family Taxation, has spent more than $1 million over the course of the last year on radio advertisements, pamphlets, and mailings in an attempt to turn public opinion against inheritance taxes. And as we have already seen, appeals to abolish the estate tax in the name of average Americans obscure the wealthier beneficiaries of repeal. The estate-tax obfuscation has infiltrated the presidential race as well. Earlier this year, Presidential candidate George W. Bush told the National Council of La Raza, a Latino advocacy group, that he supported abolishing inheritance taxes, because they hurt average Americans. In particular, they hurt a Mexican-American taco shop owner whom Bush knew personally, and who feared the estate tax would prevent him from bequeathing his business to his children. After the speech, reporters pressed Bush aides for details about the small businessman. They found that the restaurant in question was valued at $300,000, well below the point at which it would become subject to estate and gift taxes.

It turns out that very little of the effort to sway public opinion against inheritance taxes is what it seems to be. Even the term critics use to describe all forms of transfer taxes-"death" taxes-is seriously misleading. For one thing, no one gets taxed simply by virtue of dying and 98 percent of deaths do not trigger the payment of inheritance taxes. Moreover, individuals can be subject to "death" taxes while still alive; the act of exchanging gifts can trigger gift tax liability, for instance. In addition, individuals can fulfill future estate and gift tax liabilities well before they die by purchasing life insurance policies based on the expected value of an estate. Thus, as economists William Gale and Joel Slemrod have said, "[D]eath is neither necessary nor sufficient to trigger the estate and gift tax."

The Economics of Inheritance Taxes

While the rhetorical and political case against inheritance taxes is easy enough to dispel, the economic case against them requires more attention. Primarily, the economic effects of transfer taxes depend on a range of assumptions, including why individuals make bequests or accumulate wealth, and how heirs react to inheritances. Therefore, determining whether the estate tax does or does not reduce personal savings, for instance, is hardly an exact science. Despite the relative ambiguity involved in considering the behavioral consequences of the estate and gift tax, this section demonstrates that the economic case against inheritance taxes, like the political case, is not strong enough to justify repeal.

The economic case against inheritance taxes proceeds on several levels. Primarily, according to critics, it adversely affects savings, labor supply, and aggregate economic growth. On a secondary level, the tax allegedly promotes avoidance and creates huge compliance costs, which, in combination with paltry receipts, yields no revenue in net. In addition, the estate and gift tax double- and triple-taxes earnings, and has little or no effect on charitable giving.

The prima facie case indicates that transfer taxes decrease savings and aggregate capital accumulation, particularly when considered in combination with other components of the federal tax system. Combining the top marginal estate-tax rate, 60 percent, with the top marginal income tax rate, 39.6 percent, yields significant disincentives to earn and save. In fact, a dollar of income taxed at 39.6 percent, with the remainder taxed at death at 60 percent yields just 24 cents on the dollar, for a cumulative levy of 76 percent.

The estate and gift tax can adversely affect savings in still other ways. First, it theoretically reduces the aggregate stock of bequests and inter vivos transfers, which researchers tell us comprise at least half of all wealth accumulation. Second, the estate and gift tax does this quite efficiently. That is, it impacts the nation's wealthiest citizens, the point at which bequests, inter vivos gifts, and wealth are most concentrated. By reducing savings and capital stock, inheritance taxes can, in turn, reduce long-run economic growth, and decrease the capital to labor ratio, which has the effect of increasing the return to capital and decreasing wages.

Given the potentially disastrous impact the estate and gift tax could have on savings, capital, and labor supply, surprisingly little work has been conducted on the subject. Perhaps even more surprising, the analysis to date is ambivalent regarding the influence of transfer taxes on savings and capital.

Scholars have found that transfer taxes have a small negative effect on aggregate capital stock, and that repealing the estate tax would slightly increase the long-term ratio of capital to labor. Moreover, a few studies indicate a correlation between increased estate tax rates and reduced labor supply, and others suggest a similarly negative correlation between the receipt of inheritances and labor supply. Alternatively, some researchers argue that even though repealing the estate and gift tax might increase savings and capital stock, it would also create intolerable wealth inequalities. Still others have found that inheritance taxes can actually increase savings and, in turn, capital stock, for both the donor and the recipient. The effect of the estate and gift tax, these researchers suggest, depends on a range of transfer motives including why donors accumulate and transfer wealth, how heirs respond to their inheritances, and what the government does with transfer-tax revenues. For example, to the extent that inherited wealth induces heirs to reduce work effort and increase consumption, the estate tax might increase aggregate savings. To the degree that the estate and gift tax successfully reduces after-tax inheritances, it might also increase savings in households that receive inherited wealth.

Relevant indirect evidence from studies on how the income tax influences work, savings, and labor supply indicates a weak, nearly insignificant, negative correlation. Of course, estate tax rates are higher than income tax rates, which might suggest more extreme behavioral distortions. However, unlike the income tax, the impact of the estate tax is non-recurring, and it falls at a distant, unknowable point, suggesting that behavioral distortions correlated to the estate tax might be less extreme than those related to the income tax.

While ambiguities characterize the evaluation of how transfer taxes influence savings, capital formation, and labor supply, the remaining economic examination of the estate and gift tax yields more definitive conclusions.

Notwithstanding its opponents' misleading claims, the estate and gift tax yields significant revenues. In 1999, the tax generated $28 billion, or 1.5 percent of federal revenue. To put this amount in perspective, it nearly equaled the cost of the Earned Income Tax Credit. The Congressional Budget Office has estimated that by 2010, estate and gift tax revenues will reach nearly $50 billion per year, even though the exemption will steadily increase to $1 million by 2006.

Critics of the estate and gift tax argue that it is inefficient, and yields far less revenues than proponents believe. Some critics go so far as to say that repealing the estate and gift tax would "raise total tax revenues." According to these arguments, the tax suffers from significant fraud and compliance problems, which, in turn, raise administrative costs. Cumulatively, these costs exceed revenues.

The evidence belies these claims. Charles Davenport and Jay Soled have concluded that costs associated with estate and gift tax planning and compliance add up to $1.675 billion, or 6.4 percent of gross receipts. They estimate another 0.6 percent of revenues for IRS administrative costs, bringing the total costs to 7 percent of revenues. With regards to avoidance specifically, recent work suggests that compliance rates for the estate and gift tax compare favorably with those for the income tax. Economist Brian Erard has found that tax avoidance associated with the federal estate and gift tax amounts to 13 percent of the total tax base, approximately the tax gap associated with the federal income tax.

Researchers have also debunked the myth of double- and triple-taxation. Admittedly, some of the wealth subject to the estate and gift tax has already been taxed in one form or another. But one can hardly argue credibly that it represents "an unfair tax on income that has already been taxed." Economists James Poterba and Scott Weisbenner find that in 1998, for all households (that is, for households which may or may not be subject to the estate tax), 37 percent of expected estate value at death is in the form of unrealized capital gains. In other words, 37 percent of expected aggregate estate value has never been taxed. For estates with assets valued at over $10 million, over 58 percent of the expected estate value is in the form of appreciated capital assets. Charles Davenport reports even more incriminating data: almost 75 percent of all wealth subject to the estate and gift tax is in the form of appreciated property. With these figures in mind, the estate and gift tax can be said to limit what already represents a significant loophole in the federal income tax, the capital gains basis step-up at death.

Finally, the available evidence indicates that the estate and gift tax raises contributions to the non-profit sector. The deduction for charitable contributions, in combination with high marginal estate tax rates, increases charitable giving both during life (in anticipation of estate and gift tax liabilities) and at death (to avoid higher estate and gift tax levies). In 1997, more than 15,000 estates utilized the unlimited charitable deduction, donating more than $14 billion.

The size of charitable contributions, moreover, rises faster than rising estate value. William Gale and Joel Slemrod report that in 1997, charitable contributions from estates valued below $1 million amounted to 11 percent of deductions. For estates valued above $20 million, by comparison, charitable contributions comprised 40 percent of deductions. As a percentage of gross estate, Gale and Slemrod show that charitable contributions increased from 3 percent for estates valued at below $1 million to 28 percent for estates valued at above $20 million. Of the 329 estates with gross assets over $20 million, 182 reported charitable contributions at an average of $41 million per estate.

The most recent evidence suggests that marginal estate tax rates significantly influence the scale and scope of these contributions. They also indicate that abolishing the estate and gift tax would reduce charitable bequests to the non-profit sector. Treasury Department economist David Joulfaian estimates that for tax year 1997, if the estate tax had not been in effect, charitable bequests would have decreased by at least 12 percent, or $1.7 billion.

These calculations surely underestimate the extent to which repealing inheritance taxes would reduce charitable giving. In addition to making bequests, individuals make charitable contributions while alive in order to reduce their ultimate estate and gift tax liability. In 1997, for example, 82,176 charitable remainder trusts, with over $60.5 billion in assets, were in existence. This tax device enables individuals to transfer assets into a trust, live off the trust income, and at death donate the remainder of the trust assets to charity without ever accounting for them as part of their taxable estate.

Anecdotal evidence, too, indicates that abolishing inheritance taxes would dry up charitable contributions. Philanthropist George Soros, well-versed in the art of both giving and benefiting from tax-deductible contributions, argues, "Abolishing the estate tax would remove one of the main incentives for charitable giving." And Leon Botstein, long-time president of Bard College, speaks from experience when he says, "Estate taxes have been a key impetus behind the creation of our major foundations… Those of us who raise money on behalf of tax-exempt charities have learned that necessity [in the form of estate taxes] has been a reliable restraint on selfishness and an inspiration to civic duty." Not only do estate taxes increase charitable giving. They also encourage wealthy individuals to "devote part of their wealth to the public good."

Thus, the economic case for repealing the estate and gift tax falls just as flat as the political case for repeal. Inheritance taxes certainly influence behavior. But not as adversely as critics suggest. In fact, as we have seen, preserving transfer taxes provide benefits that accrue to a wide swath of society. In order to fully debunk the case against the estate and gift tax, however, we must address the question of whether or not inheritance taxes are immoral, particularly because its fiercest critics have argued that the case against the estate tax "is not an economics-based case"; rather, it is "primarily a moral case." Part II of this article will resume the discussion by examining the moral arguments for and against transfer taxes in the United States.

(The author is a Research Fellow at the Brookings Institution in Washington, D.C., and a Ph.D. candidate in economic history at the University of California, Santa Barbara. The author wishes to thank Junfu Zhang for his editorial leadership. Comments are welcome at dventry@brook.edu.)