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

Dennis J. VENTRY, Jr.

Perspectives, Vol. 2, No. 3

(Editor's Note: This is the second part of a two-part essay. Part I was published in the October, 2000 issue of the "Perspectives." Notes and references of this essay, omitted here due to space limitation, are available from the author at dventry@brook.edu.)

In the first part of this article, we examined the political and economic cases against transfer taxes in the United States. I argued that the political rhetoric surrounding the effort to repeal the estate and gift tax-particularly the charge that it destroys family farms and closely-held businesses-is, at best, misleading, and at worst, disingenuous. I demonstrated that the estate and gift tax does not necessarily threaten aggregate saving, labor supply, or economic growth as its critics maintain. Nor does it generate an insignificant amount of revenue, produce prohibitive compliance costs, primarily tax wealth that has already been taxed, or have little effect on the rate of charitable contributions, again, all of which critics maintain.

In the second part of this discussion, I challenge the assertion that transfer taxes are immoral because they prevent parents from passing along hard-earned wealth to children, and because they tax saving not consumption. The fact that we care about our children does not make transfer taxes immoral, anymore than the fact that we care about what we consume makes consumption taxes immoral. More fundamentally, I challenge the moral case against taxing wealth at death by invoking history. Americans have long considered wealth a civic right, not a birthright; thus, taxing inherited wealth fulfills a moral obligation in a liberal, democratic society.

The Moral Case for the Estate and Gift Tax

Many of the individuals who argue against inheritance taxes on moral grounds operate from the basis that taxation is fundamentally a moral issue. I agree. Tax policymaking in the United States has historically involved both social and economic factors. From the founding of the country, Americans have used the tax system to regulate economic privilege, and to restore equitable income and wealth distributions. Tax justice "American-style" has measured relative societal burdens against relative societal benefits, and it has reflected prevailing notions of social and economic justice. Since World War II, tax policymakers, particularly economists, have ceded the social justice and distributive aspects of taxation to legal theorists and philosophers. Despite this worrisome trend, tax issues still involve moral and normative considerations.

However right these individuals are to emphasize the moral underpinnings of taxation, they are wrong to attack the estate and gift tax as immoral. Their argument goes something like this. Inheritance taxes add to the pains and sufferings of grieving heirs. It penalizes frugal savers. It discourages successful individuals and families from passing along hard-earned wealth to their children. And it encourages Americans to "die broke."

Implicit (and sometimes explicit) in the argument is the objection that inheritance taxes fall on savers not spenders. Abolishing the estate and gift tax, it is said, would be morally right to do assuming that a liberal, democratic society should care about enhancing future generations, and removing inequitable consumption patterns.

This conclusion is simply untenable. First, the fact that we care about our children does not make estate taxation immoral, anymore than the fact that we care about what we consume makes consumption taxes immoral. Or as law professor Richard Schmalbeck suggests, "There is nothing immoral in consuming food, clothing, shelter, medical care, and education for the benefit of oneself and one's family." We may consider excessive consumption immoral, but that consideration is merely a matter of taste. One person's excessive consumption is another person's level of subsistence. The presumption that consumption is morally bankrupt is itself a morally ambiguous.

Second, the estate and gift tax is hardly immoral from the standpoint that it subverts the values of a liberal, democratic state. On the contrary, it reinforces the philosophical foundations of the very first liberal, democratic state, the United States. As historians and political philosophers have shown, the founding fathers worried that political equality would conflict with individual liberty. They reconciled this tension through the familiar concept of "republicanism," which upheld the ideal of civic virtue. Republicanism, with its emphasis on communal responsibilities, mitigated excessive economic liberties as well as the "tyranny of the majority." That is, republicanism struck a balance between the right to property (or Lockean liberalism) and democratic ideals of equality.

With regard to taxation, this compromise resulted in a tax system that taxed wealthy individuals despite a national aversion to infringements on individual liberty. The state protected individuals who pursued personal wealth and property through labor and reason. But the state prevented individuals from asserting entitlement through birth. That is, it tolerated persons who created wealth, but not those who inherited it; the latter reflected the distinguishing characteristic of an aristocratic society.

In this spirit, Congress created a federal wealth transfer tax in 1797 to help pay for American naval buildup against France, with whom the nascent United States was at war. The new tax was levied on receipts for legacies and probates for wills. Congress abolished the tax in 1802, but continued to search for alternative ways to use taxation to represent republican ideals.

Early federal and state legislators employed taxation to restrict privileges (by taxing corporate charters, for example), and to "affirm communal responsibilities, deepen citizenship, and demonstrate the fiscal virtues of a republican citizenry." The emphasis on communal responsibilities created a unique form of ability-to-pay taxation that was hostile to excess accumulation. The U.S. constitution restricted the federal government from levying direct, non-uniform taxes (except in proportion to state populations) thereby limiting its ability to promote more distributive forms of taxation. States, however, faced no such restriction, and actively used the tax system to prevent aristocratic concentrations of wealth. State governments taxed property at a flat, ad valorem rate, for example, believing that high-income individuals spent a larger share of their income on land and property than low-income persons. Throughout the first half of the nineteenth century, states expanded their use of the general property tax to include both tangible property (land, equipment, household goods) and intangible property (cash, credits, stocks, mortgages). By including intangible property, states increased the percentage of taxes paid by wealthy citizens, and raised these citizens' aggregate contribution to both the community and the government. Several states even experimented with income taxes prior to the Civil War "with the avowed purpose of removing inequalities in the tax system," and increasing further the civic role of its wealthy residents.

In this historical context, wealthy individuals owed a debt to society. Their success depended on the ability of the society in which they lived to sustain economic and political order. Certainly, these individuals created wealth. But they also benefited from the system in which they operated. These obligations were not lost on subsequent generations. At the end of the nineteenth century, Populists and Progressives aggressively advocated a progressive federal income tax on the grounds that it would reach what they perceived to be inequitable concentrations of economic power. In 1906, President Theodore Roosevelt, while arguing for a graduated inheritance tax and a progressive income tax, stated, "The man of great wealth owes a peculiar obligation to the State, because he derives special advantages from the mere existence of government." And in 1942, President Franklin Roosevelt proposed capping after-tax incomes at $25,000.

Perhaps these words and proposals seem strangely divorced from our own time, aberrations from a more idealistic era. But the fundamental moral imperatives they represent still resonate. The ideal of a virtuous citizenry, animated by civic duty, remains at the heart of American political culture. We tolerate deviations from this norm, to be sure, but only because they are checked by countervailing forces of equal opportunity. Abolishing the estate and gift tax could jeopardize the delicate balance between individual liberty on the one hand and equality of opportunity on the other. Indeed, as Leon Botstein argues, "[I]f inheritance taxes are eliminated, the historic and unique character of American society and culture will be placed in jeopardy." Worse, according to Botstein, it could instigate social unrest. Abolishing the estate and gift tax "after decades marked by the unparalleled accumulation in wealth and a widening gap between the poor and the rich, might trigger an unwillingness by Americans to continue to accept equality of opportunity as a surrogate for actual material equality."

Regardless whether one subscribes to Botstein's prediction, the moral foundation of inheritance taxes cannot be denied. Repealing the estate and gift tax would confer advantages on individuals "who may not have demonstrated any other skill than that of choosing affluent parents." Moreover, it would distort long-standing notions of fairness, equal opportunity and communal responsibility. Most important, it would subvert American democracy and its historical rejection of aristocratic wealth accumulation.

Conclusion: Reform, Not Repeal

This two-part study has defended the estate and gift tax on political, economic, and moral grounds. In conclusion, however, it recognizes areas for improvement as well.

Raising the effective exemption, for one, would make it impossible for critics to claim that transfer taxes threaten the future of family farms and businesses in America. Moreover, removing the "lesser" rich from the estate-tax rolls would simultaneously remove the critics' poster children. "Without small businesses and farmers in the mix," economist Martin Sullivan has argued, "the momentum the Republicans now have on estate taxes would stall. And their efforts to repeal the estate tax would crash."

Raising the exemption would not be hard. In fact, it is scheduled to increase steadily over the next few years, from $675,000 per person in 2000-2001 to $1,000,000 in 2006 and thereafter. Moreover, Congress recently demonstrated a willingness to accelerate raising the cap on exemption levels. Throughout the last legislative session, various Congressional members from both parties proposed legislation designed to increase the effective exemption over the next few years between $2.5 million and $10 million. In addition, the Democratic House substitute to H.R. 8 would have immediately increased the $1.3 million exclusion for farms and closely-held businesses to an effective $4 million exclusion per family; and the Democratic Senate substitute (in addition to the House changes) would have immediately raised the exemption for all individuals to $2 million, and for all married couples to $4 million. Most recently, the Democratic "Blue Dog" coalition proposed immediately doubling the exemption, and then raising it to $4 million over several years.

Increasing the exemption would also make good policy. First, it would more accurately reflect American society's rapidly changing perception of wealth. Specifically, it would accommodate higher modern thresholds concerning what is and what is not excessive wealth accumulation. One plausible explanation for why so many Americans favor repealing the estate and gift tax, despite the fact that less than two percent of estates pay inheritance taxes, is that "attitudes about wealth are clearly changing as more Americans either experience it, or hope to do so in the future." That is, not only do more Americans feel that it is okay to be wealthy, they also believe in the dream of achieving wealth. The estate and gift tax threatens that dream. But raising the effective exemption would remove the threat.

Meaningful reform of the estate and gift tax would involve more than increasing the exemption levels. It would also improve horizontal equity by broadening the tax base, removing distortions, and lowering marginal rates. Some of the most obvious reforms include eliminating valuation discounts on passively held assets, abusive trust devices, and tax-motivated expatriation. The tax could be simplified further by abolishing the complicated family-owned business interest qualification requirements, and by removing abnormalities in the rate structure caused by phase-outs. In addition, any changes to exemption levels should be indexed for inflation. More nuanced reform could complement the effort to prevent family enterprises from experiencing harsh estate tax obligations by, for example, increasing the number of partners in firms, for the purpose of qualifying as an interest in a closely-held business that would be eligible for deferral and installment payment of the estate tax.

All of these reforms could be implemented without damaging the progressivity of the estate and gift tax. In fact, raising the exemption levels would increase the progressivity of the tax, an arguably laudable policy goal during the prevailing decades-long trend toward greater income and wealth inequalities. In 1997, 5.4 percent of taxable estates reported gross estate values of over $5 million. These estates comprised 43 percent of total gross estate and over half of all transfer tax revenues. Raising the exemption to $5 million would make the estate and gift tax more sharply progressive while still generating significant amount of revenues. As important, it would reflect the tax's original moral purpose of limiting concentrations of inherited wealth.

Critics believe that the estate and gift tax is already too progressive. When referring to the U.S. transfer tax, editors at The Economist recently opined, "'Soaking the rich' is not a principle of good taxation." Indeed, not. But determining whether the present estate and gift tax-or even a reformed estate and gift tax-can be considered representative of "soak-the-rich" taxation is open for debate. It is both an economic and a moral question. So, too, is it a political question. Some researchers might prefer to leave these issues to empiricists in the interest of facilitating "objectivity" and "scientific rigor." But as we have seen, the debate over the estate and gift tax involves normative considerations that do not lend themselves exclusively to scientific inquiry. Rather, they require analytical, theoretical, and political inputs. The fate of transfer taxes in the United States will be decided in the political arena. Economics will certainly inform the debate. But so will political grandstanding, rhetorical slights of hand, and moral philosophizing.

Participants in the next round of debate over the future of the estate and gift tax will serve an educative role. And they will have to account for inputs other than their own if they wish to successfully defend their position. In July, at the height of Congressional squabbles over the estate and gift tax, the editors at Commonweal argued, "repealing the estate and gift tax is an idea that should be resisted on political, fiscal, and moral grounds." The debate is multi-faceted. To be heard will require an understanding of not just the revenue or behavioral effects of inheritance taxes, but also their political, social, and moral ramifications.

Those of us who wish to preserve the letter as well as the spirit of transfer-tax law have some ground to make up. Whether through empirical research, surveys of the literature, opinion pieces, Congressional testimony, policy briefs, or radio appearances, proponents have an obligation to clarify the misrepresentations that surround the estate and gift tax. Only through education will the debate move forward, characterized by reality instead of rhetoric. Indeed, only through education will all Americans-experts, average citizens, and elected officials-feel compelled to participate in the discussion over the future of transfer taxes, and thus, over the meaning of citizenship in a modern democratic state.

(Dennis J. Ventry, Jr. 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. He is the co-editor (with Joseph J. Thorndike) of Tax Justice for the 21st Century: Reconsidering the Moral and Ethical Bases of Taxation (Urban Institute Press, forthcoming). Mr. Ventry wishes to thank Junfu Zhang for his editorial leadership. Comments are welcome at dventry@brook.edu.)