Death and Taxes: Now’s Hardly the Time to Favor the Richest Among Us

Henry J. Aaron
Henry J. Aaron The Bruce and Virginia MacLaury Chair, Senior Fellow Emeritus - Economic Studies

May 4, 1997

After two decades of increasing inequality in the income of rich and poor Americans, a proposal to cut taxes paid only by the wealthiest among us would not seem likely to elicit much support. Yet Republicans and some congressional Democrats are lining up behind proposals to slash or even repeal estate and gift taxes. The growing momentum behind these proposals is bewildering for several reasons.

First, more than 98 percent of Americans who die face no estate tax at all. To mischaracterize this as an onerous “death tax,” as its opponents do, is political doublespeak.

Like other tax cuts, scrapping the estate tax would increase the deficit. The estate tax raises about $17.2 billion a year, or 1.2 percent of all federal tax revenue. That money has to be made up somewhere. At the same time, repealing the estate tax would lavish a tax cut averaging roughly $2 million on 5,000 to 6,000 of the richest families in the nation. It is not as if this group has fallen on hard times lately: Incomes of the richest 1 percent of the population rose an average of 88 percent between 1977 and 1995, while incomes of the bottom 60 percent of the population fell an average of 1.5 percent. When Americans think of tax reform, is this really what they want?

The estate tax addresses the traditional American concern about undue concentration of economic or political power. The American ethos has been that people should be encour aged to work hard, save and invest, but that there should be some brake on the unbridled transmission of economic privilege from generation to generation. To be sure, the estate tax does not and should not prevent parents who have earned large fortunes from giving their children and grandchildren advantages such as costly educations and large inheritances. What the estate tax accomplishes is to exact a modest but real toll on these transfers and help make the transmission of inherited inequality and advantage a bit less extreme. With income inequality higher than at any time since World War II, labeling a cut in such taxes as unfair is not an appeal to class warfare but an expression of common decency.

The rich can still pass along a lot of money. The estate tax is levied on estates that exceed $600,000—after subtracting unlimited transfers to spouses and charities. In addition, a good deal more can be passed along with even a modicum of planning. Individuals can give up to $10,000 annually to as many people as they wish with no tax. That means that a couple with two children and three grandchildren would be able to distribute an additional $1 million—much more with accumulated interest—if they began making such gifts just 10 years before they died. The

Repeal of the estate tax is unadulterated bad news for charities, according to a recent study by Duke University’s Charles Clotfelter and Richard Schmalbeck. Charitable bequests would fall 25 percent to 45 percent, the study estimates, enough to cause major problems for universities, museums and hospitals around the nation.

The argument, made by some, that the estate tax erodes savings, is unsubstantiated. Republicans and Democrats alike want to increase saving—and with good reason. The national saving rate—the difference between what the nation produces and what it consumes—is only about 4 percent, too little to support strong growth of productivity and much less than other major industrial countries. But there is no persuasive empirical research that cutting the estate tax would boost saving. In fact, a good case can be made that the opposite would happen. To see why, think about a Ms. Jones, a highly successful entrepreneur who has accumulated $20 million she would like to bequeath to her heirs and to charity.

Without the estate tax—and with less incentive to give to charity—Ms. Jones’s heirs will receive much larger inheritances for each dollar she saves. With the estate tax out of the way, Ms. Jones could raise her consumption and still leave her heirs larger bequests. Thus, the net effect on saving could be negative, just the opposite of claims advanced by those who want to get rid of the estate tax.

The claims that the estate tax imposes cruel hardship on owners of family farms and small businesses is greatly exaggerated. Contrary to the rhetoric of supporters of repeal, the estate tax is not forcing heirs of farmers and small business owners to sell the enterprise that mom and pop built with the sweat of their brows.

To get a fix on the potential size of the problem, farmers and small businessmen pay only 6.5 percent of total estate taxes. Among farm owners, only 1,451 farms were subject to estate tax in 1995 out of roughly 50,000 transferred at death each year. Only 666 of the estates containing “family farms” were valued at less than $1 million; the remainder of these estates contained either larger farms or significant other assets. Almost 60 percent of taxes on estates consisting substantially of family businesses comes from estates valued at $10 million or more—giving a whole new meaning to the term “small business.

Farmers and family business owners who are cash-limited can purchase life insurance sufficient to pay the anticipated tax. In addition, heirs may postpone paying any tax for five years and then defer payment an additional 10 years on estates in which a farm or closely held business accounts for at least 35 percent of the gross estate. The interest rate on the first $153,000 of unpaid balance is only 4 percent.

That said, problems may arise in a tiny number of cases and some limited relief might be justified. Congress could increase the value of estates eligible for this special treatment and increase the amount of deferred tax on which the special low interest rate is allowed.

Modest reform might also be acceptable on the amount of the exemption, which has remained unchanged at $600,000 since 1987. Since then, prices have risen 38 percent. Although the current exemption exceeds the estates of more than 98 percent of all Americans, it might be reasonable to index it, just as personal exemptions under the income tax are indexed. That would mean raising the current exemption to $830,000. This change would reduce estate collections less than 3 percent and have negligible effect on the deficit.

A third area where reform may be desirable concerns a penalty tax on accumulations in tax-sheltered savings accounts. Recent work by economists John Shoven of Stanford University and David Wise of Harvard University has found that taxpayers who have big accumulations in IRAs, Keogh plans and other savings accounts on which income tax is deferred, may face total tax rates at death of as much as 90 percent or more. The high rates result from the combination of federal and state income taxes, estate taxes and a special tax on “excess” accumulations in tax-sheltered accounts. These rates, which Congress surely did not intend, kick in only when accumulations in sheltered accounts reach about $1 million or more. While some corrective action may be in order, repeal or across-the-board reductions in the estate tax are not the answer to this problem.

Repealing the estate tax would be a gratuitous windfall for those whose talent, hard work and good fortune have already been handsomely rewarded. The revenue loss from this tax cut would increase the deficit and have to be made up by other taxes or by cuts in government expenditures. The best one can say for claims that repeal of the estate tax would boost saving is that the case is unproven. The most likely outcomes of estate tax repeal are the collapse of charitable giving and a big increase in inheritances.

If the estate tax causes any serious problems for farmers and small-business owners, despite the concessionary provisions already on the books, simple fixes are available that do not entail abandonment of the estate tax. To use the easily handled problems of family farmers and small-business owners as justification for repealing the entire tax, thereby giving an enormous tax cut to a few extremely wealthy households, is simply dishonest demagoguery.