Estate tax: Tax Needs Reform, But Repeal Would be a Giveaway to the Wealthy

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

July 27, 2003

The estate tax plays an important role in our economy and society. It does have flaws, but it should be improved, not abolished. A sensible reform would bolster the strengths of the estate tax and reduce the problems.

The estate tax has numerous strengths. It is by far the most progressive source of federal revenue. Despite the perception that advocates of repeal have created, the vast majority of estates are not subject to the estate tax. Only 2 percent of deaths result in any estate payments at all. About half of all estate taxes are paid by the wealthiest 1 out of every 1,000 estates. By 2009, couples with less than $7 million in wealth will pay nothing at all. Repeal would be a massive giveaway to the nation’s wealthiest dynasties.

The estate tax helps close what otherwise would be gaping loopholes in the income tax with respect to capital gains and other items. Repeal would create sheltering schemes that would drain massive amounts of income tax revenue from federal coffers.

The tax also helps support the nonprofit sector by providing incentives to give to charities at precisely the time when people are distributing large amounts of wealth. My own research indicates that repeal would reduce charitable giving at death and during life by about $10 billion per year. This represents 5 percent of all charitable giving and is equivalent to the annual grant-making of the nation’s 100 largest foundations.

The estate tax helps provide equal opportunity by reducing the size of massive inheritances. It is hard to see why children of the rich should be allowed to inherit scads of money tax-free when other forms of income are taxed.

Opponents claim the tax raises very little revenue. But estate taxes were slated to raise about $400 billion over the next decade before being slashed in 2001. Let’s put it another way: Retaining the estate tax, rather than repealing it, would pay for half of the entire Social Security shortfall over the next 75 years.

The alleged negatives of the tax have been grossly overstated. The vast majority of small businesses are too small to ever face the estate tax. Half of them go out of business within four years, so claims that the estate tax is a major cause of the breakup of family businesses simply are wrong.

Likewise, two major farm organizations were unable to point to a single family farm that had to be broken up due to the estate tax. Even if the tax were a serious problem for small businesses and farmers, those assets constitute less than 15 percent of all wealth subject to the estate tax.

Special provisions already allow family owned businesses and farms to shelter two to three times as much as others can and could be expanded. You don’t need to repeal the estate tax to save the family business or farm.

The impact of the tax on wealth accumulation is unproven. But the impact of large inheritances on the behavior of recipients is quite clear: Inheriting a large estate causes people to work less and spend more. Those effects clearly reduce economic growth.

The hysteria in labeling it the “death tax” also is misplaced. About 98 percent of people who die receive a “death subsidy” — their taxes on accumulated capital gains are forgiven, but they don’t pay estate taxes. Furthermore, the estate tax need not actually be paid at the time of death. It can be prepaid with prudent estate planning devices such as life insurance, and for small businesses and farms, the payments can be stretched out over many years.

The easiest way to see that all the braying over the unfairness of taxing at the time of death is a red herring is to note that no one who objects to taxes at the time of death ever proposes equally progressive taxes imposed during life.

All taxes impose burdens, and the estate tax is no exception. The bigger question is whether the burden per dollar raised from a tax on someone who inherits millions of dollars is more or less than the burden of what will result if the estate tax is eliminated — higher taxes on working families, less generous Medicare payments or some other unspecified alternative. All budgetary decisions reflect priorities, and eliminating the estate tax should be a lower priority than these and other claims on the national pocketbook.

For all of these reasons, abolishing the tax is a bad idea. After all, a tax that is progressive, closes loopholes, provides equality of opportunity and encourages charitable giving can’t be all bad.

It should be saved and enhanced, reformed to emphasize its virtues and minimize its costs. This could be done by closing loopholes, reducing rates modestly, indexing the tax for inflation and letting the exemption rise as scheduled. This would focus the tax on the truly wealthy and at the same time make it simpler and fairer.