Yes the dreaded "death tax". You even have to pay a tax to die, how distasteful! Obama has indicated he wants to keep the tax at current levels rather than letting it expire next year as was intended under the Bush tax cuts. Of course, the "death tax" is really the "estate tax" and is far more complicated than most realize.
Let's start with a primer on exactly what the estate tax is. An "estate" is all the property a deceased individual owned or had an interest in when they died. That's what a will is for- "disposing" of the property by bequeathing it to heirs as the owner intended to. When I first heard about this "death tax" years ago, the phrase sounded to me like it was a tax on dying. Someone worked their whole life and instead of leaving what they accumulated to their kids, half (or more!) of it goes to the government. Who doesn't want to leave their kids better off after a life of hard work? That's what I assumed.
In reality, very few people have to confront the estate tax. You see, the estate tax has an exemption such that only people who die with very large estates must pay. Other than the obvious revenue generation it serves a wealth redistribution purpose: it hampers the accumulation of enormous amounts of wealth across generations. In other words, it helps prevent dynastic wealth. As you know, wealth can compound over time. Allowing wealth to compound for many generations would result in temendous wealth and the power that comes with it concentrated into a small number of hands, most of which became wealthy by luck of birth rather than contribution.
Republicans have traditionally opposed the estate tax in all forms. In the past decade or two, they began popularizing the term "death tax" as if to scare Main Street into thinking it affected them and was as wrong as I described at the beginning of this post. Only 2% of annual deaths are affected by the estate tax. Park Avenue rather than Main Street are targets, but of course this doesn't justify it alone. More specifically, only estates exceeding $3.5 million at death currently face the tax and while the rate is graduated, it quickly climbs to 45% on amounts over this threshold. So, if someone worth $10 million dies, $2.9 million in tax would be owed and they would leave $7.1 million to their heirs. The bigger the wealth, the higher the effective tax rate becomes. A $100 million estate would shrink to $53 million. Obviously, the super-rich generally hate this tax and thus the effort to supplement their opposition by recruiting Main Street to their cause.
Yet $3.5 million ain't what it once was. There are lots of family businesses and farms worth that much. Lot's of farmers, for example, want to allow their family to keep the family farm intact rather than having to sell land to pay the tax. To provide some context, there are roughly 4 million "millionaires" in the U.S. (at least before the market swoon last year). Probably at least half of those are under the threshold, so we're left with roughly 2 million people eligible for the tax. (There are many exemptions and exclusions when calculating the estate's value. For example, there is a discount on family farms and a discount on the value of closely held businesses.)
Now, there is an interesting twist to the tax, it is per individual estate. Say a married couple is worth $10 million and one of them dies. They would use the $3.5 million "exclusion" to leave that much to their heirs (let's say the kids) without any tax. The other $6.5 million goes to the surviving spouse. Any proceeds left to the surviving spouse are not taxed at all until the second spouse dies. When the second spouse dies, they leave $3.5 million to heirs tax free and the remaining $3 million gets taxed at 45%. So on the original $10 million, only $1.4 million was paid in estate taxes.
Of course, the threshold for the tax and its rate are subjective values. People have to weigh how much estate tax is reasonable and appropriate. There is no right, wrong, black or white answer- only a value judgement. Now you know the facts of the debate and that it simply isn't about taxing everyone who dies.
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This is a nice summary. You did leave out, it seems, one important argument against the estate tax: double taxation. The wealth which is transferred to a new generation accrued from income, which would have already been taxed.
ReplyDeleteAlso, the targets of the tax, the super-rich, have ways of getting around the tax which makes this rather inefficient.
There might also be a small death elasticity: http://www.nber.org/papers/w8158
Good observations. I would add the the accumulated wealth is not necessarily from income. Take a Bill Gates or Warren Buffett, the vast majority of their wealth is from capital gains which would entirely lost as tax revenue when they die (since few shares are actually sold, they get the step up in basis). Of course, double-taxation isn't new- it happens in many ways such as property taxes you bought with income, taxes on dividends on top of corporate income taxes and the sales tax. Just pointing out that double-taxation is a way of taxation life and not necessarily an argument against any particular tax.
ReplyDeleteOn ways of getting around the estate tax, there really aren't many true methods. They are all indirect ways to eliminate some of the tax, but they have consequences and still cost money. Charitable giving reduces the tax, but equally reduces the money left for heirs. Remainder trusts also must give away funds, so in the end someone other than the heir gets a large piece of wealth.
I also find the elasticity interesting. Many of you might not know that the Bush tax cuts have been raising the threshold and lowering the rate. In 2010, the tax disappears entirely and then returns in 2011 to Clinton era rates (very high on anything over just $675k). This has caused many to speculate that a lot of very wealthy old people will by dying in late 2010. It would not suprise if this turned out to be true and if some fraud wasn't involved like backdating death certificates or premature plug pulling. Hopefully Congress and Obama will decide on a much more stable policy than currently in effect.
Thanks for the response, Brett.
ReplyDeleteIndeed, double taxation is commonplace, but it shouldn't be dismissed as acceptable because of its ubiquity. If double taxation is seen as a bad thing, getting rid of one form is presumably good.
I'm not entirely sure of how the rich get around estate tax. I understand there are consultancies which specialize in this stuff and they seem to do well, generally.
In any case, if the entire point of estate taxes is to prevent dynasties, wouldn't it make more sense to limit the size of estate transfers to relatives at death? Rather than putting a percentage in government coffers, the wealthy could decide for themselves where that money goes. Of course, I don't see governments giving up a revenue stream, but it's a thought.
The problem with double taxation is that the concept applies to everything. Your income is taxed, then you pay sales tax. You buy a car with after-tax income, then must pay registration, title fees and taxes built into the price of gas. Even your home, purchased with after-tax dollars also incurs property taxes, possible capital gains taxes, title recording fees etc. I'm just not buying the argument that calling something a "double-tax" is sufficient to overturn the tax- any time there is more than one tax, it is impossible to get around double-taxation since somewhere, someplace, sometime, already taxed wealth is going to have to pay the other tax too. This is slightly off topic though, so let's take it up another time. It is certainly worthy of discussion and open to opinon.
ReplyDeleteThere are small armies of highly educated lawyers and consultants which assist in estate planning. I work with many of them for clients and there is no legal way that I am aware of that eliminates the effects of the tax (which is that not all the money goes to heirs). For example, one could give the money at death to charity and pay zero in estate tax, but then no money goes to heirs. There are many strategies for reducing the tax somewhat, but again no silver bullets- severe tradeoffs are involved.
Not exactly sure what you mean by "limit the size of estate transfers to relatives".
I live in a city without sales and capital gains tax. Taxes, in general, are rather minimal here. But yes, it's another topic entirely.
ReplyDeleteWell, since one of the reasons for the existence of the estate tax is to prevent wealth from accumulating in excessive amounts across generations, I wonder if this tax could be replaced with regulation which limits the percentage of your estate which can be transfered to relatives at the time of your death. That is, instead of government taking a percentage (say, 20%) of your estate in the form of a tax, the government could instead regulate that only a certain percentage (80%, in this case) could be given to relatives. The wealth which would have gone as taxes (20%) could be used in any other way, as the owner of the wealth saw fit. It could go to charity, used for scholarships, spent recklessly even.
I doubt this will ever happen in most countries, but I'm curious as to which is more efficient.
It's a good question (which is more efficent). Mathematically, your example would leave $80 million out of a $100 million estate to heirs where the current tax would leave just $53 million. (Not passing judgement on that, just pointing it out). The current system does encourage people to give money away to avoid giving it to the gov. For example, a charitable remainder trust would leave money to charity and some to the heirs. It gets very complicated and I don't think we could discuss all the nuances here (there are many).
ReplyDeleteAnother alternative idea, proposed as a thought experiment by no other than Warren Buffet, was to reduce taxes on capital gains and income to nearly nothing, but tax HEAVILY everything when someone dies. Theoretically this would promoted efficient allocation and use of capital while individuals can do the allocating, but after death the gov gets its due and prevents dynastic wealth.
The other benefit of Buffet's idea is that it avoid the issue of double taxation. Have we done it, Brett? Have we managed to reach a consensus on a blog?
ReplyDeleteThanks for the interesting discussion. I can't wait to see what you discuss next.
Though the tax might not affect everyone who dies, it is the principle of the thing that people (or at least I) find objectionable. Being taxed on assets while you are alive and then again once you die is outrageous. The less money the government collects in taxes, the less it can waste on pork, you have to trim the fat if you're working with less capital. From the survivor's standpoint, it is hard enough to collect an inheritance at all, with obstacles like Anna Nicole Smith-esque relatives who might have a long and drawn out legal battle on their mind to try and get a portion of an estate that they think they deserve, or complex estate planning that slows down the distribution of property. For the government to put their hand in the pot first is unacceptable in my opinion.
ReplyDelete