Should We Abolish the Estate Tax?

Bruce Bartlett

January 27, 1997

National Center for Policy Analysis

The estate and gift tax brings little revenue in to the federal government. In fiscal year 1997 it is expected to raise just $17 billion, according to the Office of Management and Budget. That is only 1.1 percent of total federal revenues, estimated to reach $1.5 trillion. However, while the tax is insignificant in terms of federal revenue, it is quite significant economically. It wastes resources. It discourages work, saving and investment. And it does virtually nothing to redistribute wealth (as some who favor it would like). In short, the estate and gift tax is a failure. It should be abolished.

The federal estate tax was first enacted in 1916 on estates larger than $50,000 (equivalent to $720,000 today). The top rate was 10 percent. However, the revenue yield from the tax was small because people who would have been subject to it simply gave away their assets tax-free during their lifetimes. This led to the establishment in 1924 of a gift tax to augment the estate tax. Since 1976 the estate and gift taxes have been unified into one tax system. Today the tax applies to estates above $600,000 ($1.2 million for couples), beginning at a rate of 18 percent and rising to 55 percent. In 1991 just 1.25 percent of adult deaths in the United States resulted in taxable estates.

The Richest Don't Pay. A common misconception is that the estate tax is paid mainly by the rich - including those on the Forbes 400 list. However, by using estate-planning techniques, the very rich actually evade most of the tax.

In 1993, 52.4 percent of all estate tax revenue came from estates under $5 million.

In the same year, estate taxes as a share of gross estates fell for those with estates above $20 million. [See the figure.]
The reason for this disparity is that careful estate planning can virtually eliminate the tax. At the simplest level, individuals can give away up to $10,000 per year per person free of gift tax. Also, there is a large deduction for gifts made to spouses, whose estates may be taxed separately. More complex methods for reducing the burden of the estate tax include life insurance trusts, qualified personal residence trusts, charitable remainder trusts, charitable lead trusts and generation-skipping trusts.

For the Rich: the Tax Is Voluntary. So effective are these methods of avoiding estate taxes that George Cooper, a professor of law at Columbia University, says that the estate tax is essentially voluntary. As he writes, "The fact that any substantial amount of tax is now being collected can be attributed only to taxpayer indifference to avoidance opportunities or a lack of aggressiveness on the part of estate planners in exploiting the loopholes that exist." Economists Henry Aaron and Alicia Munnell put it even more bluntly. In their view, estate taxes are not taxes at all but "penalties imposed on those who neglect to plan ahead or who retain unskilled estate planners."

However, as the figure makes clear, the ability to exploit existing tax-avoidance techniques is not uniform. Since many of the planning techniques are costly and require long lead times to implement, those with the largest estates have the greatest ability to engage in estate planning. Families with histories of wealth are more likely to be familiar with them. Thus a disproportionate burden of the estate tax falls on those with recently acquired, modest wealth - including farmers and small business owners. In many cases their assets consist almost entirely of their businesses or farms. Though their incomes are not very high, at death they are declared to have been "rich."

Does the Tax Raise Any Money? The impact of estate planning goes beyond the estate tax and impacts the income tax as well. For example, under a charitable remainder trust one donates assets to a tax-exempt institution but retains the income from the assets until death. Not only are the assets fully shielded from the estate tax, but the charitable donation also reduces one's income taxes. Because of such interactions between the estate tax and the income tax, B. Douglas Bernheim, an economics professor at Stanford University, believes that lost income tax revenue may offset all of the revenue from the estate tax. If true, this means that the estate tax raises no net revenue for the federal government.

Slowing Economic Growth. While skeptical of the effect Bernheim identifies, Professor Edward McCaffery of the University of Southern California's law school believes that the impact of the estate tax on economic growth may be significant, reducing the incentive to work, save and invest. For example, if the primary reason why higher-income people work to earn more money is to leave a large estate to their children, the effective marginal tax rate is the income tax rate plus the estate tax rate. This rate can go as high as 73 percent at the federal level alone (39.6 percent top income tax rate, plus a 55 percent estate tax rate on the remainder), with state income taxes pushing it higher still. According to McCaffery, these negative effects on saving and work effort are not limited to the very rich. Moreover, to the extent the estate tax encourages gifts to children during the taxpayer's lifetime, it may reduce the children's work and saving as well.

Does the Tax Make the Rich Richer? According to a study by economists Laurence Kotlikoff and Lawrence Summers, intergenerational transfers constitute a significant share of the nation's capital stock. This means that the estate tax is a direct tax on capital. It follows that the nation's capital stock is automatically reduced by at least the amount of the tax. It is even larger if it affects the savings rate as well.

Ironically, the impact of the estate tax on saving and capital formation negates much of the redistributive effect of the tax. According to an article by Joseph Stiglitz, former chairman of the Council of Economic Advisers under President Clinton, to the extent that the estate tax lowers the capital stock it raises the return to the remaining capital. Since the rich already own most of the existing capital, the estate tax may actually make the rich richer.

Other Burdens for the Economy. Finally, the estate tax imposes large dead-weight costs on the economy. First is the cost of employing large numbers of Internal Revenue Service agents to collect estate and gift taxes. Second is the cost of employing legions of tax lawyers to avoid the tax. Aaron and Munnell report that some 16,000 members of the American Bar Association cite trust, probate and estate law as their specialty. They conclude that compliance costs alone may eat up a sizable fraction of all estate tax revenues.

Conclusion. The estate tax is a bad tax. It raises little revenue. It does not redistribute wealth. It imposes large costs on the economy. It is complicated and unfair. In recent years both Canada and Australia have abolished the estate tax. The United States should do the same.

This Brief Analysis was prepared by NCPA Senior Fellow Bruce Bartlett.