Bruce Bartlett
National Center for Policy Analysis
August 18, 1999

"A number of countries have already abolished the estate tax." According to the Federal Reserve, household wealth in the United States has doubled in the last 10 years, from $21.5 trillion in 1988 to $43.2 trillion last year. Since the population has only risen by about 10 percent over this period, wealth per capita has increased enormously. To be sure, much of this increase accrued to those who were already rich. But the assets of the nonwealthy have also grown, especially if one includes assets held in 401(k) plans. Even those with modest incomes can now expect to have $1 million or more at retirement if they save early and invest aggressively. That is why the estate tax will be an issue of contention for years to come.

At present, the estate tax applies to assets of $650,000 or more at death. This figure is scheduled to rise to $1 million in 2006, a rate of increase that barely keeps up with inflation. Although the lowest estate tax rate is 18 percent, because the exemption is in the form of a tax credit, those with estates larger than $650,000 will pay 37 percent of each additional dollar to the federal government.

As Figure I shows, at 55 percent, the top estate tax rate in the U.S. is among the highest in the world. According to the American Council for Capital Formation in Washington, among major countries only Japan has a higher top rate, and it applies to estates of more than $15.3 million, whereas the top U.S. rate hits at just $3 million of assets. Even many countries with governments much more to the left than ours have estate tax rates that are signficiantly lower. Sweden has a 30 percent rate, Denmark has a rate half that, and Canada has no estate tax at all. (Canada does tax capital gains at death, which the U.S. does not, but the top capital gains rate there is still well below our top estate tax rate.)

Little wonder, then, that many baby boomers still in the prime of life are already fretting about how to avoid the estate tax. Talk show host Oprah Winfrey spoke for many when she told her audience, "I think it's so irritating that once I die, 55 percent of my money goes to the United States government....You know why that's so irritating? Because you have already paid nearly 50 percent [when the money was earned.]"

To be sure, not many people are in Miss Winfrey's tax bracket, but increasing numbers of Americans are falling into the estate tax net - a region once reserved for the truly wealthy.

The federal estate tax was first enacted in 1916 on estates larger than $50,000 (the equivalent of $720,000 today). The top rate was 10 percent. However, the revenue yield from the tax was small because people simply gave away their assets tax-free during their lifetimes. This led to establishment of a gift tax to augment the estate tax in 1924. Since 1976 the estate and gift taxes have been unified into one tax system.

The estate and gift tax is now the federal government's least significant revenue source. In fiscal year 1998 it raised just $24.6 billion, according to the Treasury Department. With total federal revenues of $1.8 trillion, the tax contributed just 1.3 percent. However, while the tax is insignificant in terms of federal revenue, it is very significant economically. It wastes resources. It discourages work, saving and investment. And it does virtually nothing to equalize the distribution of wealth. For these reasons, it should be abolished.

How the Death Tax Harms Family Businesses

Many farmers and small business owners earn relatively modest incomes even though the value of those farms and businesses make their estates subject to the estate tax. For example, Douglas Stinson, a tree farmer from Toledo, Wash., told the House Ways and Means Committee that the household income of the average tree farmer is less than $50,000, but the typical tree farm can be valued at more than $2 million.1 The result many times is that the heirs have to sell the farm or business to pay the estate tax. Stinson said 25,000 acres of prime forest land in Washington is converted to other uses each year, primarily to raise money to pay estate taxes.

The impact of the estate tax on small businesses can be devastating. According to a recent survey, 51 percent of family businesses would have significant difficulty surviving in the event of a principal owner's death, due to the estate tax. And 14 percent of business owners said it would be impossible for them to survive. Only 10 percent said the estate tax would have no effect.

This same survey found that 41 percent of business owners would have to borrow against equity to pay the estate tax and 30 percent said they would have to sell all or part of the business. Eighty-one percent of family businesses reported having taken steps to minimize the estate tax bite. These include purchasing life insurance, making lifetime gifts of stock, putting the business into trust or other arrangements.2

Recent academic research has also looked at the impact of the estate tax on small businesses. According to one study, its main effect is on business liquidity. Since most small businesses are undercapitalized to begin with, the estate tax can literally suck the life blood out of a business. Increasing the ability of entrepreneurs to leave an inheritance can greatly increase the chances of a small firm's survival.3 Other research found that the estate tax encourages small business owners to sell out or merge with large firms.4

The National Grocers Association, made up of independent grocers, said 27 percent of its family-owned members reported in a 1995 study that they would have to sell all or part of the business to pay estates taxes if the owner died.5

According to the National Federation of Independent Business: 6

Only about 30 percent of family farms and businesses survive a first-to-second generation transfer, and only about 4 percent survive a second-to-third generation transfer.

One-third of small business owners will have to sell outright or liquidate part of their firm to pay estate taxes.

The failure of 90 percent of small businesses after the death of their founder can be traced to the burden of the inheritance tax.

Why the Very Rich Pay Less

A fundamental rationale for the estate tax is that it is paid only by those who can most easily afford it; namely, the rich. However, because of legal estate planning techniques, much less of the tax actually falls on the very wealthy than is commonly believed.

In 1995, 52 percent of all estate tax revenue came from estates under $5 million.

As Figure II illustrates, estate taxes as a share of gross estates actually fall for those with estates above $20 million.

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. Thus for most married couples, the estate tax only applies to estates larger than $1.3 million. Beyond that, there are a number of increasingly complex methods for reducing the burden of the estate tax. They include:

Life insurance trusts.

Qualified personal residence trusts.

Charitable remainder trusts.

Charitable lead trusts.

Generation-skipping trusts.7

One indication of the growth of estate planning is the increase in the share of total estate and gift taxes being raised by the gift tax, as shown in Table I. By making gifts of stock or other assets during their lifetimes, any subsequent increase in their value will no longer be part of the estate.

So effective are these methods of avoiding estate taxes that Professor George Cooper of Columbia University says that the estate tax essentially is a voluntary tax. As he wrote, "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."8 Economists Henry Aaron and Alicia Munnell put it even more bluntly. In their view, estate taxes aren't even taxes at all, but "penalties imposed on those who neglect to plan ahead or who retain unskilled estate planners."9

However, as Figure II makes clear, the ability to exploit existing tax-avoidance techniques is not uniform across estates. Those with the largest estates clearly have the greatest ability to engage in estate planning. This is because many estate planning techniques are costly and require long lead-times to implement. And families with long histories of wealth are more likely to be familiar with them. Thus a disproportionate burden of the estate tax often falls on those with recently acquired, modest wealth: farmers, small businessmen and the like. In many cases their incomes may not have been very high and they died not even realizing that they were "rich."

The reason those with larger estates are more likely to engage in complex estate planning is, of course, that they pay higher marginal tax rates on their assets. However, the same general principle applies to the estate tax in general. Research shows that during periods when estate tax rates were rising, revenue from the estate tax fell. Conversely, lower estate tax rates increased estate tax revenue, because it was no longer as profitable to engage in costly estate planning.10 Estate planning is costly, not just in terms of lawyers fees and the like, but also because assets placed in trust may not earn as high a rate of return as they would under the original owner's control.11

How the Tax Lowers Other Tax Revenue

The impact of estate planning goes beyond the estate tax and affects 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 reduces one's income taxes as well. Because of such interactions between the estate tax and the income tax, Professor B. Douglas Bernheim of Stanford University believes that lost income tax revenue may offset all of the revenue from the estate tax.12

While expressing some skepticism about the magnitude of the effect Bernheim identifies, Professor Edward McCaffery of the University of Southern California believes that the impact of the estate tax may be even larger for other reasons. In particular, McCaffery believes that the impact of the estate tax on economic growth may be significant, by reducing the incentive to work, save and invest. For example, he points out that if one's prime motivation is to leave a large estate to one's children, then the effective marginal tax rate on investment and labor 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 55 percent estate tax rate on the remainder), with state income taxes pushing it higher still. And McCaffery goes on to point out that these negative effects on saving and work effort are not limited to the very rich. Insofar as the estate tax encourages gifts to one's children during one's lifetime, it may have the effect of reducing their work and saving as well.13

Recent research indicates that the estate tax has a much greater impact on the behavior of the living than previously thought. Parents often use the promise of a bequest to influence the behavior of their children. They also may use bequests to equalize the financial well-being of their children.14 Thus the desire to leave a large estate is one of the primary motivations for working and saving later in life. To the extent that the estate tax reduces a parent's ability to leave an estate to his children, it will have a negative effect on his interest in accumulating wealth through work, saving and investing.15

The Effect of the Tax on Capital

With intergenerational transfers accounting for as much as 80 percent of the nation's capital stock, according to a study by Laurence Kotlikoff and Lawrence Summers, this means that the estate tax is a direct tax on capital.16 Since the capital stock is the nation's wealth, it is reasonable to say that the nation's capital stock is automatically reduced by at least the amount of the tax. The effect on capital stock is even larger if it reduces the savings rate as well.17

Of course, anything that reduces capital formation in the economy ultimately makes everyone poorer. That is why economists historically have warned against estate taxes.

Adam Smith: "All taxes upon the transference of property of every kind, so far as they diminish the capital value of that property, tend to diminish the funds destined for the maintenance of productive labor."18

David Ricardo: "It should be the policy of governments...never to lay such taxes as will inevitably fall on capital; since by so doing, they impair the funds for the maintenance of labor, and thereby diminish the future production of the country."19

C.F. Bastable: "Succession duties first of all possess the grave economic fault of tending to fall on capital or accumulated wealth rather than on income; they therefore may retard progress."20

By contrast, those wishing to destroy the capitalist system have always been enthusiastic supporters of heavy estate taxes. It is worth remembering that the third plank of The Communist Manifesto says that the right of inheritance should be abolished.21 Even today, there are those who believe it is immoral to allow people to inherit anything.22

Ironically, the negative 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 effect of the estate tax is to actually make them richer.23

Indeed, existing high estate tax rates appear to do virtually nothing to equalize the distribution of wealth.24 Recent studies, in fact, have argued that wealth has never been more unequal than it is today.25 One reason why estate taxes have less impact on wealth distribution than people imagine is that inheritances constitute less of the wealthy's assets than is usually thought. As Figure III shows, for those in the top 5 percent of the wealth distribution, inheritances make up only 7.5 percent of their wealth. Indeed, even among the super-rich, inheritance counts for less than commonly believed. According to one study, of the 265 separate fortunes represented by the Forbes 400, 157 or 59 percent were new wealth. Only 108 or 41 percent were inherited.26 Another study concluded that 75 percent to 85 percent of the rich throughout American history were self-made.27

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 primary area of concentration. They conclude that compliance costs alone may eat up a sizable fraction of all estate tax revenues.28 On the other hand, one commentator has suggested that the government may get more revenue from taxing the incomes of estate tax planners than from the estate tax itself!29

Conclusion

As part of the Financial Freedom Act of 1999, Congress has approved phasing out the death tax by 2010. However, President Clinton has vowed to veto the bill, which would leave the current death tax provisions in effect. If the president carries through on his threat, this will leave the United States with the second highest tax rate on estates of any nation.

But more significant than the tax rate is the effect of the tax itself. It has almost no virtues. It raises little if any net revenue for the government, it has little effect on the estates of the very rich and its burden falls most heavily on family farms and businesses. To pay the estate tax, heirs often sell for development land that might have otherwise remained farmland or forest.

There is no good reason to retain the death tax, and many reasons it should be eliminated now. One unfortunate feature of the bill passed by Congress is that the tax will not be eliminated completely until 2010.

Bruce R. Bartlett
Senior Fellow

NOTE: Nothing written here should be construed as necessarily reflecting the views of the National Center for Policy Analysis or as an attempt to aid or hinder the passage of any bill before Congress.