Testimony of
Howard Segermark
Vice President and Economic Counsel
The American Family Business Institute
1920 L Street, N. W.
Washington, D. C. 20036

Before the
Senate Committee on Finance on
Federal Estate Tax: Uncertainty in Planning Under the Current Law
November 14, 2007

Observations on the Economics of the Death Tax

Mr. Chairman, members of the Committee. I formerly served on the staffs of two members of the Senate, and during my tenure, I had responsibilities for advising them on tax legislation. Subsequent to my work for those Senators, I worked as Vice President of the economic consulting firm of A. B. Laffer Associates. Since then, I have continued to work in the areas of public policy and particularly, of tax and economic policy. I am currently with the American Family Business Institute, a trade association of family-owned enterprises.

In my discussion of the need to repeal the death tax, I will touch upon three key factors:

• The real economic impact on small businesses
• The real impact on employment and the economy as a whole and on federal revenues
• Why the debate is skewed against repeal

The real economic impact on small businesses

In study after study, economists show that the death tax – a direct tax on capital – deprives the American economy of massive amounts of capital not simply because it confiscates capital, but because of the incentives the death tax gives to the destruction of capital and the misallocation of capital to less or non-productive areas.

The irony of a billionaire supporting the death tax, is that the super-rich are not affected in the same way or the same magnitude that the death tax affects small and medium-sized businesses. Compare the super-rich with a businessman or farmer who has focused on building an enterprise. The cost of reducing the liability of the death tax is marginally higher and may be prohibitive.

One choice faced by those who may be subject to the death tax is to have a lawyer/estate planner calculate likely liability. Perhaps an option is to spend a lot on life insurance to cover the likely IRS levy. That would, of course, take money out of the business that would otherwise be used for reinvestment and growth. If the actuarial tables say that the odds of living a long time are not good, the cost of the insurance may be prohibitive and an entrepreneur might have to liquidate some or all of the business in preparation of the inevitable. That means a smaller business, fewer employees.

Or, perhaps the entrepreneur chooses to set up trusts, foundations, and other death tax avoidance programs. The same results: a smaller business, fewer jobs.

It is important to understand that while some American entrepreneurs do not take action to prepare for the death tax, the successful woman or man is not naïve. Just as people make out wills, she or he may have made an estate plan that cost real money but also reduces the size of a successful business in order to reduce death tax liability. In fact, simple logic shows that the vast majority of successful people do plan, which not only reduces their liability, but the absolute numbers of filings. In other words, when death tax advocates point out that few estates are affected by death tax, they ignore the vast resources that were devoted to cutting liability, the jobs destroyed and the dislocations caused. Indeed, one can affect one’s liability under the death tax, but with significant, real effects to the economy. As former Chairman of the Council of Economic Advisors Martin Feldstein, has said, the death tax is “the optional tax.”

When planning for the death tax, estate planners advise against selling appreciated assets because by passing on those assets, the surviving spouse gets a one-time step-up-in-basis. Another aspect is the fact that money consumed is not taxed away. In other words by lowering the value of an estate by consuming it you’re lowering the death tax liability. Faced with either spending on a lavish vacation or seeing half of that money go to the tax collector, what choice will many people will make? What it means is that the death tax is a great incentive for spending now. Numerous other mechanisms are used – not because they make economic sense, but because the incentives posed by the death tax encourage them.

The cost of these avoidance maneuvers: hundreds of thousands of jobs per year. The Heritage Foundation estimates 250,000 new jobs per year are lost because of the death tax, and concomitantly there is the loss of economic growth and the creation of additional capital.

One of the economic distorting effects of the death tax is the fact that restructuring a $20 million fortune doesn’t cost twice as much as a $10 million fortune. Thus, the super-rich spend a smaller percentage of their estates on planning. What that means is that the farmer or businessman who has a built a moderately successful enterprise valued over the exemption level is hurt by the death tax more than the very successful. He or she has to pay relatively much more to the lawyers and accountants to preserve the results of their sweat and ingenuity.

In sum, it is disingenuous to say that the death tax affects only a small number of people. It affects not only the hundreds of thousands who prepare for it; it affects the hundreds of thousands of men and women who don’t have jobs that would otherwise have been created. Because America is poorer because of the death tax, it affects us all.

The real impact on employment and the economy as a whole

The Heritage Foundation estimate of annual lost job creation (250,000) is cited above, but what also must be looked at is the overall level of wages in the economy. The American Council on Capital Formation estimates that our economy is roughly $1 trillion short of capital that would be in our economy were it not for the death tax.

That directly translates to lower wage levels. If political proponents of the death tax contend it has no adverse affects, they must address the universal understanding that less capital translates into lower wages. The study of Andrew Atkeson, V. V. Chari, and Patrick J. Kehoe, “Taxing Capitol Income: A Bad Idea” (Federal Reserve Bank of Minneapolis Quarterly Review Vol 23, No. 3) is only one of many examples.

Noted economist Steven Entin, President of the Institute for Research on the Economics of Taxation (IRET) estimates that the death tax reduces overall economic output by 1.1% per year. In our economy, that translates to $120 billion of foregone income. If our economy was richer by that sum, it is a fact that given the federal tax code (not counting the death tax), that federal income tax revenues would increase by approximately $35 billion: a sum far in excess of the revenues of the federal estate and gift taxes.

University of California Berkeley professor Douglas Bernheim, estimates that the death tax provides incentives of those that may be subject to the death tax to make gifts to potential heirs in a lower income tax bracket, thus lowering the tax liability of the income associated with those gifts. His estimate is that this reduces federal revenues by a sum in excess of the revenues from the death tax.

In a similar vein, in a 1999 study, economists Drs. Aldona and Gary Robbins show that the effects of the death tax destroy economic activity to such an extent that were that activity going on, it would generate tax revenues in excess of the revenues of the death tax.

Entin makes the point in his paper, “Kill the Death Tax” [url from the IRET site], that even if the above estimates are only half correct, that repeal would pay for itself overnight. If they are both right, repeal would increase federal revenues by $25 or so billion per year.

An August, 2007 study by the Chicago Federal Reserve Bank authored by Marco Cagetti and Mariacristina De Nardi estimates that the death tax results in a reduction of 1.3 % of GDP per year. In other words, repeal would generate added GDP, resulting in added tax liabilities and thus added federal revenues well in excess of any lost death tax revenues. (It should be noted that the variance between the Entin estimates and Cagetti/De Nardi estimates may be attributable to different definitions of output.)

The logical conclusion is that there is no economic rationale for the death tax. The remaining argument for the death tax is that even if it makes every American poorer, and it makes the federal government less rich, that it would somehow be socially “just” to penalize the successful creators of wealth and jobs even if the burden falls most harmfully on the job-holder.

Why the debate is skewed against repeal

Contemporary academic economic analysis seems to be banned on Capitol Hill – the major bill to repeal the death tax is estimated to result in reduced (not increased) revenues of $490 billion over ten years. The reason is that the estimators have a political agenda and choose to ignore the predominant economic literature as well as common sense.

The tragedy is that Congressional leaders agree to abide by this lie.

Thus, proponents of the death tax argue that repeal would “hurt the poor” or deprive any other group favored by federal programs.

And one of the defenders of the status quo is the lobbying group in Washington promoting life insurance companies, many of which sell policies that help pay the death tax for those subject to it. The head of the Life Insurance Council is a former Republican governor who when in office opposed the death tax. He is reportedly paid $1.6 million per year and has hired the wife of a Senator who is an avid supporter of the death tax. Her salary is reported to exceed $600,000.

Regardless of these ethical questions, the simple fact is that the life insurance industry lobbies for the death tax – against the interests of its customers. Why? Because of the premiums they get from those policies. One estimate in the year 2004 was $12 billion. Today, that would be in excess of $15 billion.

In other words, the life-insurance industry spends millions to keep a tax that hurts its customers and the economy.

Other supporters of keeping and/or raising the death tax are the more predictable advocacy groups of the left who are motivated by nineteenth century egalitarian ideologies. Other death tax fans are partisans of the late American philosopher, John Rawls, who posited a “fair” society. His views might charitably be regarded as lacking any relation to reality. (See Richard John Neuhaus’ essay, in First Things magazine, “John Rawls and the Liberal Faith,” for a discussion of Rawls’ fallacies.) Like other utopians, his followers seem to ignore the real effects of incentives on the creation of wealth and a prosperous society.

Conclusion

Public Choice Theory tells us that politicians will tend to calculate tax changes in ways that will prejudice the outcome to favor more taxes. This school of looking at government also tells us that elected leaders can’t ignore the will of the voters forever – the 67% of whom support full death tax repeal. The electorate and the weight of sound economics will eventually overcome.

There will continue to be “rent-seeking” industries that lobby to keep the death tax as long as they make money off of it. This includes not only the life insurance industry, but the estate planning businesses and “vulture capitalists” that seek to buy companies that must be sold at fire-sale prices to pay the death tax. But fortunately, their self-interest against the interests of the nation is becoming more and more apparent.

What is clear is that Americans at large understand the immorality of the death tax and see the clear logic of its repeal.

I urge the Committee to recognize these truths and adopt legislation which would repeal the federal estate tax – the death tax.