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Thursday, December 16, 2010

The Immoral Estate Tax

“We have to realize that this country in its private sector has been fighting the most successful war on poverty the world has ever seen for the last two hundred years." — President Ronald Reagan

Today is the 237th anniversary of the Boston Tea Party. On the night of December 16, 1773 (yes Sarah Palin was correct it was 1773, not 1776 as some pinheaded elites in the liberal press claimed) a group of Massachusetts colonists disguised as Mohawk Indians board three British tea ships and dump 342 chests of tea into Boston Harbor.

The midnight raid, popularly known as the "Boston Tea Party," was in protest of the British Parliament's Tea Act of 1773, a bill designed to save the faltering East India Company by greatly lowering its tea tax and granting it a virtual monopoly on the American tea trade. The low tax allowed the East India Company to undercut even tea smuggled into America by Dutch traders, and many colonists viewed the act as another example of taxation tyranny.

When three tea ships, the Dartmouth, the Eleanor, and the Beaver, arrived in Boston Harbor, the colonists demanded that the tea be returned to England. After Massachusetts Governor Thomas Hutchinson refused, Patriot leader Samuel Adams organized the "tea party" with about 60 members of the Sons of Liberty, his underground resistance group. The British tea dumped in Boston Harbor on the night of December 16 was valued at some $18,000.

Parliament, outraged by the blatant destruction of British property, enacted the Coercive Acts, also known as the Intolerable Acts, in 1774. The Coercive Acts closed Boston to merchant shipping, established formal British military rule in Massachusetts, made British officials immune to criminal prosecution in America, and required colonists to quarter British troops. The colonists subsequently called the first Continental Congress to consider a united American resistance to the British. From this action our revolution for independence from the British Crown began. It is also the driving force behind today’s “Tea Party.”

Today Congress is embroiled over the extension of the “Bush Tax Rates” for another two years. One of the main sticking points is the extension of the current estate tax (otherwise known as the death tax). At the insistence of Republicans, the plan includes an estate tax that would allow the first $10 million of a couple's estate to pass to heirs without taxation. The balance would be subject to a 35 percent tax rate.

Fox News reports; “Many House Democrats want to impose a higher estate tax, bringing back the levels in place in 2009. They persuaded House Speaker Nancy Pelosi (D-CA) to allow a vote on the change, arguing that the higher estate tax would affect only 6,600 of the wealthiest estates, and would save $23 billion. In 2009, individuals could pass $3.5 million to their heirs, tax-free. Couples could pass $7 million, with a little tax planning, and the balance was taxed at a top rate of 45 percent.”

“The estate tax was allowed to expire altogether for 2010. But under current law, it would come back in 2011 at even higher levels, with a top tax rate of 55 percent and an exclusion rate of $1 million. Democrats said their plan to reinstate the 2009 tax is still more generous than current law; many Republicans said the estate tax should be done away with altogether.”

Until recently, estate taxes were the almost exclusive headache of the super rich, their tax attorneys, and their estate planners. But a strong economy, an ever-widening distribution of wealth--both good things--coupled with tax policy that has failed to keep up with economic growth have extended the reach of estate taxes well into middle-class America.

Estate taxes are not a new phenomenon; they date back almost three thousand years. As early as 700 B.C., there appears to have been a 10 percent tax on the transfer of property at death in Egypt.1 In the first century A.D., Augustus Caesar imposed a tax on successions and legacies to all but close relatives.

Transfer taxes during the Middle Ages grew out of the fact that the sovereign or the state owned all assets. Although the king owned all real property in feudal England, he would grant its use to certain individuals during their lifetimes. When they died, the king would let the estate retain the property upon payment of an estate tax.

In the United States, the tradition of taxing assets at death began with the Stamp Act of 1797. While the first Stamp Act on tea helped precipitate the Revolutionary War, the second was far less dramatic. Revenues from requiring a federal stamp on wills in probate were used to pay off debts incurred during the undeclared naval war with France in 1794. Congress repealed the Stamp Act in 1802.

That set a pattern for the next hundred years or so in which estate taxes were used as a sporadic, and temporary, way to finance wars. When hostilities ceased, the tax was repealed.

To help finance the Civil War, the Tax Act of 1862 imposed a federal inheritance tax. As costs mounted, the Congress increased the inheritance tax rates and added a succession tax in 1864. When the need for added revenue subsided after the war, the inheritance tax was repealed in 1870.

In 1874, a taxpayer challenged the legality of the Civil War estate taxes, arguing they were direct taxes that, under the Constitution, must be apportioned among the states according to the census. The Supreme Court disagreed saying that direct taxes pertained to capitation taxes and taxes on land, houses, and other permanent real estate.

In the early 20th century, worldwide conflict cut into trade tariffs--a mainstay of federal revenues--and Congress turned to another revenue source. The Revenue Act of 1916, which introduced the modern-day income tax, also contained an estate tax with many features of today's system. After an exemption of $50,000 (over $11 million in terms of today's wealth), tax rates started at 1 percent and climbed to 10 percent on estates over $5 million (over $1 billion in terms of today's wealth). Estate taxes were increased in 1917 as the U.S. entered World War I.

However, this time the estate tax did not go away after the war ended. Despite sizable budget surpluses, Congress increased rates and introduced a gift tax in 1924. Like the estate tax, the gift tax is a levy on the transfer of property from one person to another. During the 1920s through the 1940s, estate taxes were used as another way to attempt to redistribute income. Tax rates of up to 77 percent on the largest estates were supposed to prevent wealth becoming increasingly concentrated in the hands of a few.

While the Internal Revenue Code of 1954 overhauled the federal income tax, it made a seemingly minor structural change to estate taxation. Specifically, it expanded the tax base to include most life insurance proceeds, which could substantially raise an estate's tax bill.

During the late 1960s and early 1970s loophole closing preoccupied tax reformers. These efforts culminated in a 1976 tax bill that overhauled estate taxation, giving us the system we still have today. Perhaps the biggest change was combining the previously separate exemptions for estate and gift taxes and transforming them into a single, unified estate and gift tax credit.

The 1981 tax bill brought some relief. The top rate went from 70 percent to 50 percent, and an increase in the unified credit took a lot of smaller estates--those under $600,000--off the tax rolls. But, after that, the search for revenue to close budget deficits led to more than a decade of bills that largely increased estate taxes.

In 1997, Congress provided some relief with the first increase in the unified credit since 1987. Gradual increases, which began in 1999, are slated to raise the unified credit to $1 million by 2006.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (Bush tax cuts) was the first step toward totally eliminating the death tax. It provided for a scheduled phase-out of rates and an increase in the unified credit, finally repealing the tax for calendar year 2010. Unfortunately, the provisions sunset in 2011 and the estate tax will revert back to the 1997 law with a top rate of 55 percent and a unified credit of $1 million.

According to the Heritage Foundation; “the estate tax has a large dead-weight loss. Because the estate tax falls on assets, it reduces incentives to save and invest and, therefore, hampers growth. Along with income taxes, the estate tax help raise the tax rate on income from assets relative to income from working. This unequal treatment of income leads to an inefficient mix of capital and labor.”

“The size of the dead-weight loss depends on how much of a nation's assets are subject to the tax and the amount of distortion. The estate tax exemption determines the proportion of wealth covered and the rate structure determines the degree of the distortion.”

“A rough measure of the distortion is the ratio of marginal to average rates for those paying the tax. The average rate is a proxy for the amount of revenue raised, while the marginal rate is a proxy for the overall price distortion. Under a uniform tax, the ratio would be one and the amount of distortion would be minimized. The greater the difference between the marginal and average tax rates, however, the greater the distortion and, therefore, the larger the dead-weight loss.”

“Currently, the marginal estate tax rate is nearly three times higher than the average. Even though the estate tax rate structure is progressive, the high ratio is due mostly to the unified credit. In 1916, the statutory exemption was $50,000. Adjusting the exemption for the growth in wealth between 1916 and 2003 indicates that estates under $11 million (in today's wealth) would not be taxed. In 1931, the exemption was worth even more--$14.1 million (in today's wealth). However, since then the real value of the exemption has fallen dramatically.” The low of about $356,000 was reached in 1976.

Tax bills in 1981 and 1997 provided modest increases in the exemption. However, the exemption of $675,000 in 2001 is still a far cry from its $11 million counterpart in 1916. This failure of the estate tax exemption to keep up with rising wealth is the main reason increasing numbers of average Americans face the prospect of having their heirs presented with an estate tax bill. A middle class family that owns a home and has IRAs, 401ks, or other retirement accounts could easily have assets exceeding $675,000 today or even $1 million five years from now. Remember, it’s not how much you paid for your home it’s the current appraised value at time of death.

While the eroding exemption has greatly expanded the estate tax base, both the lowest and highest tax rates also have gone up significantly since 1916. As a result, more of a taxable estate is taxed at the highest marginal rate. In 1916, only estates over $1 billion (in today's wealth) would have been taxed at the top rate of 10 percent. Contrast that with the top rate of 55 percent on estates of $3 million in place in 2001 (and possibly again in 2013).

The estate tax is particularly harmful to families that own businesses or farms. Even though the amount of the tax is based on asset value, the simple fact is that the tax must be paid out of income!

Let us look at two small business examples. Take a family-run store yielding a 10 percent return each year. Taxes reduce the return to 5 percent. If the owner dies and his estate is subject to the 55 percent estate tax rate, how do the heirs pay the bill? They could send 55 percent of the store's inventory or other physical assets to Washington, except Treasury does not accept payment-in-kind, only cash. Devoting the entire 5 percent annual return, the heirs could pay off the estate tax in only 11 years, except Treasury wants the money now. The heirs could borrow from the bank at 9 percent (4.5 percent after tax) and pay off the loan in 50 years, but rather than run the store for 50 years for free, they probably would sell.

This example is not as outlandish as one might think. Consider the small farmer who owns land near an urban area. His farm would yield a 10 percent return only when it is valued as farmland. But tax law requires that the asset be valued at its "best use," lowering the pre-tax return to 5 percent (2.5% after tax). In this case, even the 50-year bank loan will not save the farm.

The lesson to be learned here is that all taxes are paid out of income. Even if the estate tax is a "rare" event, only one chance in a lifetime, its average impact is very large — large enough that for some the combined effects of income and estate taxes approach 100 percent. The prospect is that as much as 55 percent of the principal of any investment will be taken in estate taxes on top of income taxes. In cases like these, the clear message is "don't invest, consume."

The Congress has tried to address the hardship circumstances for farmers and small business in general. But the remedy effectively has the government standing in for the bank. The final result is the same — heirs are left with a choice of owning a nonperforming asset for a number of years or simply selling. What is more, the IRS has taken these half measures as an excuse to raise appraised estate values, thereby reducing the tax relief.

The investment decision becomes even more complicated if there are ways to organize holdings to pass the income stream to heirs. Tax planning can significantly mitigate the effect of the estate tax. Because amounts involved tend to be large, estate planning richly rewards taxpayers who can anticipate that they might be subject to the tax. Those that do not plan or cannot anticipate are caught and pay the tax. This is simply unfair.

That is one reason why the largest estates do not pay the highest tax rates. Who does? Typically they are owners of small businesses, family farms, and savers who amass wealth during their lifetimes through hard work and thrift. Because wealth is often unexpected, these people may not be aware of, or take full advantage of, ways to reduce estate taxes. As a result, those who come late, or not at all, to estate planning end up paying most of the tax.

The estate tax is one of the most inefficient features of the current tax system. Its sheer complexity results in high compliance costs--as much as estate taxes raise by some estimates. High compliance costs along with distortions to economic activity warrant outright elimination of estate taxes before the sunset occurs.6

Failing repeal after 2010, the exemption should be raised significantly. Increasing the exemption to the range of $5 million to $10 million would restore eroded value and reduce the proportion of wealth subject to tax to be more in line with the 1920s and 1930s.

This would only partially address the impact of the tax, however. Under the unified credit structure, raising the exempt amount above $3 million would make the lowest marginal rate 55 percent, meaning the tax would be even less efficient than current law. While the amount of wealth subject to tax would be reduced, the rate structure would be harsher, increasing the ratio of marginal to average rates. The way to avoid this result is to convert the exemption from a credit to a deduction.

Another desirable change would be to expand the rate brackets and lower rates. As we have seen the current rate brackets have become compressed when compared to prior law. Expanding the brackets would reduce the marginal rate relative to the average and produce a more efficient system. Similarly, reducing estate tax rates would also help to improve the system. The best solution, however, would be to eliminate the estate and gift tax altogether before the sunset.

The estate tax is not only inefficient, it is immoral. The money that will be subjected to the estate tax has already been earned and taxed. It is not new found money. People have worked hard and invested wisely to accumulate estates that they want to pass on to their heirs. I can understand paying capital gains taxes on increases in investments or lands, but only when they are sold. The gain can be taxed, but not the total value of the asset as he estate tax does. This is not a tax for the “rich” — it is a tax for the middle class and working folks.

As illustrated above if a working family buys a home in the suburbs, as many Americans do, and home increased in appraised value over the years the estate tax will be based on the appraised value of the home at the time the owner dies. This is especially troubling at times of housing booms. Say a working family buys a home for $250,000 and twenty years later, after the mortgage has been paid in full, the home is now worth $800,000 on the housing market. This happened in Orange County, California during the housing boom of the late 1990s. This $550,000 is not cash, it’s merely an appraised value based on the current market. Combine this with other assets such as an IRA, an automobile, furnishing and a life insurance policy it is easy to have an estate in excess of $1 million dollars. If the home owner wants to leave the home to a surviving heir who wants to live in the home he or she will have to come with a sizable amount of cash to continue to live there. Otherwise they will be forced to sell the home and assets to pay the government for something their parents worked for their entire life.

It’s easy to see why the recipient class wants to impose an estate tax. It’s just another example of class warfare where those who have not been able to rise out of poverty want to take from those who have. What should we care what wealth our neighbor is able amass during his lifetime. He had the freedom to make choices, as we did. If he chose a different path than us and was able to gain wealth to pass on to his or her heirs so much the better. We should remember the 10th Commandment and covet thee neighbor’s goods. The estate tax should be abolished altogether.

Portions of this post were compiled using information from a report from the Heritage Foundation. You can read the full report along with accompanying graphs by clicking here.

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