April 21, 1997
Estate Tax Cuts Would
Benefit Wealthiest Americans;
Targeted Family Businesses and Farms Changes Could Help
by Iris J. Lav
Advocates of proposals to repeal or sharply scale back the estate tax often cite the problems families encounter when they inherit small businesses and farms but lack sufficient liquid assets to pay the tax. To the extent these problems exist, they account for an extremely small portion of all estates subject to estate taxes. The problems of small, family-owned businesses and farms can be addressed at a modest cost to the Treasury.
By contrast, the estate tax provisions in the Senate Republican Leadership tax plan would reduce the estate tax for large estates and for large family-owned business. The proposals go well beyond the measures needed to preserve small family businesses and farms. The revenue loss would also be large, rising to $12 billion a year by 2007.
Estate taxes play an important role in the U.S. tax system. Because they are paid only on estates left by the less-than-two percent of decedents with the greatest wealth, these taxes add progressivity to federal and state tax systems. In addition, the estate tax compensates in part for a major gap in the taxation of capital gains income. The gain in the value of assets held until death is not subject to the capital gains tax; the only way such gains are subject to tax at all is through the estate tax. If estate taxes are reduced in large-scale ways that extend beyond providing targeted relief to small family-owned businesses and farms, that would provide a windfall to the wealthiest taxpayers in the country.
A particularly stark contrast is drawn by including a costly estate tax reduction that benefits large estates in an agreement to reduce the deficit and balance the budget. The cost of the estate tax reduction would have to be paid for by increasing the amount by which the budget is cut. Thus a large estate tax cut benefiting the wealthiest Americans is likely to be paid for through sharp reductions in programs that benefit low- and middle-income households who will never amass estates large enough to be subject to taxation.
Most Estate Taxes Are Paid by Large Estates
Most estate taxes are paid by large estates rather than by small family-owned farms and businesses.
Because the first $600,000 of an estate is exempt from taxation under current law, and an unlimited amount of property can be transferred to a spouse free of tax, fewer than two percent of all deaths result in estate tax liability. The Joint Committee on Taxation estimates that only 1.66 percent of all decedents in 1997 will have estates large enough to require payment of some estate tax.
Of those estates that are taxable, it is the largest estates that pay most of the estate tax. A recent analysis by IRS of the 32,000 taxable estates filing in 1995 showed that the 16 percent of estates with gross value exceeding $2.5 million paid nearly 70 percent of total estate taxes.
Farms and small, family-owned businesses make up a small proportion of all taxable estates. All farm property, regardless of size, accounted for less than one-half of one percent of all assets included in taxable estates. Family-owned business assets such as closely-held stocks, limited partnerships, and non-corporate businesses, accounted for less than four percent of the value of all taxable estates of less than $5 million.
Smaller Estates Subject to Tax Generally Have Resources to Pay Obligations
A study of 1991 estate tax returns cited by the Congressional Research Service found that on average smaller estates have sufficient liquid assets to pay estate taxes. The study found that the 94 percent of all taxable estates valued under $5 million contained liquid assets (cash and readily marketable securities) averaging two times the amount of taxes and expenses the estate had to pay.
Smaller, Family-Owned Business Already Eligible for Favorable Treatment
Family-owned businesses and farms already are eligible for special treatment under current law.
Under current law,
family-owned businesses and farms may be valued in a
special way that reflects the current use to which the
property is put, rather than its market value. This
provision generally reduces the value that is counted for
purposes of estate tax; the reduction in value can be as
much as $750,000.
To use the special valuation, the decedent or other family members must have participated in the business for a number of years before the decedent's death, and family members must continue to operate the business or farm for the ensuing 10 years. These conditions, along with the $750,000 cap on the value of property subject to the special use valuation, assure that the benefit goes to relatively smaller businesses and farms that are family owned and operated.
When the value of a family-owned business or farm accounts for at least 35 percent of an estate, current law allows deferral of taxation. The tax payable on such an estate may be deferred for up to 14 years, including deferral of annual interest payments for four years, followed by up to 10 annual installments of principal and interest.
A below-market interest rate of four percent applies to the deferred tax attributable to the first $1,000,000 in value of a closely held (family) farm or business.
Modest Changes Could Target Additional Relief to Small Businesses and Farms
Additional estate tax relief could be targeted to small, family-owned businesses and farms.
The Clinton Administration budget proposes to raise from $1 million to $2.5 million the cap on the value of a closely held farm or business that is eligible for installment payments. It also would lower the interest rate charged on the deferred taxes. So instead a four percent interest rate on the taxes associated with the first $1 million of qualified farm or business value that is available under current law, the Clinton proposal would allow a two percent rate of interest on the first $2.5 million of value.
The Clinton proposal also would extend a below-market interest rate to additional amounts of deferred taxes. Under current law, estate taxes attributable to estate values in excess of $1 million may be deferred, but the IRS charges its normal interest rate on those deferred taxes. Under the Clinton proposal, deferred amounts in excess of $2.5 million would qualify for an interest rate that would be 45 percent of the usual IRS rate.
The cost of the Clinton estate tax proposal would be modest $1.1 billion over the five-year period from 1998-2002. Over 10 years from 1998-2007, the cost would be $2.6 billion.
Senate Leadership Proposal
Benefits Accrue Primarily to Very Large Estates
By contrast, the estate tax proposal included in the Senate Republican Leadership tax plan (S. 2), introduced by Senator Trent Lott and others, would be very costly and would provide substantial benefits to the largest family-owned companies in the country.
The Senate Republican Leadership plan would gradually raise the amount of an estate that is excluded from estate taxation from $600,000 to $1 million by 2004.
In addition to the $1
million exemption, the Republican plan would allow an
estate to exclude another $1.5 million in family-owned
business interests plus 50 percent of the remaining
value of the business interest. These additional
exclusions would apply when family-owned business
interests comprise more than 50 percent of an estate.
There is no limit on the size of the business interest that can qualify. As a result, estates that include multi-billion dollar family-owned business interests such as Mars candy, Cargill agribusiness, Continental Grain, or Koch Oil potentially could qualify to exclude half of the value of the businesses from the estate tax.
The estimate of S. 2 issued by the Joint Committee on Taxation, Congress' official "scorekeeper" on tax legislation, shows that the estate tax provisions included in the Senate Republican Leadership tax plan would cost $18 billion in the five years through 2002. The cost of this proposal would then mushroom to higher levels after that, because the estate tax cuts in this legislation phase in between 1997 and 2004. In the second five years after enactment the estate tax provisions in this legislation would be more than two and one-half times as costly as in the first five years they would cost $48 billion from 2003-2007. By 2007, these provisions would cost nearly $12 billion a year. This suggests their cost in subsequent 10-year periods is likely to exceed $120 billion.
Large, backloaded tax cuts are particularly problematic in a period when the nation must plan for the coming retirement of the baby boom generation. Some economists and budget experts are recommending the government run modest budget surpluses in the years before the baby boom generation retires to boost national saving and strengthen economic growth, so we ultimately will be better able to afford the large retirement costs of that generation. Proposals such as the Senate Republican Leadership estate tax plan, however, push in the other direction. Tax cuts that reach this magnitude after 2002 eventually must result in either bigger deficits or cuts in basic programs serving million of far less well-off Americans that are larger than either party currently admits favoring.
Estate Taxes Improve Progressivity; Offset Capital Gains Loophole
In the U.S. tax system, capital gains income the income from the appreciation of assets such as stocks, bonds, and real estate is not taxed until the income is "realized," that is, until the assets are sold. If an asset is held until the owner dies, the gain in the value of the asset is never subject to capital gains taxation. The heirs inherit the assets valued at the market price at the time of death and are not required to pay tax on any appreciation that took place during the lifetime of the decedent.
The federal revenue loss in fiscal year 1997 from not taxing these capital gains is variously estimated by the Treasury Department to be $31 billion and by the Joint Committee on Taxation to be $17 billion.1 The estate tax provides a way of recouping a portion of the loss of revenue that results from forgiving capital gains at death. The estate tax also provides a means to redress the loss of tax equity resulting from the fact that most of the untaxed capital income is held by the highest-income Americans.
If capital gains taxes were levied on unsold assets, it is likely that most of those taxes would be paid by high-income taxpayers. Three-quarters of the income from capital gains resulting from the sale of assets is received by taxpayers with incomes in excess of $100,000. It is reasonable to assume that capital gains held in unsold assets are distributed in a similar manner, because higher-income people hold most of the wealth in the country.
The estate tax recoups some of the progressivity lost by not taxing gains on unsold assets, because the market value of all assets held by a decedent is included in his or her estate. The types of assets that give rise to most capital gains income real estate and stock make up about half of the value of all property included in taxable estates. The estate tax provides a way to tax appreciated property at death when it is included in estates valued in excess of $600,000, while forgoing all taxation of appreciated assets when they are left by decedents of less wealth.
Opponents of the
estate tax often point to other countries, such as Canada
and Australia, that have repealed their estate taxes.
They rarely, however, point to the differences in the way
capital gains are taxed in those countries.
In Canada, the repeal of the estate tax occurred at the same time that taxation of the appreciated value of assets at death was instituted; one policy was substituted for another as an explicit trade-off. When a person dies in Canada, the decedent's assets are treated as though they were sold at that point in time and taxes on the gain in value of those assets must be paid.
Australia takes a different approach than Canada, but Australia's approach also results in taxing the full amount of asset appreciation whether or not the original owner has died. Inherited assets continue to be valued at the cost the original owner paid for them, and the full amount of capital gains taxes must be paid when an inherited asset is sold.
If the United States were to follow the example of Canada or Australia, estates could have a higher, rather than lower, tax burden. As noted, estimates of the 1997 revenue loss from the failure to tax capital gains at death range from $17 billion to $31 billion, while the estate tax is expected to raise $19 billion. Fully taxing capital gains at death could result in a heavier taxation of estates than is the case under the current estate tax.
States would lose revenues at time of increased responsibilities
All states levy their own estate tax by computing a percentage of the federal estate tax liability. Under special federal rules, estates may subtract the state taxes paid, dollar for dollar, from federal estate taxes that otherwise would be due, up to a specified maximum percentage of the federal taxes. In other words, the heirs have the same amount of overall tax liability whether or not their state levies an estate tax; the state tax does not change the total amount of estate taxes collected but rather allows the state to share in a portion of the federal revenue. Every state uses this type of state estate tax, which is commonly known as the "pick-up" tax.
Because state estate taxes are levied as a specified percentage of federal estate taxes, reductions in federal estate taxes will automatically reduce state revenues. States currently collect more than $3 billion a year as a result of the pick-up tax, an amount that is projected to increase somewhat in the future as federal estate tax revenues reflect the aging of the population and the expected growth in large estates. If the estate tax provisions in S. 2 were enacted, state revenues would be reduced along with federal revenues. By 2002, the state revenue loss would exceed $1 billion; by 2007, states would lose approximately $2.4 billion.
These revenue losses are likely to come at the same time states will be required to compensate for other losses in federal revenues. Grants to state and local governments account for well over one-third of all federal non-defense discretionary spending. Non-defense discretionary spending includes substantial amounts of federal spending that supports state-administered programs for purposes such as education, health and nutrition programs, construction and maintenance of highways and mass transit systems, law enforcement, and environmental protection. But the federal budget category of non-defense discretionary spending is likely to be subject to large reductions in any agreement to balance the federal budget by 2002, and state grants are likely receive at least their proportional share of reductions in federal funding for discretionary programs. State revenue losses that result from federal tax cuts will impede the ability of states to absorb these reductions in federal funding for discretionary programs in ways that do not eliminate essential services.
1. There is very little information collected on which to base an estimate of the revenue loss resulting from exempting capital gains income from taxation when the asset is held until death. While the amount of assets included in estates large enough to file estate tax returns is known, data is not collected on the original price of those assets. Moreover, no information need be filed on assets held by decedents with estates below the $600,000 estate tax filing threshold. The lack of underlying data may account for the wide variation in estimates of revenue loss.