Revised February 4, 2003

STATES CAN RETAIN THEIR ESTATE TAXES EVEN AS
THE FEDERAL ESTATE TAX IS PHASED OUT
By Elizabeth C. McNichol, Iris J. Lav and Joseph Llobrera

Summary

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A major feature of the federal tax cut package adopted in June 2001 is the phasing down and eventual elimination of the federal estate tax.  Under this law, the estate tax will be gradually reduced over the next decade until it is eliminated in calendar year 2010.  Once fully in effect, the repeal of the estate tax is projected to cost the federal government about $50 billion per year.

State governments also receive revenue through the federal estate tax.  Under the longstanding provisions of the federal estate tax, taxpayers receive a dollar-for-dollar credit against their federal estate tax liability for state estate and inheritance tax payments, up to a specified amount.  The maximum amount of the credit varies by the size of the estate.  Although the full repeal of the federal estate tax is not effective until 2010, this credit for state estate taxes is being reduced by 25 percent each year starting in 2002 and will be eliminated completely by 2005.

Currently, every state has a tax on estates equal to at least the value of the credit that can be taken against federal liability.  In most states, the estate and inheritance taxes are designed in such a way that states will face either a full or partial loss of revenues as the federal estate tax is phased out.

The potential revenue loss to states is substantial.  Under the law prior to the federal tax cut, states would have received approximately $6 billion as a result of the federal credit in Fiscal Year 2003.

At the time the federal tax cut package was passed, nearly all states stood to lose some or all of these revenues because the federal change effectively repealed most state estate taxes.  This revenue loss comes at the worst possible time for state budgets.  States are already facing fiscal distress deeper than in the early 1990s as a result of the economic recession.  An additional revenue loss on top of the revenue declines resulting from economic forces will only worsen their problems.

States can take and many have taken actions to reduce or eliminate this revenue loss.  States can retain their portion of the estate tax despite the federal phase-out by "decoupling" their state estate tax from the federal provisions.  This requires changing state law so the elimination of the state estate tax credit in federal law does not automatically eliminate or reduce the amount of estate tax due to the state.

As of January 2003, 17 states plus the District of Columbia are decoupled from the federal changes.  The estate tax laws in six states plus DC are written in such a way that the federal change does not affect them.  In addition, Kansas, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, North Carolina, Rhode Island, Vermont and Wisconsin already have acted to decouple their state estate taxes from the federal change.

Decoupling could prevent state revenue losses over the five years from state fiscal years 2003 through 2007 totaling between approximately $19 billion and $23 billion, depending on the way in which decoupling is accomplished.  Of these amounts, about one-third has been saved in states that have already decoupled.  This leaves approximately $12.7 billion to $15.4 billion in state revenue losses that could be avoided.   Examples of revenue losses in specific states include: $68 to $81 million in Louisiana, $1.2 to $1.5 billion in Illinois, and $473 to $565 million in Michigan.

The elimination or sharp reduction of state estate taxes would benefit the wealthiest taxpayers in the state.  The federal estate tax in which the states share through the state estate tax credit is paid solely by the wealthiest two percent of people who die each year.  Some 91 percent of all federal estate taxes are paid by the estates of people whose annual incomes exceed $190,000, and less than one percent of the taxes are paid by the lowest-income 80 percent of the population, those with incomes below $100,000.  Thus states that lose their estate taxes as a result of the phase-out of the state estate tax credit will lose the most progressive element of their tax systems, and their tax systems overall will become more regressive.

This paper discusses the ways that state estate taxes are tied to the federal tax, options states can consider to retain their estate tax, and estimates of the amount of revenue they would retain by pursuing these options.

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