Revised June
23, 2006
ESTATE TAX “COMPROMISE” PROPOSALS MAY ENDANGER
STATE ESTATE AND INHERITANCE TAXES
By Elizabeth C. McNichol
On June 22, the House of Representatives approved
an estate tax proposal introduced by House Ways and Means Chairman Bill Thomas.
While supporters of the proposal describe it as a “compromise,” it would in fact
eliminate the vast bulk of estate tax revenue and has been more aptly
characterized as “near repeal.” The Senate is now expected to vote on this
measure before it adjourns for the July 4 recess. (This follows the Senate’s
rejection on June 8 of a motion to consider legislation that would repeal the
estate tax permanently.)
Estimates by the Joint Committee on Taxation
indicate that the Thomas proposal would cost at least three-quarters as much as
full repeal over the long term. It could add more than $750 billion to deficits
over the first ten years that its budgetary effects would be fully felt
(2012-2021), when the costs of the added interest payments on the national debt
are included.[1]
Similarly expensive “compromise” proposals previously have been floated in the
Senate by, for instance, Senator Jon Kyl.
The Thomas and Kyl proposals both include a
provision intended to make them a little bit less costly without preserving any
more of the estate tax — and at the expense of state budgets. This provision
would repeal the existing federal tax deduction for state estate and inheritance
taxes that estate or heirs pay. Currently, as a result of this deduction,
federal estate tax liability is based on the value of an estate after state
estate or inheritance taxes have been subtracted.
The repeal of the deduction for state estate and
inheritance taxes could pose a substantial problem for the 24 states that levy
estate or inheritance taxes.[2]
State estate and inheritance taxes are an important revenue source for these
states, bringing in a total of approximately $4.5 billion per year. Most of
these dollars are deposited in state general funds, which principally pay for
education, health care, and public safety.
Without the federal deduction, however, a number
of these state estate and inheritance taxes — which already are under fire in a
number of states — may have difficulty surviving, since repeal of the deduction
would increase the burden of state taxes. It also would lead to charges of
unfair double taxation, because the federal estate tax would be leveled on the
portion of estates that had already been taxed away at the state level.
State income, sales, and property taxes are
deductible for federal tax purposes, but state estate taxes would be treated
differently, with deductibility denied. Table 1 shows the estimated estate or
inheritance collections for fiscal year 2006 for each of these 24 states. These
amounts would be placed at risk.
Estate and inheritance taxes also are one of the
most progressive sources of revenue that states have, helping to offset the
regressivity of other state and local taxes. Nearly all state tax systems are
regressive overall.
How the Deduction Works
Under the current federal tax deduction, the
estate or inheritance tax payments made to a state are deducted from the value
of an estate that is subject to taxation under the federal estate tax. Prior to
enactment of the 2001 federal tax-cut legislation, a federal tax credit was
provided for state estate and inheritance taxes paid. Every state had some form
of estate tax, with most states simply setting their state estate tax at the
amount allowed under the federal credit. Because of the credit state estate
taxes generally did not result in any increase in the total amount of taxes an
estate paid. For each dollar in state estate taxes paid up to the full credit
amount, federal estate taxes were lowered by a dollar.
The 2001 tax-cut legislation eliminated this
credit, however, and established the existing deduction in its place; the
deduction was meant to substitute, in part, for the credit. Because of the loss
of the credit, half of the states let their estate taxes expire. The other half
retained an estate or inheritance tax, with the amount of tax paid being
deducted from the value of the estate when the federal estate tax is computed.
In the states that have retained an estate or
inheritance tax, the federal deduction has played an important role in keeping
these taxes politically viable. Without the deduction, the survival of this
state revenue source would be in question.
The deduction significantly reduces the cost of
the state estate tax for estates that are subject to the federal estate tax. It
gives large estates an effective “discount” on the state estate tax. This is of
crucial importance, since the owners of large estates are often the most vocal
and active critics of state estate taxes.
Without the deduction, opponents of state estate
taxes can claim there is double taxation of estates, since the same value of an
estate would be taxed at both the state and federal levels. Stated another way,
without the deduction, the federal estate tax would be levied on a portion of an
estate that had already been used to pay the state taxes.
A deduction for the amount of state taxes paid is
a standard feature of federal taxes. When income is subject to the income tax
at both federal and state levels, the state income taxes that are paid are
deductible for federal tax purposes. State sales taxes and state or local
property taxes also are deductible under the federal personal income tax, and
state corporate income taxes are treated similarly under the federal corporate
income tax.
A deduction also dampens the “race to the bottom”
among states to eliminate their estate taxes. One of the major arguments used
by opponents of state estate taxes is that a state with an estate tax is a less
attractive place for seniors to live than a state with no estate tax. The
deduction answers this argument in part because it reduces the effective rate of
the state tax and thus reduces the differential between states with the tax and
those without. While the statutory rates of state estate taxes range up to 16
percent for the largest estates (those over $10 million) the average effective
tax rate is only 4.5 percent. The federal deduction plays a major role in
lowering the effective rate for the largest estates.
TABLE 1:
ESTIMATED STATE ESTATE AND INHERITANCE TAX COLLECTIONS (FISCAL YEAR 2006)
(ONLY STATES WITH ESTATE OR INHERITANCE TAXES ARE SHOWN.) |
|
FY2006
estimated collections
(in millions) |
Type of Tax* |
Connecticut |
$155.0 |
Estate |
Illinois |
$285.0 |
Estate |
Indiana |
$140.0 |
Inheritance |
Iowa |
$70.9 |
Inheritance |
Kansas |
$53.0 |
Estate |
Kentucky |
$47.0 |
Inheritance |
Maine |
$30.6 |
Estate |
Maryland |
$245.9 |
Estate plus Inheritance |
Massachusetts |
$218.0 |
Estate |
Minnesota |
$210.0 |
Estate |
Nebraska |
$68.7 |
Estate plus Inheritance |
New Jersey |
$580.0 |
Estate plus Inheritance |
New York |
$855.0 |
Estate |
North Carolina |
$154.3 |
Estate |
Ohio |
$310.5 |
Estate |
Oklahoma |
$64.1 |
Estate |
Oregon |
$59.0 |
Estate |
Pennsylvania |
$725.5 |
Inheritance |
Rhode Island |
$28.0 |
Estate |
Tennessee |
$84.0 |
Inheritance |
Vermont |
$26.1 |
Estate |
Virginia |
$144.0 |
Estate |
Washington |
$39.9 |
Estate |
Wisconsin |
$124.0 |
Estate |
D.C. |
$21.4 |
Estate |
U.S. total |
$4,740.0 |
Estate |
Source: State budget documents or calls to state budget offices.
*State taxes can take one of two forms — an
estate tax or an inheritance tax. An estate tax is a tax levied on the
estate and collected from the assets of the estate before it is
transferred to the heirs of the estate. An inheritance tax, on the other
hand, is a tax on the amount of the estate inherited by each heir and is
levied on and collected from the heirs. |
Conclusion
The elimination of the federal credit has already
made it difficult for many states to maintain their estate and inheritance
taxes. Serious proposals emerged this year to eliminate or significantly reduce
these taxes in six of the 24 states that have maintained them.
Eliminating the deduction that replaced the old
federal credit may pull the rug out from under states that have tried to
maintain this progressive tax in the face of powerful opposition. The
opposition to these state taxes is expected to intensify if deductibility is
denied and estates must pay federal tax.
End Notes:
[1] Joel Friedman and Aviva Aron-Dine,
“Thomas Estate Tax Proposal Still ‘Near Repeal:’ Instead of Compromising,
Proposal Tries to Have It Both Ways,” Center on Budget and Policy Priorities,”
revised June 23, 2006.
[2] The states include Connecticut,
Illinois, Indiana, Iowa, Kansas, Kentucky, Maine, Maryland, Massachusetts,
Minnesota, Nebraska, New Jersey, New York, North Carolina, Ohio, Oklahoma,
Oregon, Pennsylvania, Rhode Island. Tennessee, Vermont, Virginia, Washington and
Wisconsin. In some states, these taxes will expire in the next few years. For
more details see Elizabeth McNichol, “State Taxes on Inherited Wealth Remain
Common,” Center on Budget and Policy Prioities, revised June 23, 2006,
https://www.cbpp.org/5-31-06sfp.htm. |