Eliminating The Estate Tax:
A Costly Benefit For The Wealthiest Americans
by Iris J. Lav
Advocates of proposals to repeal or sharply scale back the estate tax often say such proposals are necessary to address problems that families encounter when they inherit small businesses and farms but lack sufficient liquid assets to pay the tax. There are two problems with this argument. First, only a very small fraction of the estate tax is paid on small family businesses. The overwhelming bulk of the large tax-cut benefits that would result from sharply reducing or eliminating the estate tax would go to wealthy individuals who are not owners of small family businesses or farms.
Second, several provisions of the tax-cut legislation enacted in 1997 already are reducing estate taxes on small family businesses and farms. In addition to increasing the amount of any estate that is exempt from the estate tax to $1 million, the 1997 law increased exemptions and special-payment provisions for family-owned enterprises. To the extent that problems may remain in the taxation of small family-owned businesses and farms under the estate tax, those problems could be specifically identified and addressed at a modest cost to the Treasury.
By contrast, elimination of the estate tax — a proposal that Rep. Bill Archer, the Chairman of the House Ways and Means Committee, has said will be part of his forthcoming tax proposal — would provide huge windfalls to a small number of the nation's wealthiest residents at a large cost to the Treasury. An analysis by the Institute for Taxation and Economic Policy finds that 91 percent of the benefits of eliminating the estate tax would go to the highest-income one percent of taxpayers, a group with incomes exceeding $300,000 a year.
And the cost of eliminating the entire estate tax would be large. Over the next 10 years, the estate tax is expected to raise approximately $330 billion. Although the Archer proposal likely will call for a gradual phase-out of the estate tax rather than its immediate elimination, the ultimate revenue loss would be on the order of $330 billion over 10 years.
It also should be noted that estate taxes play an important role in the U.S. tax system. Because they are paid only on the 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 the income from such gains are subject to tax at all is through the estate tax.
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.
- The first $650,000 of an estate is exempt from taxation in 1999 and the exemption rises to $1 million by 2006. In addition, an unlimited amount of property can be transferred to a spouse free of tax. As a result of these provisions, only about two percent of all deaths result in estate tax liability. The Joint Committee on Taxation estimates that only 1.96 percent of all decedents in 1999 will have estates large enough to require payment of some estate tax.(1)
- Of those estates that are taxable, it is the largest estates that pay most of the estate tax. An analysis by IRS of the 32,000 taxable estates filing in 1995 showed that the 16 percent of taxable estates with gross value exceeding $2.5 million paid nearly 70 percent of total estate taxes.(2)
- The IRS analysis also demonstrated that 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 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 $760,000. (As a result of the 1997
tax law changes, this maximum reduction in value is indexed annually for inflation.)
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 $760,000 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.
- The amount of an estate that is exempt from taxation is higher for family-owned businesses and farms than for other types of estates. Instead of the $650,000 exemption (rising to $1 million in 2006), the 1997 tax law increased the total exemption for most estates that include family-owned businesses to $1.3 million.
- 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 stretched over up to 14 years, including deferral of annual interest
payments for four years, followed by up to 10 annual installments of principal and
interest.
If payments are deferred and paid over time in installments, a below-market interest rate of two percent applies to the tax attributable to the first $1,000,000 in value of a closely held (family) farm or business. There also is a preferential rate on the tax attributed to the remaining value of the family farm or business.
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 life of the decedent.
The federal revenue loss in fiscal year 1999 from not taxing these capital gains at death is estimated by the Treasury Department to be $26 billion and by the Joint Committee on Taxation to be $19 billion.(3) 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 that results 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. At least three-quarters of the capital gains income 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.
- The estate tax recoups some of the progressivity lost by not taxing gains on unsold assets, because the market value of all assets a decedent owned 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 large estates (those valued in excess of $1 million when the increase in the estate-tax exemption is fully phased-in), 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 point, however,
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 was instituted on the appreciated value of assets at death; 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 must be paid on the gain in the value of those assets .
- 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, the burden of the estate tax would shift. A smaller share of the revenues would come from the wealthy taxpayers who have estate tax liability under current law, and some of the burden would be shifted to upper-middle class taxpayers that have some capital gains income but that have amassed a lesser amount of total wealth.(4)
End Notes:
1. Joint Committee on Taxation, Present Law and Background on Federal Tax Provisions Relating to Retirement Savings Incentives, Health and Long-Term Care, and Estate and Gift Taxes (JCX-29-99), June 15, 1999.
2. Internal Revenue Service, SOI Bulletin, Winter 1996-97.
3. 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 are not collected on the original price of those assets. Moreover, no information need be filed on assets held by decedents with estates below the $650,000 estate-tax filing threshold. The lack of underlying data may account for the wide variation in estimates of revenue loss.
4. In addition, revenue collections likely would be somewhat lower. Estimates of the 1999 revenue loss from the failure to tax capital gains at death range from $19 billion to $26 billion, while the estate tax is expected to raise $28 billion.