Estate Tax Reform Must Not Come at States’ Expense

As states cut everything from education to health care to address historic budget shortfalls, the last thing they need is for Congress to undercut an important revenue source for many of them. But that’s exactly what would happen if Congress eliminated the federal tax deduction for state-level estate and inheritance tax payments.

This provision was reportedly under consideration for an emerging Senate estate tax package that stalled this week, and it was part of a House estate tax bill introduced last fall.

Twenty-one states plus the District of Columbia have their own estate or inheritance taxes, which provide more than $4.5 billion a year in state revenues. They also help make states’ tax codes fairer, since they fall on only the very wealthiest residents. Nearly every state’s tax system takes a larger share of the incomes of less-affluent people than more-affluent ones.

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Right now, people who pay state estate or inheritance taxes can deduct those payments from the value of an estate on which they must pay federal estate tax. The deduction is consistent with the treatment of other taxes — for example, taxpayers can deduct their state income tax payments from their federal taxable income.

Eliminating the deduction would effectively make state estate and inheritance taxes much more expensive for wealthy individuals who also pay the federal estate tax. Those taxpayers almost certainly would pressure state lawmakers to reduce or repeal those taxes.

This wouldn’t be the first time a change in federal estate tax law undermined state estate taxes. In 2001 — when every state had an estate tax — Congress replaced the federal tax credit for state estate tax payments with the much less valuable deduction in place today. Half of the states then let their estate taxes expire.

State budgets are in such dire shape that states probably would not do away with their estate and inheritance taxes right way even if Congress eliminated the deduction. But as states begin to recover, they could face strong pressure to shrink estate and inheritance taxes on their wealthiest residents, even if that prevented states from restoring some public services that they cut during the recession. That’s not a good scenario.