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WHITHER THE ESTATE TAX?

June 07, 2006

Tomorrow the Senate is to vote on whether to repeal the estate tax. Everything I read tells me that repeal supporters will be a few votes short of the 60 votes needed to win repeal. The debate will then turn to what the future estate tax will look like. Congress will have to decide on the role of the estate tax: is it there to raise revenue, or to beat up on rich people and provide work for smart tax advisors?

SOCIAL ENGINEERING THROUGH THE TAX LAW

Many supporters of the estate tax are frank in thier belief that its role is to take the rich down a notch. Tax blogger Stuart Levine says "It's about about what sort of nation we are, want to be, and will be." Professor Maule says:

There's an undercurrent to the taxation debate that transcends taxation. It goes to the heart of whether this country will continue to have a middle-class, one of the significant indicia of genuine freedom and democracy, or whether it will atrophy into another of the "many ruled by a few" arrangements that have dominated human history. This question is even more provocative when one considers the ways in which the few have made their way into the elite.

I think these arguments ask too much of the tax code. A revenue system has its hands full raising money in a way that is reasonably fair and workable for the unionized civil servants charged with its enforcement. It's hard enough for these folks to do that much without also expecting them to transform society.

Even if you think cutting the rich down to size through the estate tax is a good idea in theory, it hasn't worked in practice. There are still plenty of wealthy families out there. Some would say that even a loophole-ridden and ineffective estate tax sends a "signal" about "what kind of society we want to be." If it's signals you want to send, it makes more sense to buy radio ads.

PROBLEMS WITH REPEAL

The advocates of repeal gloss over the problems that full repeal would cause. The biggest problem is that taxpayers would no longer be able to step up the basis of their assets to fair market value at date of death. This may seem pretty minor, but it can be hard work to find out what a living person paid for something back in the Kennedy administration. Dead people are even worse at locating their old stock purchase records.

Without basis step-up, many of the sins of the fathers will be visited on the sons. This is especially true with partnerships and real estate investments. Many of these projects have generated losses for their owners in excess of the cash invested; others have been refinanced on a non-recourse basis. Without a basis step-up at death, many beneficiaries will find themselves inheriting income tax liabilities in excess of their equity in the underlying properties.

WHY THE CURRENT ESTATE TAX FAILS

As a method of changing society, the estate tax fails. It seems like we still have plenty of heirs and poor folks.

As currently constituted, it also fails the basic tests of tax policy. It is imposed at punishingly high rates; these high rates foster the creation of loopholes and exemptions out of taxpayer self-defense, so that ultimately the tax falls primarily on the poorly-advised. In the meantime it diverts the resources of the well-advised to smart tax lawyers and to tax accountants like me. I certainly see the benefits of that, but I can't say with a straight face that this country really needs to increase my billable hours.

Ultimately, I think "levelling" the rich is unwise and doomed. If such measures are effective, they're bad for everyone (see the Soviet Union for a long-term experiment along these lines). If they're ineffective, it's pointless.

The estate tax as currently set up was only tenable as long as it hardly applied to anybody. Once inflation and growing wealth brought the reasonably well-off, instead of just the fabulously rich, into the reach of the estate tax, its high rates and complexity were bound to create a repeal movement.

WHAT A SENSIBLE ESTATE TAX MIGHT LOOK LIKE

Any continued estate tax should have several components:

1. A generous exemption
2. A low rate
3. A gift tax at the same rate and exemption
4. A great reduction in loopholes

A tax with a $3 million to $5 million per person exemption and a 15% rate would enable the repeal of the whole raft of exemptions for farms and small businesses. While a 15% tax is no fun to pay, it is low enough that it won't normally put people out of business. If taxpayers are given an installment payment option, that and low rates would take away most of the incentive for estate tax engineering like family limited partnerships and elaborate trust arrangements. Families could manage their wealth based more on family and business needs and charitable considerations, rather than on avoiding the estate tax.

Such an estate tax would back up the income tax by ensuring that large gains are taxed at some point. It would support income tax administration by financing a basis step-up for heirs. It would be adminsterable and would greatly reduce the need to employ armies of accountants and attorneys to avoid a crippling financial burden at death.

Unfortunately, I expect a muddle - rates high enough (25%-40%) to be worth spending lots money on tax professionals (ah! a silver lining!), without eliminating the complexity and potential for foot-faults in the current law - all the while failing to achieve the (dubious) social engineering and symbolism desired by estate tax advocates.

Link:

The TaxProf has an excellent roundup of articles on estate tax repeal.

Tax Analysts permanent $link.

Open thread on this issue at the WSJ Law Blog.

UPDATE: A good analysis of the politics of the issue at Asymmetrical Information.

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Comments

Great post, Joe -- clear-headed and rational.

I'm pretty conservative (fiscally), so I chafe at the idea of "punishing" the rich, especially since this type of social engineering never seems to work. Of course, while there are some good reasons in favor of repeal, I have big problems with most of the pro-repeal folks -- they seem to prefer lies ("it hurts the farmers!") and other ridiculous arguments (the most recent: "Karl Marx would've loved the estate tax").

I especially liked your discussion of carryover basis, which seems to be the elephant in the room.

Joel-

Thanks! You've made my day.

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