The Estate Tax

A repeal of the estate tax seems to be dead in Congress, at least for now. Don't worry; they'll try again. After all, they're getting paid well to do so. But a flat-out repeal is only way way to approach the "problem" of the estate tax. The authors of this column in today's Washington Post think that we should try something that's perhaps even more radical than a repeal; turning the tax on it's had and taxing the receipient's bequest as earned income:

While it may seem perverse to tax one person's earnings twice, a key feature of inherited wealth is that upon transfer it goes from being one person's income to another's. There is nothing unreasonable then, about asking the person who receives an inheritance to pay their fair share on their new income -- particularly when all other earners, including minimum wage workers, pay taxes on the very first dollar they earn. To discuss whether to increase the size of estates exempted from taxation to $3 million, $10 million, or to make it unlimited is to move in the wrong direction in a society that values hard work. The current favorable treatment of inherited versus earned income is the opposite of what it should be...A far better approach would be to tax people equivalently on all the income they receive, whether it be from earned or inherited income, by replacing the estate tax with an income tax on inheritances. Under such a tax, inheritances would be treated the same as other forms of earned income and taxed in the same manner.

The advantage to this, as the authors explain, is that it is fairer than our current system. If you are in a higher tax bracket as a result of your own wealth, then you pay more on the income receive from an inheritance. If you're poorer you may pay less, or nothing at all depending on the size of the bequest. More people would be hit by the tax of course, but the authors do not say if it would bring in more tax revenue or not. I would imagine though that it would, as there would be no estate tax exemption under this system (though perhaps you could create an "exemption" by not taxing bequests from estates under a certain size.)

This system would also have to be structured not to remove the motivation upon the wealthy to donate to charity either before death or upon it. Under our current system, charitable donations are tax deductible for the purposes of income tax, and exempt from taxation for the purposes of the estate tax. This serves to encourage charitable giving, which the super-wealthy at least (beyond notable examples such as Warren Buffet and Bill Gates) are not so inclined to do on their own.

Of course there are those that argue not necessarily for the abolition of the estate tax, but rolling back it's reach. Unfortunately, like many who oppose the estate tax altogether, they peddle various myths about the tax to make rolling it back seem like a good idea for peons such as you and me:

If you give more than $12,000 a year to your children or grandchildren, then you will owe the IRS a gift tax. If you give the money to total strangers, on the other hand, you are entitled to a tax deduction. The tax rules get even stranger when you die.

That Mr. Reynolds begins his colunn this way is a bad sign. This rule isn't "strange." Rather, it's common sense. If people could give their money to their heirs before they die without having to pay any tax at all, can you imagine where all of their money would end up? But what Mr. Reynolds is really after is the charity justification for the estate tax. To him, the foundations that charitable contributions often go to are simply giant tax "loopholes":

People commonly confuse foundations with charities. Actually, nearly all foundations are grant-making, rather than operating, foundations. That means they simply dispense funds to other tax-exempt organizations, paying for programs and projects that others have designed. Foundations do not deliver charitable services...In a 1997 study for the Philanthropy Roundtable, "Death, Taxes and the Independent Sector," I found that foundations devote a significantly smaller portion of their giving to human services than individual donors do and a much larger share to "public/society benefit" (which is often aimed at influencing public policy and perhaps elections). Some giving defined as public affairs includes grants to state and local governments. Foundations also allocate relatively more than individual donors do to international affairs, environmental and wildlife groups, performing arts, museums and universities.

I'm not sure what the problem is here. No, foundations do not provide charitable services. But, foundations frequently provide money to other groups that provide charitable services, and to me this makes it a distinction without a difference. These grants to state and local government are for projects that you and I would certainly regard as charity, otherwise these foundations could not continue to exist as tax-exempt organizations. Do we have a problem with our money going to special causes such as the environment or the arts? Certainly we seem unwilling to pay for them with our taxes, and the money has to come from somewhere.

Unfortunately, the estate tax discourages accumulation of assets beyond the exempt amount, which means there is less to give away than would have been the case in the absence of death taxes. That also makes capital more scarce than otherwise, slowing the growth of productivity and real wages. Since charitable giving is a remarkably constant 2 percent of GDP, anything that makes the economy grow more slowly (including the estate tax) must also make charitable giving grow more slowly.

That's an absurdity. No one who is gradually accumulating wealth makes the decision to simply stop doing so at the estate tax exemption limit. Even if you have to pay some tax on the money you make...well you still have more money. And the more money you have, the more you can afford lawyers to help you figure out ways around paying any estate tax. This is why the estate tax encourages charitable giving. Better to give it away than to give it to the government, as Mr. Reynolds knows full well. So what is his solution?

Reducing the gift and estate taxes to the same bearable level as the capital gains tax would not make affluent people any less charitable, but it would alter the lifetime timing of giving away from delayed grants (gradually dribbled out through bureaucratic foundations after death) toward inter vivos gifts directly to charities. Because sooner is better than later, and direct donor supervision is wiser than letting politically correct professionals dole out the grants, this would be a colossal improvement over the presently overexploited foundation loophole for financial dynasties.

"Bearable" being the 10 to 15% rate that is currently paid on most capital gains. Since this is a lower rate than the current estate tax rate of 46%, it would seem to me that this would encourage people to leave more behind to their heirs when they die. Mr. Reynold's solution makes sense when you go along with his assumptions that people only accumulate wealth to the estate tax exemption, and people give away the same amount during their life no matter what the estate tax rate is, but unfortunately that makes little sense. As a result, neither does his solution.

Of course another solution would be...no change at all. Keep the estate tax just the way it is, undo the repeal of the estate tax slated for 2010, and keep soaking up billions from the super wealthy who would just give it to their kids to establish family financial dynasties. It's hard to make a newspaper op-ed out of that of course.