Congress took its first tentative step toward fundamental tax reform when it enacted the Taxpayer's Relief Act of 1997. Certainly, the Taxpayer's Relief Act belongs to a class of legislation that warms only the hearts of lobbyists and specialists who must deal with the growing tax labyrinth. But it also prompted a much-needed discussion on repealing the estate tax--which is more commonly known as the death tax--that can claim as much as 55 percent of a family's estate at the time of a loved one's death.²

Taxes on intergenerational wealth transfers are a central part of current tax policy in the United States, so the surprisingly fair and extensive congressional hearing afforded the repeal of federal death taxes last year marks a virtual turning point in the evolution of the tax system. That discussion on Capitol Hill led to some helpful revisions in the death tax in the 1997 tax bill. And it also led to the crafting of a number of proposals this year to eliminate the death tax. The best of these proposals should form core features of the 1998 tax bill.

HOW DEATH TAXES AFFECT AMERICANS

Death taxes often burden most the very groups in society that the current tax policy is intended to help: specifically, minority and female business owners, farmers, the self-employed, and--indirectly but just as important--blue-collar workers, especially those who are just starting their working careers. Consider:

• Owners of small and medium-sized businesses very often are minorities or female. After sacrificing daily to build their businesses by reinvesting their profits, they soon realize that the financial legacy of their hard work and frugality, which they hoped to pass on to their children, instead will fall victim to confiscatory taxation and liquidation.

• Farmers, many of whom have grandparents who supported the taxation of wealth at the end of the 19th century, often are faced with losing their farms. But this is not so much because of competition from wealthy agribusinesses or capitalist "robber barons"; more often, it is because the federal government taxes heavily the estate of people who invested most of their earnings back into their farms and accumulated only meager liquid savings.

• Workers suffer when they lose their jobs because many small and medium-sized businesses are liquidated to pay death taxes, and because high capital costs depress the number of new businesses that could offer them new jobs.

• Low-income people are harmed--not only because the general economy is weakened by the death tax's rapacious appetite for family-owned businesses, but also because the death tax discourages savings and encourages consumption (particularly among wealthy individuals). This encouragement to consumption undermines the federal income tax, which raises funds to support programs for Americans at the lower end of income distribution.

Death taxes affect Americans in the following key ways:

Death taxes hurt small businesses
Investing in a business is one of the many forms of saving for the future, and it is the only form for some families. For most small firms, every available dollar goes into the family business--the dry cleaning business, the restaurant, the trucking company--because the business creates an income for the owners and an asset for their children. Women who reenter the workforce after raising their children often find self-employment to be the only entry-level employment available. Minorities, many of whom wish to raise their families in an ethnic community, understand well the virtues and promises of self-employment. The financial security that these family-owned and small businesses provide is put at risk if the owner dies with a taxable estate.

In an important 1995 study of how minority businesses perceive the estate tax, Joseph Astrachan and Craig Aronoff, two economists at Kennesaw State College,³ find that:

• Some 90 percent of the surveyed minority businesses know they might be subject to the federal estate tax;

• About 67 percent of these businesses have taken steps (including gifts of stock, ownership restructuring, life insurance purchases, and buy/sell agreements) to shelter their assets from taxation;

• Over 50 percent of these same businesses indicate that they would not have taken these steps had there been no estate tax; and

• Some 58 percent of all businesses in the survey anticipate failure or great difficulty surviving after determining their estate taxes.

Death taxes are more "affordable" as income rises
In other words, what appears to be a progressive tax contains a regressive dimension. Students of the estate tax continually are struck by the frequency with which taxpayers are insufficiently prepared to pay the death tax, and nearly as amazed by the high correlation between those who are unprepared to pay and those who have not had the benefit of high-priced legal and accounting advice. Indeed, legal avoidance of high death tax liabilities is closely related to the amount of fees taxpayers are able to pay throughout their lives for expensive tax-planning advice. Taxpayers who cannot pay these tax-planning fees frequently pay higher estate taxes.

Death taxes undermine savings
Not only do death taxes reduce potential employment and undermine the promise that hard, honest labor will be rewarded, they also reward consumption and undermine savings. What can be said generally about income taxes can be affirmed emphatically about death taxes: Accumulation of even modest wealth will lead to heavy taxes, while consumption of income results in relatively light taxation. In other words, it makes tax-planning sense to buy vacations in Aspen, Colorado, or a painting by Rubens instead of investing in new productive equipment or expanding a business.

The economic effects of the disincentive to savings and investment are quite striking, especially in light of the relatively small amounts of federal revenue raised by federal death taxes. An analysis by Heritage Foundation economists using the WEFA Group's U.S. Macroeconomic Model and the Washington University Macro Model finds that repealing the death tax would have a large and beneficial effect on the economy.⁴

Specifically, the Heritage analysis finds that, if the estate tax were repealed this year, then over the next nine years:

• The U.S. economy would average as much as $11 billion per year in extra output;

• An average of 145,000 additional new jobs could be created;

• Personal income could rise by an average of $8 billion per year above current projections; and

• The deficit actually would decline because revenues generated by extra growth would more than compensate for the meager revenues currently raised by the inefficient death tax.

Richard Fullenbaum and Mariana McNeill, consulting economists who formerly held senior positions at DRI/McGraw-Hill, recently confirmed these results in an important study for the Research Institute for Small and Emerging Business.⁵ In a simulation of death tax repeal using the WEFA U.S. Macroeconomic Model, they found that private investment would rise by an average of $11 billion over the seven-year period following repeal. Consumption expenditures would rise by an average of $17 billion (after inflation), and an average of 153,000 new jobs would be created in this more buoyant economy.⁶

Federal death taxes probably are the most expensive taxes to pay and to collect
Death taxes raise just slightly more than 1.0 percent of total federal revenues, but they are amazingly expensive for the taxpayer and the tax collector. According to one 1994 analysis, total compliance costs (including economic disincentives) amount to about 65 cents for every dollar collected.⁷ Other studies that subtract disincentives and examine only direct outlays by taxpayers to comply with estate tax law put compliance costs at about 31 cents.⁸ This additional cost of compliance means that the $19 billion collected in federal death taxes last year actually cost taxpayers $25 billion.

WHAT CONGRESS ACCOMPLISHED IN THE TAXPAYER'S RELIEF ACT OF 1997

Arguably, the most important aspect of the recent tax debates was the emerging sense that the country's fundamental tax policy assumptions may be wrong; yet the first session of the 105th Congress did accomplish several policy changes in the area of death tax reform. Not only will these relatively small tax policy changes form the revised context for the ongoing debate over death taxes, they also will become an important starting point for continued reform efforts.

The Taxpayer's Relief Act of 1997 contains a variety of tax policy changes that deal with intergenerational wealth transfer. The death tax provisions of the act, in fact, mark the most comprehensive changes in death tax law since the Economic Recovery Tax Act of 1981. That legislation phased in the amount that would be exempt from estate and gift taxes, from $175,625 to $600,000, for the years following 1986, and it reduced the maximum tax rate from 70 percent to 50 percent over five years (which Congress changed in 1993 by establishing the top rate of 55 percent). The Taxpayer's Relief Act of 1997 does not reduce the rate, but it does contain increases in the exemption levels and several specifically targeted relief provisions, called "carve-outs," particularly for family businesses and farms.

Features of the Taxpayer's Relief Act that involve intergenerational transfer of wealth include:

• An increase in the estate and gift tax "unified" credit. The current $192,800 unified estate and gift tax credit is increased, so that by the year 2006 every taxpayer may transfer up to $1 million in assets during his lifetime and at death before incurring estate and gift taxes. Although the scheduled increases in the unified credit appear generous, more than half the increase does not occur until the last two years of the ten-year phase-in period. By 2006, the inflation-adjusted value of the credit is $253,000, which implies an exclusion amount of about $787,400.⁹ The inflation-adjusted credit by 2003 (the year just before its massive increase in value), however, is $190,000, actually lower than the credit is today. Thus, the phase-in schedule results in a real tax increase for taxable estates. Table 1 shows the phase-in schedule for unified credit increases.

• Relief for family businesses and farms. The Taxpayer's Relief Act of 1997 provides estate tax exclusions for qualified family-owned businesses. For deaths occurring after 1997, "qualified family-owned business interests" are excluded from a taxable estate, so long as such interests plus the applicable exclusion amount do not exceed $1.3 million. The business interests must comprise more than 50 percent of the estate to qualify for this exemption. Qualified business interests include a sole proprietor's interests in a trade or business, as well as an interest in an entity carrying on a trade or business that is held at least 50 percent by one family, 70 percent by two families, or 90 percent by three families of which the decedent's family owns at least 30 percent. The principal place of business must be located within the United States, and the business or trade must not have been publicly traded within three years of death.

• Indexing of certain other estate, gift, and generation-skipping transfer (GST) taxes. Several estate, gift, and GST tax provisions are indexed for inflation in the case of decedents dying and transfers made after 1998:

• The annual $10,000 exclusion from the gift tax for each donee ($20,000 if gift splitting is elected);¹⁰

• The $750,000 maximum reduction in value allowed for certain property held in a decedent's estate as a real property used in farming or a trade or business;

• The $1 million exemption allowed each taxpayer for transfers that otherwise would be subject to the GST; and

• The $1 million limitation on the special 2 percent interest rate applied against estate taxes paid in installments and attributable to the value of a closely held business included in a decedent's estate.¹¹

• Other estate and gift tax provisions. An election is provided to allow an executor to treat distributions paid within 65 days after the close of an estate's tax year as having been made on the last day of that year. This rule previously was available only to trusts. The election became available after August 5, 1997, and potentially simplifies the administration of an estate.

The "throwback rules" covering amounts of accumulated income that are distributed by a trust have been eliminated for distributions from domestic trusts in tax years beginning after August 5, 1997. Under these rules, a beneficiary who receives a distribution from a trust that includes income the trust earned in an earlier year must perform a lengthy calculation to determine his or her income tax. The throwback rules still apply to foreign trusts, trusts that were foreign but now are domestic, and certain domestic trusts created before March 1, 1984, that would be treated as "multiple trusts" under the tax laws.

Under prior law, the GST exception made by a predeceased parent excluded certain direct transfers by a grandparent to a grandchild if the grandchild's parent was the child of the transferor and the parent was deceased at the time of the transfer. The exception now applies to transfers to collateral heirs, so long as the decedent has no living lineal descendants at the time of the transfer.¹² The exception extends also to transfers in trust when a parent of a trust's beneficiary is dead at the time the transfer first becomes subject to gift or estate tax.

A SCORECARD ON DEATH TAX REFORM PROPOSALS

The growing documentation of the social and economic harm caused by federal death taxes has engendered a host of reform proposals. Many of these initiatives appeal to those who seek greater death tax reforms than were passed in the Taxpayer's Relief Act of 1997 . The death tax "reforms" enacted last year actually increased the complexity and compliance costs of the death tax. And even though Congress raised the unified estate and gift exemption from $600,000 to $1 million over the next ten years, these increases barely will keep up with inflation. In fact, in years three through eight of this ten-year period, the growth in the exemption will be less rapid than during the first two years. This "flattening out" of the credit means that inflation in asset values will exceed the growth of the credit, which will result in an actual increase in death taxes for these middle years.

If Congress were to grade these proposals in terms of how well they promoted lowered tax rates, simplicity, and fairness, something like the following "report card" would result.

Senator Don Nickles (R-OK) proposed a similar rate restructuring in S. 650. His legislation calls for a rate of 20 percent on estates exceeding $1 million, and 30 percent on estates over $10 million.

Although these bills respond to demands for tax relief (and, thus, receive a passing grade), the interests they represent would be served better by a more principled approach. Immediate repeal or a phase-out of the tax burden (either through rate reduction or increases in the excluded amount of otherwise taxable estate) would serve all taxpayers and their families equally, thus achieving for everyone who is haunted by death taxes the equitable treatment they deserve.

CONCLUSION

Despite scheduled increases in the unified credit and provisions aimed at family farms and qualifying non-farm businesses, Congress did little in the Taxpayer's Relief Act of 1997 to reduce the adverse effects of federal death taxes on Americans. In fact, the phase-in schedule for the new unified credit limits actually will raise taxes after adjusting for inflation. The burden of taxation will continue to fall on hardworking men and women whose thrift and entrepreneurial spirit expose them to confiscatory tax rates that increase with their success.

Death taxes remain the greatest threat to the success of minority- and women-owned businesses and family farms. They erode the efforts of first-generation successful Americans to provide a better economic future for their children. In short, the pomp that surrounded Congress's death tax relief legislation--the Taxpayer's Relief Act of 1997--did little to change the circumstances of taxable estates.

The mounting economic evidence and the moral arguments of prominent tax reform advocates underscore the viability of the only "fix" for the federal government's death tax habit: complete elimination. Whether the repeal of the death tax happens immediately or over a targeted period is an important consideration, but not nearly so crucial as the decision by Congress and the President to end the estate tax travesty that turns the American dream into an American nightmare.

--William W. Beach is Director of the Center for Data Analysis and John M. Olin Senior Fellow in Economics at The Heritage Foundation.

Endnotes

1. The author would like to thank Ryan J. Lehrfeld, an intern at The Heritage Foundation from Cornell University's Department of Policy Analysis Washington Intern Program, for his significant contributions to this paper.

2. Actually, the top tax rate is 60 percent for estates between $10 million and $21 million in order to phase out the effects of the unified credit. After $21 million, the five percentage point surcharge expires and the rate drops back to 55 percent.

3. Joseph H. Astrachan and Craig E. Aronoff, "A Report on the Impact of the Federal Estate Tax: A Study of Two Industry Groups," Family Enterprise Center of the Coles School of Business, Kennesaw State College, Kennesaw, Georgia, July 24, 1995.

4. See William W. Beach, "The Case for Repealing the Estate Tax," Heritage Foundation Backgrounder No. 1091, August 21, 1996. The methodologies, assumptions, conclusions, and opinions in this study are entirely those of The Heritage Foundation. They have not been endorsed by, and do not necessarily reflect the views of, the owners of these two macroeconomic models.

5. Richard F. Fullenbaum and Mariana A. McNeill, "The Effects of the Federal Estate and Gift Tax on the Aggregate Economy," Research Institute for Small & Emerging Business Working Paper Series 98-01 (1998). See especially pp. 11-15.

6. Ibid., p. 15.

7. Christopher E. Erblich, "To Bury Federal Transfer Taxes without Further Ado," Seton Hall Law Review, Vol. 24, No. 4 (1994), pp. 1953-1956.

8. For a review of this literature, see Fullenbaum and McNeill, p. A-2.

9. This assumes an annual inflation rate of 3 percent.

10. Gift splitting occurs when one spouse makes a gift and the other spouse elects to have one-half of the gift treated as a gift made by the non-donor spouse.

11. KPMG US, Tax Act 1997; see also http://usserve.us.kpmg.com/taxact/booklet/3estate.html.

12. Collateral heirs are heirs other than direct descendants.