The Estate Tax and the Economy

By :: June 18th, 2009

Unless Congress acts in the next six months, the estate tax will be repealed in 2010 and then revert to its 2001 parameters — substantially more burdensome than current levels — in 2011. This bizarre policy makes it very likely that Congress will reform the levy by the end of this year, but it’s unclear exactly how.

 

A recent paper co-authored by Doug Holtz-Eakin, former CBO Director and chief economist for the McCain Campaign, argues that Congress should permanently repeal the estate tax and reap the economic rewards. Among them: higher national saving, creation of over one million new jobs, and billions of dollars in new investment. Unfortunately the paper — perhaps because it relies on back-of-the-envelope analysis rather than empirical data — gets the economics all wrong.

 

Holtz-Eakin and co-author Cameron Smith hypothesize that the estate tax reduces economic growth because small-business owners, who are motivated to bequeath wealth to their heirs, are less inclined to generate wealth when their estates face high marginal rates. Thus, they claim estate tax repeal will increase small business payrolls by 2.6 percent (1.5 million new jobs!) and boost investment by 3.0 percent, while reducing the nationwide cost of capital by between 0.1 and 0.4 percentage points and unemployment by almost a full percentage point. These are fairly remarkable claims for a tax that directly falls on only 0.2 percent of decedents, or 6,000 estates.

 

In truth, while we don’t really know the exact impact of the estate tax on saving and job growth, most studies suggest that the impact is small—it may modestly increase saving and job growth or it may actually reduce them by a bit. The biggest reason for this ambiguity is that taxpayers accumulate wealth for many reasons. The opportunity to bequeath it to their heirs is one, for sure. But they also do so to pay children and others for services, protect against high retirement related expenses, and to donate to charity. Only in the first case would the estate tax be expected to reduce saving. And even in that case, the effect is ambiguous.  If a taxpayer intends to give a certain amount to his heirs, an estate tax requires more saving, not less, to meet the after-tax bequest target.

 

More important, the estate tax can’t have much effect on hiring by small business because hardly any owners ever face the estate tax. Most small businesses are worth far less than the exemption level (currently set at $7 million per couple and higher for many small business owners who value their firms at below market price). We estimate that only 100 small businesses and family farms would pay any tax in 2009, assuming current law is extended.

 

Holtz-Eakin and Smith also fail to account for the net effects of repealing the estate tax. With no tax on estates, the lost revenue will have to be made up elsewhere. Not only would Treasury lose nearly half-trillion dollars over ten years that would have been collected directly by the levy, but also billions more that would be lost due to the new gaping hole in the tax code if the estate tax no longer serves as a backstop. JCT estimates that the reduction in income tax receipts accounts for about 20 percent of the cost of repeal. Depending on how this other revenue is generated — or if it’s collected at all — the estate tax repeal could depress future economic growth.

 

When Congress addresses estate tax reform in the next six months — and it will — I hope the wide body of economic evidence, and not opinion, will help guide its decision.  

12Comments

  1. Anonymous  ::  3:25 pm on June 18th, 2009:

    The tax either has an impact or it doesn't. If it has a large fiscal impact, it must effect some type of business.
    Of course, the easy way around this is to call the bluff of the anti-taxers by taxing only withdrawls from inherited firms and not the inheritences themselves. Treat such withdrawls as normal income – and allow the normal exemption for sales of a firm to an ESOP. The floor for inheritance can also be significantly lowered to the floor for income taxes under tax reform. I suggest $150,000 per year for families. If an hier and his spouse make $120,000 a year and cash out $29,000, then under the plan I propose, they would make no income tax. If they cash out $50,000 from the inheritance, family income goes to $170,000 and they pay taxes on the last $20,000. If you use the Clinton era rates – adjusted for the existence of the Business Income Tax and VAT that I propose elsewhere, the rate would be 6%, making the tax an onerous $1,200. Of course, any spending would be taxed at a fairly high rate, and if they are drawing out of an inheritance they may not be saving any money – which is all the better for the economy.

  2. Anonymous  ::  12:48 pm on June 19th, 2009:

    Neither increasing or decreasing economic growth will ever justify, in my mind, the Govt robbing dead people.

  3. Anonymous  ::  1:16 pm on June 19th, 2009:

    Taxation is not robbery. It is necessary to fund the government. Then the question becomes when you collect the tax. Personally, I think the estate tax is a great deal. Getting to defer a chunk of your lifetime tax liability until after you and your spouse have died–and then only owing tax on the portion of your combined estate over $7 million plus all charitable bequests–seems pretty benign compared with taxes collected during life.

  4. Anonymous  ::  3:09 pm on June 19th, 2009:

    I agree with Len, it's too benign. Better to tax the heirs on every dollar they spend which puts there income over $75,000 if they are single and $150,000 if they are married (and make them pay a VAT on every dollar – just like everyone else).
    In other words, the question is not when they are taxed, but who gets taxed. Whoever spends the money should pay.

  5. Anonymous  ::  3:49 pm on June 19th, 2009:

    I agree that an inheritance tax would be much better. I don't know why that never has any salience with politicians.

  6. Anonymous  ::  7:07 pm on June 19th, 2009:

    The rich ones have greedy children, as do their contributors.
    A VAT is actually the best inheritence tax, because it can't be avoided unless all of your spending is on prostitution and drugs. (While prostitutes and drug dealers will pay the VAT as consumers – their customers won't – which is why the whole FAIR Tax argument on that vein is a canard).

  7. Anonymous  ::  7:18 am on June 20th, 2009:

    I'm astonished that Ben Harris can get so much wrong in one short article.
    According to TaxVos's own tables (T09-0201), estate taxes will generate $15 billion in revenue this calendar year.
    The federal government will spend $3.5 trillion in the same period (ignoring the inevitable social security and medicare explosions).
    Ie, estate taxes raise about .4 % of government spending.
    As someone who has worked in and around DC for many years, I assure you that the government could reduce its spending by 10% with almost zero impact on its operations. I'll give you two justifications for this assertion:
    1. Private companies with profitability problems often set 20% cost reduction targets, meet them within a year, and go on to full recoveries when things improve. The government is long overdue for such a house cleaning. It has way more dead wood than productive workers, thanks to the SEIU.
    2. I personally witnessed a case in which a federal employee ordered a $250,000 Sun computer system (for which her dept had neither use nor aptitude) because she had that much unspent in her budget, and didn't want to “lose” the allocation next year. When the computers arrived, there was no suitable space for them — they went into storage and were never used. I regret not having blown the whistle on that crime — the perp was a “friend” and I was too cowardly to stir up trouble. Similar profligate and useless spending happened recently in several states with federally-mandated voting machines. The list is endless.
    I am a single man (actually I'm married to a wonderful Thai woman who's not a US citizen so she doesn't get the 3.5M exclusion). I built my business starting from zero. After busting my butt for 40+ years I retired with a sizable fortune. I paid taxes in full on every dime.
    I would like to pass that money on to my biological children, with whom I was reunited a few years ago. They've had medical and many other problems and they really need the money. I've set up CRUTs for them but it's not really enough to protect them when inflation kicks in, as it surely will. The 45% that the government plans to extract from my estate would go a long way to protect my kids, and I could die knowing that the second half of their lives was going to be a lot better than the first.
    I cannot tell you how deeply I resent self-appointed comptrollers who presume to decide how much of my remaining money should be wasted on a government that screws up 95% of everything it touches..

  8. Anonymous  ::  1:01 pm on June 22nd, 2009:

    The government could easily save 10%, but it would not get smaller unless FTE cuts were mandated. Instead, it would come out of contracting with the private sector. Training contractors would get hit first (actually, they are getting hit now). The large training companies will weather the storm nicely, since they offer open enrollment classes that bureaucrats take with their own money. The little guys, however, will be laying folks off and not scheduling instructors (who are often retired Feds). The retired Feds will take less trips, not to the remodel, give less to their kids or eat out less, leading to higher unemployment in those sectors. They also won't buy that new car – or use the services of your business.
    While I have no doubt that you paid every tax you owed – after taking advantage of not more than a few deductions in the tax code, the fact is that most likely the tax rate you paid was too low – especially for the past 9 years – most likely by a factor of 10% to 20%.
    Whether your kids pay it with the inheritance or through higher taxes on the money they do make (or spend if the inevitable VAT tax passes), that shortfall in the taxes you and those like you paid is now on them – or their children – especially if the money set aside for the kids goes toward educting the grandkids so that they will be the kind of high income earners that will pay the highest rates.

  9. Anonymous  ::  5:28 pm on June 22nd, 2009:

    While it's not particularly relevant, you should know that the SEIU does not typically represent employees of the federal government.

  10. Anonymous  ::  4:47 pm on June 23rd, 2009:

    I've been looking at the new economic study on the Brookings site. Interesting. Of course, this study describes the problem and does not posit a solution. It also does not include the detail needed to estimate the cost of the solution I favor – tax reform with tax rates set to adequately fund the spending that actually exists in each of three areas: domestic defense and non-defense discretionary (paid by a VAT), entitlement spending – including health care reform (paid by expanded Business Income Taxes – which replace Corporate Income, lower rate Personal Income and Payroll taxes) and Net Interest/International – including the wars, foreign aid, IMF bad debt funding, the transition of military retirement to a funded program, repayment of the Social Security Trust fund and possibly either retirement of the debt – including that held by the Federal Reserve (paid for by high personal income and inheritance surtaxes). Each of these spending totals can be aggregated, each tax base constructed and a rate applied that could have the budget in balance in the near term, with debt retirement in the long term (with the term adjusted by the rate specified on personal income surtaxes).
    Determining what goes where would be an interesting exercise. If the numbers look ugly in one area (like the VAT or the Business Income Tax) it is important to know that and then decide what spending items move (or get cut).

  11. Anonymous  ::  3:37 pm on July 15th, 2009:

    Because politicians are dumb Len. ;-)

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