The Estate Tax Debate: Watch the Rate, Not the Exclusion

By :: December 15th, 2009

It is almost 2010, and Congress is scrambling to figure out what it is going to do about the estate tax.

In some perverse way, it’s fun to watch lawmakers dive into a mess largely of their own making. But as you do, don’t be distracted by the argument over the size of estates that should be excluded from tax, or whether the rules are extended for one year or two. The real argument is over the rate. That’s where the bucks are.

Most everyone knows the tragic-comic back story by now. The big Bush tax cut of 2001 steadily cut the inheritance tax until 2010, when it is scheduled to disappear entirely. Then, bizarrely, in 2011 the tax will come back to life, reverting roughly to what it was in 2000.

This is, of course, impossible. So Congress is trying to figure out what to do. It has only two basic options on the table: Extend the 2009 rules (a 45 percent rate and a $3.5 million exemption) for another year or two and figure it all out when it addresses the rest of the expiring Bush tax cuts in 2010. Or find on a permanent fix. The House has agreed to extend the current rules permanently. The Senate, tied in knots over the health bill, is likely to go for a temporary fix, but no-one knows when. Sometime soon, this will all sort itself out.

But Congress is playing a game of hide-the-pea here. Most of the attention has been on the size of the exclusion. Should all estates valued at $3.5 million be excluded from tax? Should the exemption be increased to $5 million?  (And, btw, with a bit of estate planning, a couple can easily double their exemption).  Don’t get me wrong, the exemption matters, but the rate is far more important.  To see why, just ask yourself the question: Would I rather have a higher exemption or a lower rate? Then do some simple math (to keep it very simple, I’m excluding the effects of state taxes).

Suppose Congress raises the exemption from $3.5 million to $5 million but also increases the rate from 45 percent to 50 percent. Today, someone with a $20 million estate would pay about $7.4 million in tax. Under those new rules, they’d pay a bit more-- $7.5 million. Now say Congress decides to keep the exemption at just $3.5 million but cuts the rate to 40 percent: In that case, the estate would owe only $6.6 million in tax. I don’t know about you, but in my world $900,000 is real money.

This matters even more, of course, with bigger estates. For a $100 million estate, the difference between a $3.5 million and a $5 million exclusion is trivial. But the difference between a 40 percent rate and a 50 percent rate is big bucks. This estate would pay $9 million more in taxes with a $5 million exemption and a 50 percent rate than with a $3.5 million exemption and a 40 percent rate. ($47.5 million v. $38.6 million).

Just so you know, while only a handful of estates exceed $20 million, that’s where the money is. In 2011, assuming a $3.5 million exclusion and a 45 percent rate, TPC figures only about 800 estates over $20 million will owe tax, but they’ll pay $11 billion, or more than 60 percent of total estate taxes.    

The flip side to this rate/exemption trade-off is that the cost to the Treasury rises significantly as the rate is cut. Thus, there is an odd consensus here. While the headlines focus on the exemption, the inside players are giving most of their attention to the rates. Whether you want to slash the estate tax as much as possible, or want to hold down the revenue loss in the face of massive budget deficits, the rate is the name of the game.     


  1. Anonymous  ::  11:26 pm on December 15th, 2009:

    For those of pedestrian means, the exemption amount is more important. As long as the exemption exceeds our estate size, we don't need to engage in expensive and restrictive estate planning. We save money. We're far less concerned with whether the government makes a few billion more or a few billion less on the large estates.
    In my opinion, the name of the game is exemption amount, indexation of the tax, and exemption portability (in which the unused portion of one spouse's exemption flows to the second-to-die spouse). As far as I'm concerned they put the rate wherever they want if they address these three issues.
    The House and Senate proposals completely fail to address the last two issues. I therefore conclude that they favor estate tax bracket creep and that they have accepted too many contributions from the estate planning lobby.

  2. Anonymous  ::  6:02 pm on December 16th, 2009:

    Those of us of really pedestrian means will never be caught in this tax. Of course, we also won't be caught in the tax brackets that will need to be increased to pay for the lost revenue.
    This whole thing does need to be part of the overall debate on tax reform, especially if an expanded business income tax or a VAT is used to keep people at the lower rates from having to pay taxes directly at all. As part of this, I have long championed taxing heirs and not estates, and then only for the liquidation of pension assets or cash inheritances, with this taxation being at the normal rate for their tax bracket.
    The “45% rate” in such cases, when the VAT is taken out, would be much lower. If you assume that part of tax reform is blowing the cap off of FICA (and making it entirely an employer tax with equal credit for each employee), a 55% rate under todays standard would be needed to simply equal the Clinton era top tax rate plus the uncapping of FICA. If the cap is not blown off FICA and the House's 5% health care surtax is enacted (for either health care or deficit reduction) than the 45% tax rate is actually equal to the highest income tax rate, which will be about 45% (or maybe a bit more).

  3. Anonymous  ::  8:36 pm on December 16th, 2009:

    A person of pedestrian means will not owe estate tax if he has a defined benefit pension. However a defined contribution plan should approach $2M at retirement if it is to provide a reliable middle income for the rest of your life. That's half the current exemption amount right there, before you add the value of a home and other assets. If you die just before retirement age or soon thereafter, your estate will be inflated by savings that you intended to spend during your retirement.
    Defined benefit retirees will not face estate tax on their retirement benefits, because their plans take the money saved on early deaths to fund retirees who live longer. This insurance-style feature is available to defined contribution retirees: it's called buying an annuity. However this conversion cannot be made before retirement, and prudent financial planning would argue against doing so if one is in poor health or if one fears inflation.
    Defined contribution and other cash balance retirement plans will be raided by the government through the estate tax or by other means. Perhaps it won't be as brazen as Argentina's recent move, but the government will find a way to confiscate a large portion of what prudent citizens have saved. It's the Willie Sutton principle.

  4. Anonymous  ::  6:39 am on December 17th, 2009:

    ATMbuff: if the estate tax is 50% with an exemption of $3.5 million and I inherit an estate worth $3.5 million plus $1 how much tax do I owe the government?

    I owe the government 50 cents! It's called marginal taxation for a reason. There is no way middle class families will pay much as a result of this tax**. A few might have to plan for this, but if you have a $2 million or more estate, that is something that should already be happening…
    **You also have to keep in mind the step up in basis eliminates most capital gains. With the first couple million exempted, it isn't until you pass $5 million in total value that the estate tax is harsher than the cap gains tax.

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  10. Anonymous  ::  12:52 pm on October 23rd, 2010:

    My own view is that an exemption of $ 3.5 million is too high. I prefer to see the exemption linked to median household income – maybe 5, 7, 15 (not 75) times the average income, with a provision for multi-generational family business viable.
    One observation that I have in the broader debate is not often speak of follow-up phase in the basic provisions that affect many more people than the estate tax. IMO, should be on the table as well, thorns and all.
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    Let âs face it. The debate over the federal estate tax â which Republicans & libertarians like to call the death tax â is a heated debate despite the fact that it âs not that important. I mean it âs not a giant government revenue generator. But the debate over the tax does dig at the heart of a person âs political philosophy…. jogos de motos

  13. frases de amor  ::  2:50 pm on November 9th, 2011:

    â I listen to all sorts of things, which means I listen to nothing, Craig Jennings, a federal fiscal policyowner analyst at OMB Watch, told The Hill.

    Interest groups on both sides of the estate tax debate are uncertain how the issue will play out when lawmakers return to Washington for the post-election lame-duck session.

  14. mensagens de carinho  ::  2:52 pm on November 9th, 2011:

    The tax ought to die.I can see raising the bottom limit up to somewhere between three and five million, but not extending it as is, no way. The estate tax is often the only tax levied on the tremendous rich, who hire tax lawyers to keep away from paying taxes their whole life. Capital gains is already low, but interest, which the common man pays, is much higher.

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