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