CRS Report: RL30600 - Estate and Gift Taxes: Economic Issues

Jane G. Gravelle

Senior Specialist in Economic Policy
Government and Finance Division

The estate and gift tax has been the subject of recent legislative interest. In the 105^th Congress, the unified credit was increased to $1 million to be phased in by 2006. In the 106^th Congress, the "The Death Tax Elimination Act of 2000," which would have gradually eliminated the tax by 2010, was passed and subsequently vetoed by President Clinton. This report explains the mechanics of the tax and discusses the issues important to the debate.

The estate and gift tax is a relatively small source of revenue, accounting for 1.5% of federal receipts. The first $675,000 of estates and gifts is exempt from tax (this amount rises to $1,000,000 by 2006); this amount is in addition to an annual gift exclusion of $10,000 per donee. Estate and gift transfers to spouses are exempt from tax as are gifts to charity. While the rate schedule begins at 18 percent, taxable estates are subject to marginal rates from 37% to 55% because of the credit. There is also a credit for state estate taxes.

Supporters of the estate and gift tax cite its contribution to progressivity in the tax system and to the need for a tax due to the forgiveness of capital gains taxes on appreciated assets held until death. Arguments are also made that inheritances represent a windfall to heirs that are perhaps more appropriate sources of tax revenue than income earned through work and effort. Critics of the estate tax argue that it reduces savings and makes it more difficult to pass on family businesses and farms to the next generation. Critics also argue that death is not an appropriate time to impose a tax; that much wealth has already been taxed through income taxes, and that complexity of the tax not only imposes administration and compliance burdens but undermines the progressivity of the tax.

The analysis in this study suggests that the estate tax is highly progressive, although that progressivity is somewhat undermined by avoidance mechanisms. If greater progressivity were desired, it could be obtained in the federal system by altering other taxes. Neither economic theory nor empirical evidence indicate that the estate tax is likely to have much effect on savings. While some family businesses and farms are burdened by the tax, the estate tax applies to only a tiny fraction (probably around 3% or 4 %) of businesses that have, in most cases, sufficient liquid assets to pay the tax. Only a small percentage of estate tax revenues are derived from family businesses and other measures could be considered to provide further relief. Even though there are many estate tax avoidance techniques, it also is possible to reform the tax and reduce these complexities as an alternative to eliminating the tax. Thus, the evaluation of the estate tax may largely turn on the general appropriateness of such a revenue source and its interaction with existing capital gains and other income taxes. Changes in the estate tax will, however, have important implications for charitable giving and for state estate taxes.

A number of alternative revisions are discussed including proposals to reduce tax rates and exemptions as well as proposals to reduce the opportunities for tax avoidance and broaden the estate and gift tax base. This report will be updated as legislative events warrant.

The estate and gift tax has been the subject of legislative interest for the last two Congresses. The effective exemption levels for the tax were substantially increased in 1997 (the 105^th Congress) and will become $1,000,000 in 2006. The 1997 legislation also allowed a larger deduction for family owned businesses, including farms.

A number of bills were introduced in the 106^th Congress that would have repealed or reformed the estate tax. The most recent, "The Death Tax Elimination Act of 2000" (H.R. 8), which was passed by Congress and vetoed, would have phased out the tax over the next 10 years.⁽¹⁾ In March of 2000, H.R. 3081, which would have reduced estate and gift tax rates, passed in the House and was sent to the Senate where no action was taken. An even earlier major tax bill (H.R. 2488), which would have repealed the estate tax, was also vetoed by the President.⁽²⁾ While these bills propose tax elimination or reduction, the Clinton Administration proposed a variety of changes that would have been aimed largely at reducing estate tax avoidance. Some of these provisions were included in a Democratic substitute to "The Death Tax Elimination Act of 2000" (H.R. 8), in addition to a variety of other changes, some broadening the estate tax base and others that lowered rates and increased exemptions. Clinton Administration proposals would have also restored the phase out of the exemption for large estates.

Proponents of an estate and gift tax argue that it contributes to progressivity in the tax system by "taxing the rich." (Note, however, that there is no way to objectively determine the optimal degree of progressivity in a tax system). A related argument is that the tax reduces the concentration of wealth and its perceived adverse consequences for society.⁽³⁾ Moreover, while the estate and gift tax is relatively small as a revenue source (yielding $28 billion in FY1999 and accounting for 1.5 percent of federal revenue), it raises a not insignificant amount of revenue - revenue that could increase in the future due to the strong performance of stock market and growth in inter-generational transfers as the baby boom generation ages. Eliminating or reducing the tax would either require some other tax to be increased, some spending program to be reduced, or the national debt be decreased less rapidly. In addition, to the extent that inherited wealth is seen as windfall to the recipient, such a tax may be seen by some as fairer than taxing earnings that are the result of work and effort. Finally, many economists suggest that an important rationale for maintaining an estate tax is the escape of unrealized capital gains from any taxation, since heirs receive a stepped-up basis of assets. Families that accrue large gains through the appreciation of their wealth in assets can, in the absence of an estate tax, largely escape any taxes on these gains by passing on the assets to their heirs.

The estate tax also encourages giving to charity, since charitable contributions are deductible from the estate tax base. Since charitable giving is generally recognized as an appropriate object of subsidy, the presence of an estate tax with such a deduction may be seen as one of the potential tools for encouraging charitable giving.

Critics of the estate and gift tax typically make two major arguments: the estate and gift tax discourages savings and investments, and the tax imposes an undue burden on closely held family businesses (including farms). In the latter case, the argument is made that the estate tax forces the break-up of family businesses without adequate liquidity to pay the tax. Critics also suggest that the estate and gift tax is flawed as a method of introducing progressivity because there are many methods of avoiding the tax, methods that are more available to very wealthy families (although this criticism could support reform of the tax as well as repeal). A related criticism is that the administrative and compliance cost of an estate and gift tax is onerous relative to its yield (again, however, this argument could also be advanced to support reform rather than repeal). In general, there may also be a feeling that death is not a desirable time to impose a tax; indeed, the critics of the estate and gift tax often refer to the tax as a death tax. Critics also argue that some of the wealth passed on in estates has generally already been subject to capital income taxes.

The remainder of this paper, following a brief explanation of how the tax operates, analyzes these arguments for and against the tax. The paper concludes with an inventory and discussion of alternative policy options.

The unified estate and gift tax is levied on the transfer of assets that occurs when someone dies or gives a gift. Filing an estate tax return can be difficult depending on the value and complexity of the estate. The purpose here is to outline the mechanics of the estate and gift tax. The first section begins with a brief review of the general rules accompanied with a numerical example. There are some minor provisions of the law that are not discussed here, however (such as the phase out of the graduated rates and the credit for taxes on property recently transferred).⁽⁴⁾ The second section summarizes the special rules for farms and small businesses. And, the final section briefly describes the generation skipping transfer tax. The appendix of this report provides detailed data from returns filed in 1998, the latest year for which data are available.

Filing Threshold. In FY2001, estates valued over $675,000 must file an estate tax return. The filing threshold is scheduled to increase along with the unified credit to $1 million by 2006. The unified credit, which is identical to the filing threshold, effectively exempts from taxation the portion of the estate that falls below the filing threshold. (The filing threshold is lower, however, if gifts have already been made). Table A1 in the appendix reports the current filing requirement and the unified credit equivalent for 1997 through 2006.

Gross Estate Value. The gross estate value, which was $174 billion for returns filed in 1998, is the total value of all property and assets owned by decedents. Table A2 in the appendix provides the gross estate value for the returns filed in 1998 by wealth category. The data represent the returns filed in 1998, not the decedents in that year. Thus, a portion of the returns filed in 1998 are from estates valued in years before 1998.

Allowable Deductions. Deductions from the estate reduce the taxable portion of the gross estate and in turn the number of taxable returns. In 1998, $71 billion was deducted from estates. The most valuable deduction is for bequests to a surviving spouse, $49 billion; the most prevalent (though smallest reported) deduction is for funeral expenses, $604 million. Appendix table A3 lists the deductions in greater detail for returns filed in 1998.

Taxable Estate. After subtracting allowable deductions, the remainder of the estate is the taxable estate. Taxable estate value was $103 billion in 1998. Adjusted taxable gifts are then added to the taxable estate to arrive upon the adjusted taxable estate. An individual is allowed to exclude $10,000 in gifts per year per donee from taxable gifts. Thus, only the amount exceeding the $10,000 limit is added back to the taxable estate. Only 11,917 returns filed in 1998 included taxable gifts, adding approximately $4.7 billion to the taxable estate value. Thus, adjusted taxable estates were worth $108 billion in 1998. Generally, the adjusted taxable estate represents the base of estate tax.

Rates and Brackets. After establishing the value of the taxable estate, the executor calculates the tentative estate tax due.⁽⁵⁾ The tax due is tentative because the executor has not redeemed either the unified credit amount or the federal credit for state estate taxes paid. The brackets and applicable rates are reproduced in appendix table A4.

A Numerical Example. The remaining steps in calculating the estate and gift tax are most easily exhibited through numerical example. To accomplish this, we first assume a decedent has an estate worth $2 million and leaves $800,000 to his wife and contributes $300,000 to a charitable organization. We also assume the decedent has not made any taxable gifts leaving $900,000 in his estate after deductions. This simple example is exhibited below.

The taxable estate is valued at $900,000 after the allowable deductions have been subtracted from the gross estate value.⁽⁶⁾ The tax is applied to the $900,000 in increments of estate value as provided for in the tax code. For example, the first increment of $10,000 is taxed at 18%, the second increment of $10,000 is taxed at 20%, the third increment of $20,000 is taxed at 22%, etc. This process continues until the entire $900,000 is taxed. The last increment of estate value, that from $750,001 to $900,000, is taxed at a 39% rate. Thus, even though this estate is in the 39% bracket, only a portion of the estate is taxed at the 39% rate.

Tentative Estate Tax. In 1998, the tentative estate tax after deductions and before credits was $43 billion. Returning to our example, the $900,000 taxable estate yields a tentative estate tax of $306,800. Recall, however, we have not yet considered the "applicable unified credit."

The Unified Tax Credit. For decedents dying in 2001, the unified credit is $220,550, which leaves an estate tax due in our example of $86,250. If our hypothetical estate tax return were filed in 2005, when the credit is $326,300, the estate presented here would owe nothing in estate taxes. (The unified credit reduced the tentative estate tax by $19 billion in 1998.)

Federal Credit for State Estate Taxes. The state estate tax credit reduced the federal estate tax due by $5 billion in 1998. This tax credit is determined by yet another tax rate schedule. The taxable estate value, which is $900,000 in our example, is reduced by a standard exemption of $60,000 and the credit rate schedule applies to the remainder. For our hypothetical estate, the credit is $27,600. Because the credit reimburses decedents for state estate taxes, it is analogous to a federal government transfer to state governments. Table A5 of the appendix reproduces the credit schedule for the state estate tax.

Net Federal Estate Tax. The net estate tax due was $20 billion in 1998.⁽⁷⁾ This is the final step for the estate executor. After all exemptions, deductions, and credits, the $2 million dollar estate we began with must now remit $58,650 to the federal government.

All of the steps described above are included in the following table. Also, two estimates of the average estate tax rate are presented in the bottom two rows. The federal rate is calculated as the federal estate tax due divided by the gross estate value. The combined rate is the credit for state taxes added to the federal estate tax due divided by the gross estate value. The latter measure of average estate tax rate better represents the full (federal and state) estate tax burden.

Gross Estate Value	$2,000,000
Less: marital deduction	$800,000
Less: charitable contribution	$300,000
Taxable Estate	$900,000
Tentative Estate Tax (from the rate schedule)	$306,800
Less: Applicable Credit Amount (FY2000)	$220,550
Estate Tax Due Before State Inheritance Tax Credit	$86,250
Less: State Inheritance Tax Credit¹ (FY2000)	$27,600
Net Federal Estate Tax	$58,650
Average Effective Federal Estate Tax Rate	2.93%
Combined Federal and State Average Effective Estate Tax Rate¹	4.31%

¹ This calculation assumes that the state has adopted the federal credit schedule as its estate tax mechanism.

There are primarily three special rules for family owned farms and businesses. The first special rule ⁽⁸⁾ allows an additional deduction for qualified estates. The Qualified Family Owned Business Interest (QFOBI) deduction is set at a maximum of $675,000 and is coordinated with the applicable credit to yield a total maximum exclusion of $1.3 million. Specifically, an estate qualifies as a QFOBI if the decedent is a U.S. citizen or resident and the QFOBI comprises at least 50% of the adjusted gross estate value. The principal place of business must also be in the United States and it must be owned as follows: at least 50% by one family; 70% by two families; or 90% by three families. However, if the business is owned by multiple families, the decedent's family ownership must represent at least 30% of the gross estate value. The qualified heirs must also materially participate in the business for at least 5 years of 8 years before the death of the decedent. In addition, the qualified heirs must participate for 5 of 8 years within the 10 years following the decedent's death.

The second special rule ⁽⁹⁾ allows family owned farm and business estates to pay the tax in installments over a maximum of 10 years after a deferment of up to 5 years. The farm or business must comprise at least 35% of the adjusted gross estate value to qualify for the installment method. A portion of the deferred estate tax is assessed an annual 2% interest charge.⁽¹⁰⁾

The third special rule ⁽¹¹⁾ allows family farms and businesses that meet certain requirements to value their land as currently used rather than at fair market value. To avoid a recapture tax, heirs must continue to use the land as designated in the special use notice for at least 10 years following the transfer. The market value can be reduced by a maximum $750,000 in 1998. After 1998, the maximum is indexed for inflation, rounded to the next lowest multiple of $10,000. In 1999, the maximum was $760,000.

Generally, the generation skipping transfer (GST) tax is levied on transfers from the decedent to grandchildren. The tax includes a $1,000,000 exemption per donor that is indexed for inflation after 1998. Married couples are allowed to "split" their gifts for an effective exemption of $2,020,000. The rate of tax is the highest estate and gift tax rate or 55% in FY2000. These transfers are also subject to applicable estate and gift taxes. Very few estates pay a GST-only 360 returns were filed in 1998- because the high rate of tax discourages this type of bequest.

As noted in the introduction, the principal arguments surrounding the estate and gift tax are associated with the desirability of reducing the concentration of wealth and income through the tax and the possible adverse effect of the tax on savings behavior and family businesses. There are a number of other issues of fairness or efficiency associated with particular aspects of the tax (e.g. marital deductions, charitable deductions, effects on small businesses, interaction with capital gains taxes) , and the possible contribution to tax complexity. These issues are addressed in this section.

Distributional effects concern both vertical equity (how high income individuals are affected relative to low income individuals) and horizontal equity (how individuals in equal circumstances are differentially affected). Note that economic analysis cannot be used to determine the optimal degree of distribution across income and wealth (vertical equity).

Vertical Equity. The estate tax is the most progressive of any of the federal taxes; out of the approximately 2.3 million deaths in 1998, only 2.0% of estates pay any estate tax (and only 4.2% file a return). These numbers can be contrasted with the income tax where most families and single individuals file tax returns and about 70% of those returns owe tax. In addition, out of the 2.0% of decedents whose estates pay tax, about 42% of these had gross estates valued at less than $1 million. Because the exclusion is rising to $1 million by 2006, the share of decedents' estates paying estate taxes will fall somewhat; the fall would be greater but for the growth in wealth that has been fueled by a rising stock market.

Evidence suggests that the average effective tax rate rises with the size of the estate except for the highest tax rate bracket, as shown in table 1 (last two columns). The next to last column reports 1998 effective tax rates for the decedent before the credit for state taxes and the last column reflects the actual amount paid to the federal government. Estates valued at less than the exemption amount, of course, pay no taxes and the tax rate rises and then falls with the very largest estates, despite the fact that the rates are graduated. Columns (2)-(4) show the deductions and it is clear that the primary reason for the lower tax rate in the highest levels of the estate tax is the charitable deduction, which accounts for 6% of estates on average but 15.2% in the highest wealth bracket. The deduction for bequests left to spouse is larger relative to gross estate with larger estates as well, although this rise is not confined to the highest bracket. The progressivity through the initial brackets is the result of the unified credit and the graduated rate structure.

The figures in table 1 may actually overstate the amount of rate progression in the estate tax. To the extent that tax planning techniques reduce the size of the gross estate (e.g. though use of gift tax exclusions or valuation discounts, as discussed subsequently), and that these tax planning techniques are more common with larger estates, the effective tax rates may be overstated more for larger estates.

Despite the lack of progressivity through all of the estate size brackets, the principal point for distributional purposes is that the estate and gift tax is confined to the wealthiest of decedents and to a tiny share of the population and hence is more progressive than any other federal tax. And the larger estates nevertheless pay much more of the estate tax. For example, estates over $5 million accounted for about 4.1% of estates filing returns and 6.1% of taxable estates, but paid just over half of total estate tax. Thus, to the extent that concentration of income and wealth are viewed as undesirable, the estate tax plays some role, albeit small (because it is a small tax) in increasing income and wealth equality.

Source: CRS calculations from Statistics of Income, Internet published data, September 21, 2000. *Net estate is estate value less expenses. Expenses include funeral expenses, attorney's fees, executors' commissions, other expenses/losses, and debts and mortgages.

Note also that, to the extent the Carnegie conjecture (large inheritances reduce labor effort by heirs) is correct, the estate tax would play a role in increasing output and economic growth through increased labor supply - an effect opposite to some claims made by opponents of the tax. A recent study found some evidence that this effect on labor supply occurs,⁽¹²⁾ although for very large inheritances the consequences of labor supply effort of a single individual may be small relative to the effects on saving. Claims have also been made that inequality retards growth, although this view is theoretically uncertain; evidence of this effect is weak and conflicting.⁽¹³⁾

Horizontal Equity. Estate and gift taxes can affect similar individuals differentially for a variety of reasons. Special provisions for farmers and family businesses (discussed subsequently) can cause families with the same amount of wealth to be taxed differentially. The availability and differential use of avoidance techniques (also discussed subsequently) can lead to different tax burdens for the same amount of wealth. Moreover, individuals who accumulate similar amounts of wealth may pay differential taxes depending on how long they live.

Many people presume that the estate tax reduces savings, since the estate and gift tax, like a capital income tax, applies to wealth. It may appear "obvious" that a tax on wealth would reduce wealth. However, taxes on capital income do not necessarily reduce savings. This ambiguous result arises from the opposing forces of an income and substitution effect. An investment is made to provide future consumption; if the rate of return rises because a tax is cut, more consumption might be shifted from the present to the future (the substitution effect). This effect, in isolation, would increase saving.

However, the tax savings also increases the return earned on investment and allows higher consumption both today and in the future. This effect is called an income effect, and it tends to reduce saving. Its effect is most pronounced when the savings is for a fixed target (such as a fund for college tuition or a target bequest to an heir). Thus, saving for precautionary reasons (as a hedge against bad events) is less likely to increase when the rate of return rises than saving for retirement. Empirical evidence on savings responses, while difficult to obtain, suggests a small effect of uncertain sign (i.e. either positive or negative). Current events certainly suggest that savings falls when the rate of return rises: as returns on stocks have increased dramatically, the savings rate has plunged.

The same points can generally be made about a tax on estates and gifts, although some analysts suspect that an estate tax, to be paid at a distant date in the future, would be less likely to have an effect (in either direction) than income taxes being paid currently. A reduction in estate taxes makes a larger net bequest possible, reducing the price of the bequest in terms of forgone consumption. This substitution effect would cause savings to increase. At the same time, a reduction in estate taxes causes the net estate to be larger, allowing a larger net bequest to be made with a smaller amount of savings (the income effect). Again, the latter effect is most pronounced when there is a target net bequest; a smaller gross bequest can be left (and less savings required on the part of the decedent) to achieve the net target.

Unfortunately, virtually no empirical evidence about the effect of estate and gift taxes exists, in part because these taxes have been viewed as small and relatively unimportant by most researchers and in part because there are tremendous difficulties is trying to link an estate and gift tax which occurs at the end of a lifetime to annual savings behavior. But a reasonable expectation is that the effects of cutting the estate and gift tax on savings would not be large and would not even necessarily be positive.

Of course, the effect on national saving depends on the use to which tax revenues are put. If revenues are used to decrease the national debt, they become part of government saving, and it is more likely that cutting estate and gift taxes would reduce saving by decreasing government saving, since there may be little or no effect on private saving. If they are used for government spending on consumption programs, or transfers that are primarily used for consumption, then it is less likely that cutting estate and gift taxes would reduce saving because the estate tax cut would be financed out of decreased consumption (rather than decreased saving). In this case, reducing the tax would probably have a small effect on national saving, since the evidence suggests a small effect on private saving. A similar effect would occur if tax revenues are held constant and the alternative tax primarily reduced consumption.

Actually, the estate and gift tax is, in some ways, more complicated to assess than a tax on capital income or wealth. There are a variety of possible motives for leaving bequests, which are likely to cause savings to respond differently to the estate tax. In addition, there are consequences for the heirs which may affect their savings.

Several of these alternative motives and their consequences are outlined by Gale and Perozek.⁽¹⁴⁾ Motives for leaving bequests include: (1) altruism: individuals want to increase the welfare of their children and other descendants because they care about them; (2) accident: individuals do not intentionally save to leave a bequest but as a fund to cover unexpected costs or the costs of living longer than expected (thus, bequests are left by accident and are in the nature of precautionary savings); (3) exchange: parents promise to leave bequests to their children in exchange for services (visiting, looking after parents when they are sick); and (4) joy of giving: individuals get pleasure directly from giving, with the pleasure depending on the size of the estate. To Gale and Perozek's classifications we might add satiation: when individuals have so much wealth that any consumption desire can be met.

The theoretical effects of these alternative theories on decedents and heirs are summarized in table 2. A discussion of each follows in the text, but it is interesting to see that there is a tendency for estate taxes to increase saving, not decrease it. This effect occurs in part because there are "double" income effects that discourage consumption, acting on both the decedent and the heir.

Altruistic. When giving is motivated by altruism, the effect of the tax is ambiguous, as might not be surprising given the discussion of income and substitution effects. The effects on the parents are ambiguous, while the windfall receipt of an inheritance tends to reduce the need to save by the children. That is, the estate tax reduces the inheritances and thus increases saving by heirs. The outcomes are also partly dependent on whether children think they can elicit a larger inheritance by squandering their own money (which causes them to save even less) and whether the parent sees this problem and responds to it in a way that forestalls it. Interestingly, some parents might respond by spending a lot of their assets before death to induce their children to be more responsible and save more. The cost of doing this is the reduction in welfare of their children from the smaller bequest as compared with the parent's benefit from consumption. The estate tax actually makes the cost of using this method smaller (in terms of reduced bequests for each dollar spent), and causes the parents to consume more. While these motivations and actions of parent and child can become complex, this theory leaves us with an ambiguous effect on savings.

Accidental. In the second case, where bequests are left because parents die before they have exhausted their resources, the estate tax has no effect on the saving of the parents. Indeed, the parents are not really concerned about the estate tax since it has no effect on the reason they are accumulating assets. If they need the assets because they live too long or become ill, no tax will be paid. Bequests are a windfall to children, in this case, and tend to increase their consumption. Thus, taxing bequests, because it reduces this windfall, reduces their consumption and promotes savings. If the revenue from the estate tax is saved by the government, national saving rises. (If the revenue is spent on consumption, there is no effect on savings). Thus, in this case, the estate tax reduces private consumption and repealing it, reducing the surplus, would increase consumption (reduce savings).

Exchange. In the third case, parents are basically paying for children's services with bequests and the estate tax becomes like a tax on products: the price for their children's attention has increased. Not surprisingly, the savings and size of bequest by the parents depends on how responsive they are to these price changes. If the demand is less responsive to price changes (price inelastic) parents will save and bequeath more to make up for the tax to be sure of receiving their children's services, but if there are close substitutes they might save less, bequeath less, and purchase alternatives (e.g. nursing home care). In this model, the child's saving is not affected, since the bequest is payment for forgone wages (or leisure).

Joy of Giving. A fourth motive is called the "joy-of-giving" motive, where individuals simply enjoy leaving a bequest. If the parent focuses on the before-tax bequest, the estate tax will have no effect on his or her behavior, but will reduce the inheritance and theoretically increase the saving of children. Thus, repealing the estate tax would reduce private saving. If the parent focuses on the after-tax bequest, the effect on saving is ambiguous (again, due to income and substitution effects).

Satiation. Some families may be so wealthy that they can satisfy all of their consumption needs without feeling any constraints and their wealth accumulation may be a (large) residual. In this case, as well, the estate tax would have no effect on saving of the donor, and perhaps little effect on the donee as well.

Empirical Evidence. Evidence for these motives is not clear but this analysis does suggest that there are many circumstances in which a repeal of the estate tax would reduce savings, not increase it. Virtually no work has been done to estimate the effect of estate taxes on accumulation of assets. A preliminary analysis of estate tax data by Kopczuk and Slemrod found some limited evidence of a negative effect on savings, but this effect was not robust (i.e. did not persist with changes in data sets or specification).⁽¹⁵⁾ This effect was relatively small in any case and the authors stress the many limitations of their results. In particular, their analysis cannot distinguish between the reduction of estates due to savings responses and those due to tax avoidance techniques. Given the paucity of empirical evidence on the issue, the evidence on savings responses in general, and the theory outlined above, it appears difficult to argue for repeal of the estate tax to increase private saving. Even if the responsiveness to the estate and gift tax is as large as the largest empirical estimates of interest elasticities, the effect on savings and output would be negligible and more than offset by public dissaving.⁽¹⁶⁾ Indeed, if the only objective were increased savings, it would probably be more effective to simply keep the estate and gift tax and use the proceeds to reduce the national debt.

Much attention been focused on the effect of the estate and gift tax on family farms and businesses and there is a perception that the estate tax is a significant burden on these businesses. Typically, family farm and business owners hold significant wealth in business and farm assets as well as other assets such as stocks, bonds and cash. Because many business owners are relatively well off and the estate and gift tax is a progressive tax, the probability of a farm or small business owner encountering tax liability is greater than for other decedents.

Opponents of the estate and gift tax suggest that a family business or farm may in fact have to sell assets, often at a discounted price, to pay the tax. In his 1997 testimony, Bruce Bartlett from the National Center for Policy Analysis, stated that

"...according to a survey, 51% of businesses would have difficulty surviving in the event of principal owner's death and 14% said it would be impossible for them to survive. Only 10% said the estate tax would have no effect; 30% said they would have to sell the family business, and 41% would have to borrow against equity."⁽¹⁷⁾

Are the data from this survey representative of the country as a whole? And, what are the policy issues associated with this effect? In response to the above testimony, there are two questions to explore. One, is repeal of the estate and gift tax efficiently targeted to relieve farms and small businesses? And two, of the farmer and small business decedents, how many actually encounter tax liability?

Target Efficiency. Congress has incorporated into tax law three provisions, outlined earlier, that address and reduce the negative consequences of the estate tax on farms and small businesses. These laws are targeted to benefit only farm and small business heirs. In contrast, proposals to repeal the estate and gift tax entirely are poorly targeted to farms and small businesses.

Of the 47,482 taxable returns filed in 1998, 2,897 (6.1%) returns included farm assets. Additionally, no more than 13,904 (29.3%) returns included "business assets" in the estate.⁽¹⁸⁾ (Some returns may be double counted). Together, farm and business owners, by our definition, represent no more than 36% of all taxable estate tax returns.

However, this estimate may be overstated, even aside from the likelihood of double counting. The estimate for farms assumes any estate with a farm asset is a farm return thus including part-time farmers or those who may own farm land not directly farmed. The estimate for business assets may include many returns that include small interests (particularly for corporate stock and partnerships). Treasury data for 1998 made available during the recent debate indicated that farm estates where farm assets accounted for at least half of the gross estate accounted for 1.4% of taxable estates, while returns with closely held stock, non-corporate business or partnership assets equal to half of the gross estate accounted for 1.6%. The same data indicated that farm real estate and other farm assets in these returns accounted for 0.6% of the gross value of estates. Similarly estates with half of the assets representing business assets accounted for 4.1% of estates' gross values.⁽¹⁹⁾ Thus, it is clear that if the main motive for repealing the estate tax or reducing rates across-the-board were to assist farms and small businesses, most of the revenue loss would accrue to those outside the target group.

How Many Farm and Small Business Decedents Pay the Tax? The more difficult question to answer is how many decedent farmers and small family business owners pay the tax. The first step in answering this question is to estimate the number of farmers and business owners (or those with farm and business assets) who die in any given year. We chose 1998 as our base year.

About 2.3 million people over the age of 14 died in the United States in 1998. Some portion were farm and business owners. To estimate the number of those who died that were farm or business owners, we assume that the distribution of income tax filers roughly approximates the distribution of deaths in any given year. Or, the portion of farm individual income tax returns to total income tax returns in 1998 approximates the number farm deaths to total deaths. The same logic is used to approximate the number of business owner deaths. (Note that farmers tend to be older than other occupational groups and have somewhat higher death rates, which may slightly overstate our estimates of the share of farmer estates with tax).

In 1998, there were 125 million individual income tax returns filed; about 2 million were classified as farm returns and 17 million included business income or loss. These returns represent 1.7% and 13.7% of all returns respectively. If the profile of individual income tax return filers is similar to the profile of decedents, this implies approximately 38,000 farmers and 315,000 business owners died in 1998.⁽²⁰⁾

Recall that the estate tax return data include 2,897 returns with farm assets and 13,904 returns we classify as business returns. Dividing these two numbers by the estimated number of deaths for each vocation yields an taxable estate tax return rate of 7.5% for farm owner decedents and 4.4% for business owner decedents. Thus, one can conclude that most farmers and business owners are unlikely to encounter estate tax liability.

Additional Issues. The estimated estate tax return filing rates calculated above seem to indicate that the estate and gift tax, though affecting many farms and small businesses, should not lead to "...51% of businesses [having] difficulty surviving in the event of principal owner's death"⁽²¹⁾ as suggested earlier. The three special rules for farms and small businesses would further reduce the probability of the estate and gift tax inducing premature closure of a farm or family business. Specifically, the 5 year deferment coupled with the 10 year installment payment plan allows the taxable farm or small business estate 15 years to settle its tax liability.

In addition, liquidity constraints or the inability of farms and small business to meet their tax liability with cash, may not be widespread. A recent National Bureau of Economic Research (NBER) paper using 1992 data estimated that 41% of business owners could pay estate and gift taxes solely out of narrowly defined liquid assets (insurance proceeds, cash and bank accounts); if stocks (equities) were included in a business's liquid assets, an estimated 54% could cover their estate and gift tax liability; if bonds are included an estimated 58% could cover their tax.⁽²²⁾ These estimates suggest that only 3 to 4% of family farms and businesses would potentially be at risk even without accounting for the special exemptions; the special exemption suggests a much smaller number would be at risk.⁽²³⁾ If one included other non-business assets that are either not included in these estimates through lack of data (such as pensions) or nonfinancial assets (such as real estate) the estimate would be even higher. For many businesses a partial sale of assets (e.g. a portion of farm land) might be made or business assets could be used as security for loans to pay the tax. Finally, some estates may wish to liquidate the business because no heir wishes to continue it. Given these studies and analysis, it appears that only a tiny fraction, almost certainly no more than a percent or so, of heirs of business owners and farmers would be at risk of being forced to liquidate the family business to pay estate and gift taxes.

One of the most important deductions from the estate tax is the unlimited marital deduction, which accounted for 30% of the gross value of all estates, and close to 40% for larger estates (larger estates may be more likely to reflect the death of the first spouse). An individual can leave his or her entire estate to a surviving spouse without paying any tax and getting step-up in basis (which permits no tax on accrued gains) besides. The arguments for an unlimited marital deduction are obvious: since spouses tend to be relatively close in age, taxing wealth transferred between spouses amounts to a "double tax" in a generation and also discourages the adequate provision for the surviving spouse (although this latter objective could be met with a large, but not necessarily unlimited, marital deduction). (There is, however, a partial credit for prior transfers within a decade which could mitigate this double taxation within a generation.) Moreover, without an exclusion for assets transferred to the spouse, a substantial amount of planning early in the married couple's life (e.g. allowing for joint ownership of assets) could make a substantial difference in the estate tax liability.

Nevertheless, the unlimited marital deduction causes a certain amount of distortion. If a spouse leaves all assets to the surviving spouse, he or she forgoes the unified credit, equivalent to an exclusion that is currently $675,000 and will eventually reach $1 million. In addition, because the estate tax is graduated, leaving all assets to a spouse can cause the couple to lose the advantage of going through the lower rate brackets twice. A very wealthy donor would leave enough to children (or to the ultimate beneficiary after the second spouse's death) to cover the exemption and to go through all of the rate brackets; then when the second spouse dies, another exemption and another "walk through the rate brackets" will be available. Donors can try to avoid the loss of these benefits and still provide for the surviving spouse by setting up trusts to allow lifetime income to the spouse and perhaps provide for invasion of the corpus for emergencies. These methods, of course, require pre-planning and may not be perfect substitutes for simply leaving assets to the surviving spouse, who would not have complete control.

Under other circumstances, the unlimited marital deduction can cause a decedent to leave more wealth to his or her spouse than would otherwise be preferable. For example, a decedent with children from a previous marriage might like to leave more assets to the children but the unlimited marital deduction may make it more attractive to leave assets to a spouse. One way of dealing with this problem is to leave a lifetime interest to the spouse and direct the disposal of the corpus of the trust to children. Indeed, the tax law facilitates this approach by allowing a trust called a Qualified Terminable Interest Property (QTIP) trust. Nevertheless, this approach also requires planning and is not a perfect substitute for directly leaving assets to children (particularly if the spouse has a long prospective life).

The point is that these provisions, whether deemed desirable or undesirable, distorts the choices of a decedent and cause more resources to be devoted to estate planning than would otherwise be the case.

Capital Gains. One reason frequently cited by tax analysts for retaining an estate tax is that the tax acts as a back-up for a source of leakage in the individual income tax - the failure to tax capital gains passed on at death. Normally, a capital gains tax applies on the difference between the sales price of an asset and the cost of acquiring it (this cost is referred to as the basis). Under current law, accumulated capital gains on an asset held until death will never be subject to the capital gains tax because the heirs will treat the market value at time of death (rather than original cost) as their basis. Assuming market values are estimated correctly, if heirs immediately sold these assets, no tax would be due. This treatment is referred to as "step-up in basis." It is estimated that 50% or more of gains escape taxes through step-up.⁽²⁴⁾

The estate and gift tax is not a carefully designed back-up for the capital gains tax. It allows no deduction for original cost basis, it has large exemptions which may exclude much of capital gains from the tax in any case (including the unlimited marital deduction), and the tax rates vary from those that would be imposed on capital gains if realized. In particular, estate tax rates can be much larger than those imposed on capital gains (the current capital gains tax is capped at 20%, while the maximum marginal estate tax rate is 55%).

If the capital gains tax were the primary reason for retaining an estate and gift tax, then the tax could be restructured to impose capital gains taxes on a constructive realization basis. Alternatively, one could adopt a carry-over of basis, so that the basis remained the original cost, although this proposal could still allow an indefinite deferral of gain.

Owner-Occupied Housing and Other Assets. Owner occupied housing also escapes income tax on both capital gains (for the most part) and implicit rental income. There are practical economic and administrative reasons for some of these tax rules. It is administratively difficult to tax implicit rental income and taxing capital gains would potentially impede labor mobility. There are other assets as well that escape the income tax (such as tax exempt bonds). The estate and gift tax could also be seen as a backstop for these lapses in the individual income tax.

One group that benefits from the presence of an estate and gift tax is the non-profit sector, since charitable contributions can be given or bequeathed without paying tax. As shown in table 1, over 6% of assets of those filing estate tax returns are left to charities; 15% of the assets of the highest wealth class are left to charity. Although one recent study found that charitable bequests are very responsive to the estate tax, and indeed that the charitable deduction is "target efficient" in the sense that it induces more charitable contributions than it loses in revenue, other studies have found a variety of responses, both small and large.⁽²⁵⁾ One problem with these types of studies is the difficulty in separating wealth and price effects.

An individual would have even greater tax benefits if charitable contributions were made during the lifetime, since they are deductible for purposes of the income tax, thereby reducing not only income tax but also, because the eventual estate is reduced, the estate tax as well. On the other hand, under the income tax charitable gifts are limited to 50% of income (30% for private foundations) and there are also restrictions on the ability to deduct appreciated property at full value. Despite this effect, a significant amount of charitable giving occurs through bequests and one study estimated that total charitable giving through bequests would fall by 12% if the estate tax were eliminated.⁽²⁶⁾ This reduction is, however, less than 1% of total charitable contributions.⁽²⁷⁾

Charitable deductions play a role in some estate planning techniques described in the next section. In addition, some charitable deductions allow considerable retention of control by the heirs, as in the case of private foundations. Unlike the case of the income tax, there are no special restrictions on bequests to private foundations. (Under the income tax system, deductibility as a percent of income is more limited for gifts to foundations; there are also more limitations on gifts of appreciated property to foundations).

There are a number of tax-planning and tax avoidance techniques that take advantage of the annual gift exclusion, the charitable deduction, the unlimited marital deduction, and issues of valuation. Because choices made with respect to these techniques can affect total tax liability, these planning techniques complicate compliance on the part of the taxpayer and administration on the part of the IRS. They may also induce individuals to arrange their affairs in ways that would not otherwise be desirable, resulting in distortions of economic behavior.

The most straightforward method of reducing estate and gift taxes is to transfer assets as gifts during the lifetime (inter-vivos transfers) rather than bequests. Gifts are generally subject to lower taxes for two reasons. First, assets can be transferred without affecting the unified credit because of the $10,000 annual exclusion. The exclusion was designed to permit gifts (such as wedding and Christmas presents) without involving the complication of the gift tax. This annual exclusion can, however, allow very large lifetime gifts. For example, a couple with two children, who are both married, could make $80,000 of tax free gifts per year (each spouse could give $10,000 to each child and the child's spouse). Over 10 years, $800,000 could be transferred tax free (and without reducing the lifetime credit). Moreover, the estate is further reduced by the appreciation on these assets.

The effective gift tax is also lower than the estate tax because it is imposed on a tax-exclusive basis rather than a tax-inclusive basis. (If the tax rate is 50%, a gift of $100,000 can be given with a $50,000 gift tax, for an out-of-pocket total cost of $150,000. However, the estate tax on the total outlay of $150,000 would be 50% of the total, or $75,000). Despite these significant advantages, especially from the annual exclusion, relatively little inter-vivos giving occurs.⁽²⁸⁾ There are a number of possible reasons for this failure to take advantage of the gift exclusion, and one is that the donee does not wish to relinquish economic control or perhaps provide assets to children before they are deemed to have sufficient maturity to handle them. There are certain trust and other devices that have been developed to allow some control to be maintained while utilizing the annual gift tax exclusion.⁽²⁹⁾ The annual gift exclusion can also be used to shift the ownership of insurance policies away from the person whose life is insured and out of the gross estate.

One particular method which allows a potentially large amount of estate tax avoidance is a Crummey trust. Normally, gifts placed in a trust are not eligible for the $10,000 exclusion, unless the trust allows a present interest by the beneficiary. The courts have held that contributions to a trust that allows the beneficiary withdrawal rights, even if the individual is a minor, and even if withdrawal rights are available for only a brief period (e.g. 15 or 30 days), can be treated as gifts eligible for the annual exclusion. This rule has been used to remove insurance assets from an estate (by placing them in a trust and using the annual $10,000 gift exclusion to pay the premiums without incurring tax). Under the Crummey trust, a large number of individuals (who may be children or other relatives of the primary beneficiaries) can be given the right (a right not usually exercised) to withdraw up to $10,000 over the limited time period. (Under lapse of power rules, however, this amount is sometimes limited to $5,000). All of these individuals are not necessarily primary beneficiaries of the trust but they expand the gift exclusion aggregate. In one case, a Crummey trust with 35 donees was reported.⁽³⁰⁾

There is, however, one disadvantage of inter vivos gifts: these gifts do not benefit from the step-up in basis at death that allows capital gains to go unrecognized, so that very wealthy families with assets with large unrealized gains might prefer bequests (at least after the annual exclusion is used up).⁽³¹⁾

Individuals can also avoid taxes by skipping generations; although there is a generation skipping tax, there are large exemptions from the tax ($1 million per decedent). Generation skipping may be accomplished through a direct skip (a decedent leaves assets to grandchildren rather than children) or an indirect skip (assets are left in a trust with income rights to children, and the corpus passing to the grandchildren on the children's death). The generation skipping tax rate is 55%. Relatively little revenue has been collected from the generation skipping tax because the tax has been successful in eliminating generation skipping transfers that are above the limit.⁽³²⁾

Charitable deductions can also be used to avoid estate and gift taxes (and income taxes as well). For example, if a charity can be given rights to an asset during a fixed period (through a fixed annuity, or a fixed percentage of the asset's value), with the remainder going to the donor's children or other heirs, estate taxes can be avoided if the period of the trust is overstated (by being based on a particular individual life that is likely to be shorter than the actuarial life). Although restrictions have now been applied to limit reference persons to related parties, in the past so-called "vulture trusts" that recruited a completely unrelated person with a diminished life expectancy were used to avoid tax. ⁽³³⁾

Assets can also be transferred to charity while maintaining control through private foundations. Private foundations allow an individual or his or her heirs to direct the disposition of funds in the foundations for charitable purposes and continue to exercise power and control over the assets.

As noted earlier, some estate planning techniques are used to provide maximum benefits of the marital deduction plus the exclusion and lower rates; these approaches can also involve the use of trusts, such as the Qualified Terminable Interest Property (QTIP). These plans may permit the invasion of the corpus for emergency reasons.

Finally, a significant way of reducing estate taxes is to reduce the valuation of assets. A lower valuation can be achieved by transferring assets into a family partnership with many interests so that one party is not technically able to sell at a "market price" without agreement from the other owners to sell, a circumstance that the courts have seen as lowering the value of even obviously marketable assets, such as publicly traded stocks (the minority interest discount). Undervaluation can also be argued through the claim that a sale of a large block of stock (a "fire sale") would reduce asset value or, with a family-owned business, that the death of the owner (or a "key man") lowers the value substantially. A fractional interest in a property (such as real estate) may also qualify for a discount. Discounts may also be allowed for special use property whose market value may be higher than the value of the property in its current use.

Estate planning techniques complicate the tax law, increase the resources in the economy devoted to planning and also increase the administrative burden on the IRS especially when such cases go to court. Some claims have been made that the administrative costs and costs to taxpayers comprise a large part of the revenues. However, a recent study set the costs of complying with the estate tax at 6 to 9% of revenues. Moreover, an interesting argument was also made in that study that the inducement to settle affairs provided by the existence of an estate tax may be beneficial as it encourages individuals to get their affairs in order and avoid costly and difficult disputes among heirs.⁽³⁴⁾

Of course, the administrative and compliance costs are, themselves, in part a consequence of the design of the tax. If the estate tax were revised to mitigate some of the need for tax planning, the administrative and compliance costs might be lower.

The high tax rates for some estates and the lack of third-party reporting mechanisms suggest that compliance may be a problem, although a large fraction of returns with large estates are audited. Estimates of the estate "tax gap," or the fraction of revenues that are not collected, have varied considerably; a recent estimate suggests about 13% of estates and gift taxes are not collected, although the authors suggest that this measure is very difficult to estimate.⁽³⁵⁾

The credit for state estate or inheritance taxes was introduced to discourage states from luring wealthy taxpayers to their state to die.⁽³⁶⁾ In theory, the federal credit for state taxes eliminates the incentive for states to "race to the bottom" of estate tax rates and burden. Lower state liability simply increases federal liability by an equal amount. Thus, the estate still pays the same amount in taxes. In short, the state credit is simply a federal transfer to states contingent upon the state's maintenance of an estate tax.

The credit also reduces the federal tax burden of the estate and gift tax. The highest credit rate is 16% of the gross estate value which reduces the highest federal rate of 55% to 39%. The relationship between the federal rate-before and after the credit is imposed-is simulated in the chart below. The difference between the two lines represents state inheritance tax credit or the transfer to state governments from the federal government by size of estate.

The relationship between state and federal estate taxes is important for considering many policy options. For example, changing the unified credit to an exemption would lower the tax burden on estates at the expense of state inheritance taxes. In our example provided earlier, the estate tax due is $23,450 lower under an exemption regime. Switching to the exemption regime would have a similar effect on all estates. The lower estate tax occurs with the exemption because the first increments are taxed at 18%, 20%, 22%, etc. Basically, the credit mechanism means that tax rates applied on the first $675,000 (from 18% to 37%) are irrelevant. A numerical example of the effect on the estate is included in the expanded numerical example below.

¹ This calculation assumes that the state has adopted the federal credit schedule as its estate tax mechanism.

The response of states to a switch from a credit to an exemption is uncertain. States may do nothing and allow the base of their estate tax and the resulting revenues to decline. In which case, all estates will be better off though the effective rate of the federal burden will actually increase because the state credit is worth less. The lower estate tax burden is derived from the lower state collections.

On the other hand, states may adjust their estate taxes to compensate for the change in federal law.⁽³⁷⁾ In this case, the federal estate and gift tax burden is lower, however, the state burden is unchanged. As a portion of total state and federal estate tax burden, the states would collect a much greater share than prior to the change.

Repeal of the federal estate tax also implies repeal of the federal credit for the state estate and inheritance taxes. If states collect their estate tax only when a federal credit exists for those taxes, then their estate and gift taxes will also be repealed. Again, the response of states to repeal of the federal estate and gift tax is uncertain.

One option is to eliminate the estate tax or to reduce estate tax rates. This approach has been taken in two bills passed by the House: H.R. 8, which would phase out the estate tax, and H.R. 3081, which would reduce the estate tax rates. The Democratic substitute considered in the House would have reduced the rates by 20%. According to the Congressional Budget Office, estate tax revenues will rise from $30 billion in FY2000 to $47.8 billion in 2010, for a 5- year revenue yield of $172.7 billion and a 10 year revenue yield of $385.5 billion. Because of the slow phase out in H.R. 8 its five and 10 year costs are only $28.3 billion and $104.7 billion. These savings, however, will be only temporary.

Some proposals would further increase the credit (e.g. the Democratic alternative to the 106th's H.R. 8 would have immediately increased the exemption to $1.1 million, and to $1.2 million in 2006). Another option would be to convert the credit to an exemption. The latter approach would also have the effect of reducing the estate tax rates, since the rate structure under an exemption would begin at the lowest rate (18%) rather than the rate at which the estate tax credit ends (37%). Note, however, that the conversion of a credit to an exemption, while reducing aggregate taxes, could actually slightly increase the net federal tax by dramatically reducing the state tax credit, unless revisions were also simultaneously made in the computation of the state credit. Another alternative is to index either the credit or an exemption replacement, for inflation.

Increasing the exemption favors individuals with less wealth compared to rate reductions with the same revenue cost. Indexing exemptions would preserve the value of the exemption against erosion by inflation.

Taxing Capital Gains at Death or Providing Carry-over Basis As a Substitute for the Estate Tax

Some authors have proposed that the estate and gift tax be replaced by taxing capital gains at death. Taxing capital gains at death would yield about $25 billion of revenue according to tax expenditure estimates for FY2001.⁽³⁸⁾ This yield is smaller than the current estate tax collections of about $30 billion. The distribution of tax burdens would also be different. Because of the estate tax exemptions coupled with relatively high marginal tax rates, very wealthy taxpayers would pay more under the estate tax while less wealthy individuals would pay more under the capital gains tax.⁽³⁹⁾ Of course, the burden on the less wealthy individuals could be lessened if exemptions still apply.

An alternative to taxing capital gains at death is to maintain carry-over basis. That is, heirs would have to pay the tax if and when they sold the assets. Carryover basis was included in H.R. 8, the bill repealing the estate and gift tax over 10 years, but an exemption for the first $1.3 million was allowed along with an additional $3 million exclusion for the surviving spouse.

The Congressional Budget Office includes estimates of proposals for both constructive realization and carryover in its budget options (these estimates will also be referred to subsequently in discussions of policy options).⁽⁴⁰⁾ The constructive realization provision would gain about $9 to $10 billion a year ($78.5 billion over 10 years from FY2001-FY2010), assuming an exclusion for gains left to a spouse, to charity, and special provisions to defer gains on family businesses, allow an exclusion for personal residences, and an exclusion for small gains on personal property. Carryover basis would raise $1 to $4 billion annually in the first few years, with a total of $47.8 billion over 10 years. This provision would allow a safe harbor basis option of 50% of fair market value. Thus, these alternatives would not raise as much revenue as the current estate tax: constructive realization would yield about 20% of estate and gift tax revenues, and carryover basis would yield about 12%. The revenue gains would be even smaller if some flat exemption were allowed.

There are efficiency gains to taxing capital gains at death, since such taxation would reduce some of the lock-in effect. That is, some taxpayers hold on to their assets because the tax on gain will be entirely forgiven if left to heirs. However, carryover basis could have ambiguous effects on lock-in. It would reduce the lock-in effect for those who are concerned about leaving assets to heirs, but increase the lock-in effect on the heirs.

Both taxation of gains at death and carry-over basis may be complicated by lack of information by the executor on the basis of assets (some of which may have been originally inherited by the decedent). Indeed, a proposal in the seventies to provide carry-over basis was never put into place because of protests, some associated with the problem of determining the basis. This problem may be less serious for H.R. 8 because of a significant exemption from the carry-over of basis rule. It would also be possible to adopt some sort of safe harbor basis.

Allowing constructive realization or carryover basis could further complicate estate planning if an exemption were allowed, because it would be advantageous to pick those assets with the largest amounts of appreciation for the exclusion or carryover basis. In addition, since the tax arising from carryover basis would depend on the heir's income tax rates, revenues could be saved by allocating appreciated assets to heirs with the lowest expected tax rates.

Farms and family businesses could receive further relief by increases in the special exemptions. For example, the Democratic substitute for H.R. 8 would have increased the total $1.3 million exemption to $2 million. Because of the distribution of estates across asset types almost all decedents with significant farm or business asset shares would be excluded from the tax. Other bills have proposed to increase the exemption for these assets or exempt all such assets from the tax.

While this approach would be effective at targeting the farm and family business issue, it exacerbates a concern that already exists in the estate and gift tax area - the unfairness of a differential treatment of owners of these business and farm assets compared to those with other forms of assets. Why should a wealthy individual whose assets are in a closely held corporation escape estate and gift tax on his or her assets, while an individual who holds shares in a publicly traded corporation pay a tax? These discrepancies are potentially exacerbated by the significant valuation discounts that may be given to these types of assets.

Larger exemptions also encourage wealthy decedents to convert other property into business or farm property to take advantage of the special exemptions. An incentive already exists to shift property into this exempt form and it would be exacerbated by an expansion of the exemption.

An alternative is to extend the deferment period for the payment of taxes on farms and family businesses, which, while not as generous as an increased exemption also does not violate horizontal equity between owners of these assets and other assets as much.

Revisions to Reduce Avoidance, Simplify Estate Planning, Or Make Other Structural Changes

Clinton Administration Proposals. Most of the Clinton Administration proposals would have been revisions aimed at estate tax avoidance or at current inconsistencies in the estate tax law and they will be discussed briefly, as a package. They included the following proposals with 10 year revenue estimates (FY2001-FY2010) prepared by the Administration also provided (in parentheses).⁽⁴¹⁾ Note that all of these revisions are relatively small compared to the predicted revenue yield of the estate tax of $385.5 billion; the largest, relating to valuation discounts, amounts to only 1.5% of the estate and gift tax yield.

(1) Phase out of unified credit. This provision would allow for a phase out of the unified credit as well as the lower rates, by extending the bubble. This provision would cause very large estates to be taxed at the flat rate of 55 percent. ($1,105 million).

(2) Consistent valuation. The Administration has proposed that valuation of assets be the same for income tax purposes as for estate tax purposes. Basically, it is advantageous for valuation to be high for purposes of the income tax, so as to minimize any future capital gains, while it is advantageous for valuation to be low for estate tax purposes to reduce estate tax. In addition to requiring consistency in valuation for both purposes, the Administration has also proposed that the donor report the basis of assets transferred by gift to the donor (currently, assets transferred by gift and then sold do not benefit from step-up in basis, but the donor is not required to report the basis to the donee). ($216 million).

(3) Allocation of basis. Under current law, a transaction that is part gift and part sale assigns a basis to the asset for the donee that is the larger of the fair market value or the amount actually paid. The donor pays a tax on the difference between amount paid and his basis and may frequently recognize no gain. The Administration proposal would allocate basis proportionally to the gift and sale portions.⁽⁴²⁾ ($55 million).

(4) Eliminate stepped up basis on survivor's share of community property. Under present law, in the case of common law states, one half of property held jointly by a married couple is included in the first decedent's gross estate and that one half is thus eligible for step-up in basis for purposes of future capital gains. In the case of a community property state, however, where all properties acquired during marriage are deemed community property, a step up in basis is available for all community property, not just the half that is allocated to the decedent spouse. The reason for this rule, which is quite old, was the presumption in the past that property in a common law state would have been held by the husband (who would have acquired it) and thus would all have been eligible for step-up, while only one half of property in community property states would have been deemed to be held by the husband and be eligible for step up. This older treatment, it is argued, was made obsolete by changes in 1981 that determined that only half of any jointly held property would be included in the estate regardless of how the property was acquired, and thus made the step up apply to only one half of this type of property. Thus, currently couples in community property states are being treated more favorably than those in common law states. ($1,054 million).

A reservation with this treatment is that property that could be allocated to one spouse in a common law state may not be able to escape the community property treatment in a community property states, and common law states may now be favored if these assets in common law states tend to be held by the first decedent. However, couples in community property states may be able to convert to separate property by agreement, and thereby take advantage of the same planning opportunities as those in common law states.

(5) QTIP Rules. Under present law, an individual may obtain a marital deduction for amounts left in trust to a spouse under a Qualified Terminable Interest Property (QTIP) trust, with one requirement being that the second spouse must then include the trust amounts in their own estate. In some cases the second estate has argued that there is a defect in the trust arrangement so that the trust amount is not included in the second spouse's estate (even though a deduction was allowed for it in the first spouse's estate). This provision would require inclusion in the second spouse's estate for any amount excluded in the first spouse's estate. ($18 million).

(6) Eliminate non-business valuation discounts. This provision would require that marketable assets be valued at the fair market value; i.e. there would be no valuation discounts for holding assets in a family partnership or for "fire-sale" dispositions. ($6,140 million).

(7) Eliminate the exception for a retained interest in personal residences from gift tax rules. Under current law, when a gift is made but the grantor retains an interest, that retained interest is valued at zero (making the size of the gift and the gift tax larger). In the case of a personal residence, however, the retained interest is valued based on actuarial tables. In general, retained interests are only allowed to be deducted from the fair market of the gift (reducing gift taxes) if they can be objectively valued (and hence are allowed for certain types of trusts, such as those that pay an annuity). The Administration makes the argument that rental value of residences cannot be easily valued because the user often remains responsible for upkeep and maintenance. ($408 million).

(8) Disallowance of annual gift taxes in a Crummey Trust. As noted earlier, the annual gift exclusion is not available for gifts placed in trust unless certain rules are met, but a Crummey trust which allows some right of withdrawal is eligible. This revision would allow gifts in trust to be deductible only if the only beneficiary is the individual, and if the trust does not terminate before the individual dies, the assets will be in the beneficiary's estate. These rules are similar to generation skipping taxes. ($208 million).

Some of the revisions discussed in the following sections have some elements of the Administration's proposal, but in most cases the Administration provisions are more narrowly focused.

Reducing the Annual Gift Tax Exclusion. The annual gift tax exclusion allows significant amounts to be transferred free of tax and also plays a role in transferring insurance out of the estate (by using the annual gift tax exclusion to pay the premium). While some gift tax exclusion is probably desirable for simplification purposes, the $10,000 exclusion's role in estate tax avoidance could be reduced by reducing its size. An alternative change that would limit the use of the annual exclusion in tax avoidance approaches would be a single exclusion per donor (or some aggregate limit per donor), to prevent the multiplication of the excluded amount by gifts to several children and those children's spouses and the use of techniques such as the Crummey trust.

Allowing Inheritance of Marital Deductions or Lower Rates. One of the complications of estate planning is maximizing the use of the exemption and lower rate brackets by a married couple. In this case, while it may be economically and personally desirable to pass the entire estate (or most of the estate) to the surviving spouse, minimizing taxes would require passing to others at least the exemption amount and perhaps more to take some advantage as well of the lower rate brackets. Such complex situations could be avoided by allowing the surviving spouse to inherit any unused deduction and lower rate brackets so that the couple's full deductions and lower rates could be utilized regardless of how much was left to the surviving spouse. This treatment is referred to as portability, and has also been proposed in the recent Democratic alternative for the increased exemption for family farms and businesses considered in June (when H.R. 8 was passed by the House).⁽⁴³⁾

Allowing Gift Tax Treatment Only on Final and Actual Transfer. Many of the tax avoidance techniques with charitable gifts involve over-valuation of a deductible interest. For example, a gift may be made of the remainder interest after an annuity has been provided to a charitable organization . The larger the value of the charitable annuity, the smaller the value of the gift (and the gift tax). One way to over-value an annuity is to allow the annuity to extend to a particular individual's lifetime, when that individual has a shorter life than the actuarial tables indicate. Similarly, a way to transfer income via the gift tax exclusion without the recipient having control over it is to place it in a Crummey trust. Even if the individual is able to exercise withdrawal rights, the expectation of not receiving future gifts if the assets are withdrawn in violation of the donor's wishes may mean that such rights will never be exercised. A rule that excludes all assets placed in trusts from consideration for the gift tax would eliminate this mechanism.

These types of valuation techniques could be addressed by only allowing the gift tax to be imposed at the time of the actual final transfer. In such a case, no actuarial valuation would be necessary and no trust mechanisms would be available.

Valuation of Assets. One option is to disallow discounts for property that has a market value (such as bonds, publicly traded stock and similar assets) regardless of the form the asset is held in, as suggested by the administration tax proposals. Eliminating valuation discounts on holdings of non-business assets was also part of the Democratic alternative to H.R. 8. Such a change would prevent the avoidance technique of placing assets into a family partnership or similar arrangement and then arguing that the property has lost market value because it would require agreement of the heirs to sell it. The Democratic alternative to H.R. also disallowed minority discounts for business assets if people in the same family have voting control. In addition to these revisions in the Administration proposals or in the Democratic alternative to H.R. 8, other limits on valuation discounts could be imposed. For example, blockage discounts based on "fire sale" arguments could be disallowed. Such a provision might allow for an adjustment if the property is immediately sold at such a lower price.

The Congressional Budget Office estimated that eliminating non-business valuation discounts would raise about $0.7 billion a year, and thus about $7 billion over 10 years; the Administration estimated $6 billion over 10 years for its proposal.

Including Life Insurance Proceeds in the Base. Some tax avoidance techniques are associated with shifting life insurance proceeds out of the estate by shifting to another owner. The Congressional Budget Office has estimated that this change would raise $0.5 billion per year, or about $5 billion over 10 years.

Changing the State Tax Credit to a Deduction. In the case of the income tax, state and local income taxes are deducted (and then only if the taxpayer itemizes deductions). In the case of the estate and gift tax, there is a dollar for dollar credit, which is effectively a form of revenue sharing in most cases. According to the CBO study, changing that credit to a deduction would raise about $5 billion a year, and $10 billion over 10 years.

Switching to an Inheritance Tax. Some authors have suggested that an inheritance tax should be substituted for the estate tax. Some states have inheritance taxes. An estate tax applies to the total assets left by the decedent. An inheritance tax would be applied separately to assets received by each of the heirs. If tax rates are progressive, smaller taxes would be applied the greater the number of beneficiaries of the assets. One reason for such a change would, therefore, be to encourage more dispersion of wealth among heirs, since taxes would be lower (assuming exemptions and graduated rates) if split among more recipients. In addition, under an inheritance tax the tax rate can be varied according to the status of the heir (son vs. cousin, for example). At the same time, one can see more avoidance complications arising from an inheritance tax.

The analysis in this study has suggested that some of the arguments used for and against the estate tax may be questioned or of lesser import than is popularly assumed. For example, there is little evidence that the estate tax has much effect on savings (and therefore on output); indeed, estate taxes could easily increase rather than reduce savings. Similarly, only a tiny fraction of farms and small businesses face the estate and gift tax and it has been estimated that the majority of those who do have sufficient non-business assets to pay the tax. Moreover, only a small potion of the estate tax is collected from these family owned farms and small businesses, so that dramatically reducing estate tax rates or eliminating the tax for the purpose of helping these family businesses is not very target efficient.

While the estate tax does contribute to the progressivity of the tax system, this progressivity is undermined, to an undetermined degree, by certain estate tax avoidance techniques. Of course, one alternative is to broaden the estate tax base by restricting some of these estate planning techniques. At the same time progressivity could be achieved by other methods.

On the other hand, arguments that the estate tax is a back-up for the income escaping the capital gains tax, would not support the current high rates of the estate tax, which should be lowered to 20% or less to serve this purpose.

More intangible arguments, such as the argument that inheritances are windfalls that should be taxed at higher rates on the one hand, or that death is an undesirable time to levy a tax and that transferred assets have already been subject to taxes, are more difficult to assess but remain important issues in the determination of the desirability of estate and gift taxes.

Source: IRS, Statistics of Income, Internet published data, Table 1 and author's calculations.

Taxable Estate Value From	to	Current Statutory Rate (in Percent)
$0	$10,000	18
$10,001	$20,000	20
$20,001	$40,000	22
$40,001	$60,000	24
$60,001	$80,000	26
$80,001	$100,000	28
$100,001	$150,000	30
$150,001	$250,000	32
$250,001	$500,000	34
$500,001	$750,000	37
$750,001	$1,000,000	39
$1,000,001	$1,250,000	41
$1,250,001	$1,500,000	43
$1,500,001	$2,000,000	45
$2,000,001	$2,500,000	49
$2,500,001	$3,000,000	53
$3,000,001	$10,000,000	55
$10,000,000	$17,184,000	55+5
$17,184,000	and over	55

Taxable Estate Value (less the $60,000 exemption)	to	Current Statutory Credit Rate (in Percent)
$0	$40,000	0
$40,001	$90,000	.8
$90,001	$140,000	1.6
$140,001	$240,000	2.4
$240,001	$440,000	3.2
$440,001	$640,000	4.0
$640,001	$840,000	4.8
$840,001	$1,040,000	5.6
$1,040,001	$1,540,000	6.4
$1,540,001	$2,040,000	7.2
$2,040,001	$2,540,000	8.0
$2,540,001	$3,040,000	8.8
$3,040,001	$3,540,000	9.6
$3,540,001	$4,040,000	10.4
$4,040,001	$5,040,000	11.2
$5,040,001	$6,040,000	12.0
$6,040,001	$7,040,000	12.8
$7,040,001	$8,040,000	13.6
$8,040,001	$9,040,000	14.4
$9,040,001	$10,040,000	15.2
$10,040,001	and over	16.0

1. ^(back)For a discussion of this bill see CRS Report RS20592, Estate Tax Legislation: A Description of H.R. 8, by Nonna A. Noto.

2. ^(back)See the Bills entry in the CRS Taxation electronic briefing book for a variety of bills that have been introduced (http://www.congress.gov/brbk/html/ebtxr33.html).

3. ^(back)Possible consequences that have been discussed include concentrations of political power, inefficient investments by the very wealthy, and disincentives to work by heirs (often referred to as the Carnegie conjecture, reflecting a claim argued by Andrew Carnegie).

4. ^(back)For a history of the estate and gift tax as well as a detailed explanation of current law, see the following CRS reports by John R. Luckey: Federal Estate, Gift, and Generation-Skipping Taxes: A Description of Current Law, 95-416, updated May 11, 1999; and A History of Federal Estate, Gift, and Generation-Skipping Taxes, 95-444, updated May 10, 1999. See also David Joulfaian, The Federal Estate and Gift Tax: Description, Profile of Taxpayers and Economic Consequences, U.S. Treasury Department Office of Tax Analysis Paper 80, December 1998, for an overview of the tax and associated issues.

6. ^(back)We have dropped the modifier "adjusted" from taxable estate for the benefit of the reader. The taxable estate and the adjusted taxable estate are identical in the absence of taxable gifts.

7. ^(back)This is slightly greater than the tentative estate tax less credits because of rounding.

10. ^(back)The 2% is applied to: the estate tax due on the sum of $1 million in estate business assets (the $1 million is indexed for inflation after 1998) and the applicable exclusion amount for the return year. So, in 1999, the indexed amount was $1,010,000 and the applicable exclusion was $650,000. The sum of these two numbers, $1,660,000, is then run through the estate tax rate schedule to yield a tentative tax of $627,800. The applicable credit in 1999 was $211,300 which leaves $416,500 to multiply by the 2% interest. The result: $8,330 in annual interest cost.

12. ^(back) Douglas Holtz-Eakin, David Joulfaian, and Harvey S. Rosen, The Carnegie Conjecture: Some Empirical Evidence, Quarterly Journal of Economics, vol. 108, May 1993, pp. 413-435 found some evidence that large inheritances reduce labor supply of the recipients.

13. ^(back)See Robert J. Barro. Inequality, Growth and Investment. National Bureau of Economic Research Working Paper 7038, March 1999.

14. ^(back)William G. Gale and Maria G. Perozek. Do Estate Taxes Reduce Savings? April 2000. Presented at a Conference on Estate and Gift Taxes sponsored by the Office of Tax Policy Research, University of Michigan, and the Brookings Institution, May 4-5, 2000.

15. ^(back)Wojciech Kopczuk and Joel Slemrod, The Impact of the Estate Tax on the Wealth Accumulation and Avoidance Behavior of Donors. April 17, 2000. Presented at a Conference on Estate and Gift Taxes sponsored by the Office of Tax Policy Research, University of Michigan, and the Brookings Institution, May 4-5, 2000.

16. ^(back)Interest elasticities have generally been estimated at no higher than 0.4; that is, a one percent increase in the rate of return would increase savings by 0.4 percent. Ignoring the effect on the deficit or assuming the revenue loss is made up by some other tax or spending program that has no effect on private savings, this amount is about 40 percent of the revenue cost, so that savings might initially increase by about $12 billion. Output would increase by this increase times the interest rate, or about $1 billion, which amounts to 1/100 of one percent of output. In the long run, savings would accumulate, and national income might eventually increase by about one tenth of one percent. (This calculation is based on the following: the current revenue cost of $28 billion accounts for about 1.4 percent of capital income of approximately 25 percent of Net National Product; at an elasticity of 0.4, a 1.4 percent increase in income would lead to a 0.56 percent increase in the capital stock and multiplying by the capital share of income (0.25) would lead to an approximate 0.14 increase in the capital stock. This effect would take many years to occur, however, and would be more than offset if the loss were not made up for through some other revenue increase.

17. ^(back)Statement before the Subcommittee on Tax, Finance, and Exports, Committee on Small Business, June 12, 1997.

18. ^(back)A return is classified as a business return if at least one of the following assets is in the estate: closely held stock, limited partnerships, real estate partnership, other non-corporate business assets. Counting the same estate more than once is likely which overstates the number of business estate tax returns.

20. ^(back)The percentages are multiplied by the 2,272,237 deaths of those 15 years old and over.

21. ^(back)Bruce Bartlett in his statement before the Subcommittee on Tax, Finance, and Exports, Committee on Small Business, June 12, 1997.

22. ^(back)Holtz-Eakin, Douglas, John W. Philips, and Harvey S. Rosen, "Estate Taxes, Life Insurance, and Small Business," National Bureau of Economic Research, no. 7360, September 1999, p. 12.

23. ^(back)Of course, if all heirs do not wish to continue ownership in the family business, these liquid assets might need to be used to buy them out; that, however, is a choice made by the heirs and not a forced sale.

24. ^(back) See The Limits to Capital Gains Feedback Effects. Congressional Research Service Report 91-250, March 15, 1991, by Jane G. Gravelle. This study examined accumulated realizations relative to accumulated accruals.

25. ^(back)See David Joulfaian, Estate Taxes and Charitable Bequests by the Wealth, National Bureau of Economic Research Working Paper 7663, April 2000. This paper contains a review of the econometric literature on the charitable response. Note that, in general, a tax incentive induces more spending than it loses in revenue when the elasticity (the percentage change in spending divided by the percentage change in taxes) is greater than one.

27. ^(back)Bruce Bartlett, Misplaced Fears for Generosity, Washington Times, June 26, 2000, p. A16.

28. ^(back) See James Poterba. Estate and Gift Taxes and Incentives for Inter Vivos Giving in the United States, forthcoming Journal of Public Economics. Even at high income levels, Poterba found that only about 45% of households take advantage of lifetime giving. He also found that those with illiquid assets (such as family businesses) and those with large unrealized capital gains are less likely to make inter-vivos gifts.

29. ^(back)For a more complete discussion of this and other techniques, see Richard Schmalbeck, Avoiding Wealth Transfer Taxes, paper presented at the conference Rethinking Estate and Gift Taxation, May 4-5, 2000, Office of Tax Policy Research, University of Michigan, and the Brookings Institution and Charles Davenport and Jay Soled. Enlivening the Death-Tax Death-Talk. Tax Notes, July 26, 1999, pp. 591-629..

31. ^(back)See David Joulfaian, Choosing Between Gifts and Bequests: How Taxes Affect the Timing of Wealth Transfers. U.S. Department of Treasury Office of Tax Analysis Paper 86. May 2000.

32. ^(back)For a description see CRS Report 95-416 (pdf). Federal Estate, Gift, and Generation-Skipping Taxes: a Description of Current Law, by John R. Luckey.

33. ^(back)See Schmalbeck, op cit. The reference individual cannot be terminal (have a life expectancy of less than a year), however.

34. ^(back)See Davenport and Soled, op cit. This study also reviewed a variety of other studies of estate tax compliance costs.

35. ^(back)See Martha Eller, Brian Erard and Chih-Chin Ho, The Magnitude and Determinants of Federal Estate Tax Noncompliance. Presented at the conference on Rethinking Estate and Gift Taxation, May 4-5, 2000, Office of Tax Policy Research, University of Michigan, and the Brookings Institution.

36. ^(back) John R. Luckey: A History of Federal Estate, Gift, and Generation-Skipping Taxes, Congressional Research Service Report 95-444.

37. ^(back)States could simply require estate executors to calculate tax liability based upon pre-exemption gross estate value.

38. ^(back)The Joint Tax Committee estimates a $23.7 billion cost, while the Administration budget documents provide a $25.8 billion cost estimate.

39. ^(back)See James M. Poterba and Scott Weisbenner. The Distributional Burden of Taxing Estates and Unrealized Capital Gains at the Time of Death. Presented at the conference on Rethinking Estate and Gift Taxation, May 4-5, Office of Tax Policy Research and the Brookings Institution.

40. ^(back)Congressional Budget Office, Budget Options, Washington, D.C., U.S. Government Printing Office, March 2000.

41. ^(back)These proposals are discussed in more detail in General Explanations of the Administration's Fiscal Year 2001 Revenue Proposals, Department of Treasury, February 2000, and Description of Revenue Provisions Contained in the President's Fiscal Year 2001 Budget Proposal, Joint Committee on Taxation Print JCS-2-00, March 6, 2000.

42. ^(back)For example, suppose an asset with a basis of $50,000 but a market value of $100,000 is sold to the donee for $50,000. The donor would realize no gain and the gift amount would be $50,000, with the donee having a basis of $50,000. Eventually, the gain would be taxed when the donee sold the property, but that tax would be delayed. However, if the asset were divided into a gift of $50,000 with a basis of $25,000 and a sale of $50,000 with a basis of $50,000, the donor would realize a gain of $25,000; the donee would now have a basis of $75,000. Half of the gain would be subject to tax immediately. (These split rules would not apply in cases where the fair market value is less than basis, i.e. where a loss rather than a gain occurs and it is advantageous to realize the loss earlier.)

43. ^(back)See Jay A. Soled, A Proposal to Make Credit Shelter Trusts Obsolete. 51Tax Lawyer 83 (Fall 1997) for a discussion of making the estate credit portable.

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