Estate and Gift Taxes: Economic Issues

Abstract

The estate and gift tax has been the subject of legislative interest for several years, with increases in the exemption enacted in 1997 and proposals to reduce or eliminate the tax (including H.R. 8 which has been approved by Congress).

Supporters of the estate and gift tax cite its contribution to progressivity in the income tax system and 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.

Our analysis 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 2% or 3%) 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 implications for charitable giving and for state and local estate taxes.

A number of alternative revisions are discussed including proposals to reduce tax rates and exemptions, to reduce the opportunities for tax avoidance and broaden the estate and gift tax base.