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| June 12, 1997 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Presented to the Subcommittee on Tax, Finance, and Exports Committee on Small BusinessStatement by Bruce R. Bartlett Senior Fellow National Center for Policy Analysis |
Thank you for the opportunity to testify today on the subject of the estate and gift tax and its impact on small businesses. The estate and gift tax is the federal government's least significant revenue source. In fiscal year 1997 it is expected to raise just $17 billion, according to the Office of Management and Budget. With total federal revenues estimated at $1.5 trillion, the estate and gift tax contributes just 1.1 percent. However, while the tax is insignificant in terms of federal revenue, it is very significant economically. It wastes resources. It discourages work, saving and investment. And it does virtually nothing to equalize the distribution of wealth. In short, the estate and gift tax is a failure. It should be abolished. The federal estate tax was first enacted in 1916 on estates larger than $50,000 (equivalent to $720,000 today). The top rate was 10 percent. However, the revenue yield from the tax was small because people simply gave away their assets tax-free during their lifetimes. This led to establishment of a gift tax to augment the estate tax in 1924. Since 1976 the estate and gift taxes have been unified into one tax system. Today the tax applies to estates above $600,000. It begins at a rate of 18 percent, going up to 55 percent. This year, just 1.66 percent of adult deaths in the United States are expected to result in taxable estates.1 Table 1
Source: Commerce Clearing HouseA fundamental rationale for the estate tax is that it is paid only by those who can most easily afford it; namely, the rich. However, because of legal estate planning techniques, much less of the tax actually falls on the wealthy than is commonly believed. In 1995, 54 percent of all estate tax revenue came from estates under $5 million. And as Table 2 illustrates, estate taxes as a share of gross estates actually fall for those with estates above $20 million.
Table 2
* Millions of dollars
Source: Martha Britton Eller, "Federal Taxation of Wealth Transfers, 1992-1995," Statistics of Income Bulletin, vol. 16, no. 3 (Winter 1996-1997), pp. 42, 46.The reason for this disparity is that careful estate planning can virtually eliminate the tax. At the simplest level, individuals can give away up to $10,000 per year per person free of gift tax. Also, there is a large deduction for gifts made to spouses, whose estates may be taxed separately. Thus for most married couples, the estate tax only applies to estates larger than $1.2 million. Beyond that, there are a number of increasingly complex methods for reducing the burden of the estate tax. They include:
One indication of the growth of estate planning is the increase in the share of total estate and gift taxes being raised by the gift tax. By making gifts of stock or other assets during their lifetimes, any subsequent increase in their value will no longer be part of the estate. Table 3
*Billions of dollars
Source: Internal Revenue Service, 1995 Data Book (Washington: U.S. Government Printing Office, 1996), p. 3; idem, 1993-94 Data Book (Washington: U.S. Government Printing Office, 1995), p. 5; idem, 1992 Annual Report (Washington: U.S. Government Printing Office, 1993), p. 25.So effective are these methods of avoiding estate taxes that Professor George Cooper of Columbia University says that the estate tax essentially is a voluntary tax. As he wrote, "The fact that any substantial amount of tax is now being collected can be attributed only to taxpayer indifference to avoidance opportunities or a lack of aggressiveness on the part of estate planners in exploiting the loopholes that exist."3 Economists Henry Aaron and Alicia Munnell put it even more bluntly. In their view, estate taxes aren't even taxes at all, but "penalties imposed on those who neglect to plan ahead or who retain unskilled estate planners."4 However, as Table 2 makes clear, the ability to exploit existing tax-avoidance techniques is not uniform across estates. Those with the largest estates clearly have the greatest ability to engage in estate planning. This is because many estate planning techniques are costly and require long lead-times to implement. And families with long histories of wealth are more likely to be familiar with them. Thus a disproportionate burden of the estate tax often falls on those with recently acquired, modest wealth: farmers, small businessmen and the like. In many cases their incomes may not have been very high and they died not even realizing that they were "rich." The reason why those with larger estates are more likely to engage in complex estate planning is, of course, because they pay higher marginal tax rates on their assets. However, the same general principle applies to the estate tax in general. Research shows that during periods when estate tax rates were rising, revenue from the estate tax fell. Conversely, lower estate tax rates increased estate tax revenue, because it was no longer as profitable to engage in costly estate planning.5 And I would emphasize that estate planning is costly, not just in terms of lawyers fees and the like, but also because assets placed in trust may not earn as high a rate of return as they would under the original owner's control.6 As this committee well knows, the impact of the estate tax on small businesses can be devastating. According to a recent survey, 51 percent of family businesses would have significant difficulty surviving in the event of a principal owner's death, due to the estate tax. And 14 percent of businesses said it would be impossible for them to survive. Only 10 percent said the estate tax would have no effect. This same survey found that 41 percent of businesses would have to borrow against equity to pay the estate tax and 30 percent said they would have to sell all or part of the business. Eighty-one percent of family businesses reported having taken steps to minimize the estate tax bite. These include purchasing life insurance, making lifetime gifts of stock, putting the business into trust, or other arrangements.7 Recent academic research has also looked at the impact of the estate tax on small businesses. According to one study, its main effect is on business liquidity. Since most small businesses are undercapitalized to begin with, the estate tax can literally suck the life blood out of a business. Increasing the ability of entrepreneurs to leave an inheritance can greatly increase the chances of a small firm's survival.8 Other research found that the estate tax encourages small business owners to sell out or merge with large firms.9 The impact of estate planning goes beyond the estate tax and impacts the income tax as well. For example, under a charitable remainder trust one donates assets to a tax-exempt institution but retains the income from the assets until death. Not only are the assets fully shielded from the estate tax, but the charitable donation reduces one's income taxes as well. Because of such interactions between the estate tax and the income tax, Professor B. Douglas Bernheim of Stanford University believes that lost income tax revenue may offset all of the revenue from the estate tax.10 While expressing some skepticism about the magnitude of the effect Bernheim identifies, Professor Edward McCaffery of the University of Southern California believes that the impact of the estate tax may be even larger for other reasons. In particular, McCaffery believes that the impact of the estate tax on economic growth may be significant, by reducing the incentive to work, save and invest. For example, he points out that if one's prime motivation is to leave a large estate to one's children, then the effective marginal tax rate on investment and labor is the income tax rate plus the estate tax rate. This rate can go as high as 73 percent at the federal level alone (39.6 percent top income tax rate plus 55 percent estate tax rate on the remainder), with state income taxes pushing it higher still. And McCaffery goes on to point out that these negative effects on saving and work effort are not limited to the very rich. Insofar as the estate tax encourages gifts to one's children during one's lifetime, it may have the effect of reducing their work and saving as well.11 Another way in which the estate tax negatively interacts with other taxes relates to pensions. In a recent paper, Professors John B. Shoven of Stanford and David Wise of Harvard point to a little-known provision of the law that imposes a 15 percent excise tax on "excess" pension assets. This tax was enacted in 1986 and is imposed on withdrawals exceeding $155,000 per year. (At age 70, it would take only $1.2 million in assets to generate this much income in an annuity.) It is in addition to federal and state income taxes. This means that the marginal tax rate on pensions larger than $155,000 is over 61 percent--far higher than the top income tax rate of 39.6 percent. This is bad enough, but in fact the tax burden is even higher when the estate tax is considered. Shoven and Wise point out that prior to 1982, pension assets passed through estates tax-free. Whatever money one had in an IRA at death, for example, could be passed to one's heirs free of estate tax. After 1982, only $100,000 could be given free of estate tax, and since 1984 all pension assets are taxed. Estate tax rates go as high as 55 percent. The combination of federal and state income taxes plus estate taxes and the 15 percent excise tax means that extraordinarily high tax rates can apply to pension assets in estates. As the figure shows, for an estate larger than $1.9 million (in 1996 dollars), the marginal tax rate has risen from 39 percent in 1982 to over 85 percent today. And in some states the rate can go as high as 99.73 percent! Shoven and Wise strongly emphasize that these tax rates are not reserved only for the very rich. Anyone, even of modest means, who saves and invests steadily throughout their lifetime can find their estates subject to confiscatory tax rates. For example, someone age 25 earning just $25,000 who saves 10 percent of their income yearly would find themselves with $2.4 million in pension assets at age 70. Such people should not have their wealth virtually confiscated merely because they were thrifty.12 With intergenerational transfers accounting for as much as 80 percent of the nation's capital stock, according to a study by Laurence Kotlikoff and Lawrence Summers, this means that the estate tax is direct tax on capital.13 Therefore it is reasonable to say that the nation's capital stock is automatically reduced by at least the amount of the tax. It is even larger if it affects the savings rate as well.14 Recent research indicates that the estate tax has a much greater impact on the behavior of the living than previously thought. Parents often use the promise of a bequest to influence the behavior of their children. They also use bequests to equalize the well-being of their children.15 Thus the desire to leave a large estate is one of the primary motivations for working and saving later in life. To the extent that the estate tax reduces a parent's ability to leave an estate to his children, it will have a negative effect on his interest in accumulating wealth through work, saving and investing.16 Of course, anything that reduces capital formation in the economy ultimately makes everyone poorer. That is why economists historically have warned against estate taxes. Adam Smith: "All taxes upon the transference of property of every kind, so far as they diminish the capital value of that property, tend to diminish the funds destined for the maintenance of productive labor."17 David Ricardo: "It should be the policy of governments...never to lay such taxes as will inevitably fall on capital; since by so doing, they impair the funds for the maintenance of labor, and thereby diminish the future production of the country."18 C.F. Bastable: "Succession duties first of all possess the grave economic fault of tending to fall on capital or accumulated wealth rather than on income; they therefore may retard progress."19 By contrast, those wishing to destroy the capitalist system have always been enthusiastic supporters of heavy estate taxes. It is worth remembering that the 3rd plank of The Communist Manifesto says that the right of inheritance should be abolished.20 Even today, there are those who believe it is immoral to allow people to inherit anything.21 Ironically, the negative impact of the estate tax on saving and capital formation negates much of the redistributive effect of the tax. According to an article by Joseph Stiglitz, former chairman of the Council of Economic Advisers under President Clinton, to the extent that the estate tax lowers the capital stock it raises the return to the remaining capital. Since the rich already own most of the existing capital, the effect of the estate tax is to actually make them richer.22 Indeed, existing high estate tax rates appear to do virtually nothing to equalize the distribution of wealth.23 Recent studies, in fact, have argued that wealth has never been more unequal than it is today.24 One reason why estate taxes have less impact on wealth distribution than people imagine is that inheritances constitute less of the wealthy's assets than is usually thought. As Table 4 indicates, for those in the top 5 percent of the wealth distribution, inheritances make up only 7.5 percent of their wealth. Indeed, even among the super-rich, inheritance counts for less than commonly believed. According to one study, of the 265 separate fortunes represented by the Forbes 400, 157 or 59 percent were new wealth. Only 108 or 41 percent were inherited.25 Another study concluded that 75 percent to 85 percent of the rich throughout American history were self-made.26 Table 4
Source: James P. Smith, Unequal Wealth and Incentives to Save (Santa Monica, CA: Rand Corporation, 1995), p. 16.Finally, the estate tax imposes large dead weight costs on the economy. First is the cost of employing large numbers of Internal Revenue Service agents to collect estate and gift taxes. Second is the cost of employing legions of tax lawyers to avoid the tax. Aaron and Munnell report that some 16,000 members of the American Bar Association cite trust, probate and estate law as their primary area of concentration. They conclude that compliance costs alone may eat up a sizeable fraction of all estate tax revenues.27 On the other hand, one commentator has suggested that the government may get more revenue from taxing the incomes of estate tax planners than from the estate tax itself!28 In conclusion, the estate tax is a bad tax. It raises little revenue. It does not redistribute wealth. It imposes large costs on the economy. And it is complicated and unfair. It should be abolished. In recent years a number of countries have done exactly that (see appendix). The United States should join them.29 Of course, outright repeal may not be politically feasible at this time. In that event, I would certainly support any of the efforts underway to reduce the estate tax by raising the exempt amount to $750,000 or $1 million. Other proposals would target estate tax relief to family businesses. While I would support these efforts as well, I think they are less desirable than repeal or increasing the exempt amount because they introduce further complexity to an already complex section of the Tax Code. Short of outright repeal, I would also suggest that the Congress consider these options:
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