Wealth, Inheritance and the Estate Tax

Policy Reports | Taxes

No. 289
Thursday, September 21, 2006
by Jagadeesh Gokhale and Pamela Villarreal

The Estate Tax

Figure IV - Federal Tax Revenue%2C 2006

In the current debate over eliminating the estate tax, or returning to pre-2001 levels, there are two major arguments.  One is that the federal government needs the revenue; the other is that the estate tax mitigates wealth inequality.  Indeed, some argue that in its absence, wealth would become more highly concentrated into fewer and fewer hands.

In most countries, including a number of developed countries in the Organization for Economic Cooperation and Development (Finland, France, Germany, Iceland, Luxembourg, the Netherlands, Norway, Spain, Sweden and Switzerland),24 the majority of wealth is concentrated in a fairly small number of hands, making a wealth tax appealing to politicians since it allows substantial amounts of revenue to be raised from comparatively few people.25

“Estate taxes are a minor source of federal revenue.”

However, critics argue that estate taxes create economic inefficiencies by discouraging wealth-creating activities, resulting in slower economic growth.  Moreover, the revenue collected may prove disappointing, since the wealthiest people are often the most skilled at tax avoidance.   In the United States, estate taxes account for less than 3 percent of total federal tax revenue[See Figure IV.]

“Estate tax rates will rise in 2010.”

From Revenue to Redistribution.  An estate tax was legislated in 1916 to pay for World War I, and it has remained in force since.26  The initial top rate was just 10 percent, suggesting that its original purpose was to raise revenue, rather than redistribute wealth. The estate tax did not become explicitly redistributive until the administration of Franklin Roosevelt. The Revenue Act of 1935, in particular, was almost solely concerned with redistribution.  The top estate tax rate, which was 45 percent when Roosevelt took office, was ratcheted up to 60 percent in 1934 and 70 percent in 1935.27  The 2001 Economic Growth and Tax Relief Reconciliation Act is temporarily phasing out the estate tax.  Tax rates are falling and the amount of wealth exempted from the tax is rising.  In 2009, the tax will disappear, only to return in 2010 at the same rates that existed before the temporary tax cut.

Today the estate tax exists almost exclusively for redistributive purposes, since the revenue yield is minuscule.  The estate and gift tax is the federal government's least significant revenue source.28  [Note that if the estate tax were abolished, most bequests would still be subject to capital gains taxation when assets are sold - generating offsetting revenue increases.]

Figure V - Estate Tax as a Share of Gross Estate%2C 2004

Current Estate Tax.  For 2006, the top estate tax rate is 46 percent.  However, the average effective estate tax rate - the percentage of the total estate actually paid in taxes - is much lower.  In 2001, when the top rate was 55 percent, the average effective estate tax rate was only 19 percent. Today, with a lower top rate and a higher exemption ($2 million), the average effective tax rate is even lower.29  In fact, after a certain point, the estate tax burden tends to fall as the size of estates increases, leaving those with smaller estates to shoulder a greater proportion of the tax.  For instance:

  • The effective estate tax rate on estates of $5 million to $10 million is 16.8 percent.  [See Figure V.]
  • However, for estates of $20 million or greater, the tax consumes only 13.5 percent of the estate.

Despite the reduced estate tax rate since 2001, the United States still has the third-highest top estate tax rate in the world at 46 percent; only Japan's (70 percent) and South  Korea's (50 percent) rates are higher.30

Burden of the Estate Tax.  A fundamental justification for the estate tax is that it is paid only by those who can most easily afford it, namely the rich.  Today, roughly one-half of one percent of those who die leave estates that are subject to the tax.31  However, the burden of the tax falls primarily on the recipient, not the giver.  For this reason, one cannot state with certainty what the distributional effect of the estate tax actually is, since heirs may be either wealthy or poor. This alone may be a sufficient reason to abolish the estate tax.32 

The fact that the burden of the estate tax falls on heirs rather than decedents has important distributive implications. Generally speaking, heirs have less wealth and income than decedents who leave large bequests.  Hence, it would make more sense to tax the heirs rather than the estates alone.  Attributing the estate tax to the heirs rather than the estates would show the burden of the estate tax on those with middle incomes to be much higher than standard distributional tables indicate.  Indeed, Congress's Joint Committee on Taxation has resisted inclusion of the estate tax in its tables showing the distribution of the tax burden by income groups, owing to uncertainty about who actually bears the burden of the tax.33

Redistributive Effects.  Ironically, the deleterious impact of the estate tax on saving and capital formation negates much of the redistributive effect of the tax.  According to Joseph Stiglitz, to the extent that the estate tax reduces the capital stock, it raises the return to the remaining capital.34  Since the rich already own most of the existing capital, the effect of the estate tax is actually to make them richer. Consequently, it is not surprising that existing high estate tax rates appear to do virtually nothing to equalize the distribution of wealth.35

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