Chipping Away at the Estate Tax

by Michael Linden

This article was published by the Center for American Progress.

Last week, the House of Representatives passed a $233 billion tax cut for the very wealthiest of wealthy Americans—a cut that would benefit fewer than 50,000 people in the entire country. The Senate has yet to pass a similar tax cut in part because some senators believe it would be a big mistake to enact the bill as it was passed in the House without some major changes. Many of the senators opposed to passing the House’s tax cut bill expressed serious reservations about the size of our future budget deficits and would like to see concrete steps taken to close that fiscal gap.

Here is where things get strange. The senators who have called for deficit reduction and more fiscal discipline aren’t opposing the House’s bill because it’s a big giveaway to the very wealthy at a time when we simply can’t afford such profligacy. They’re opposing it because it isn’t big enough. Instead, they think the tax cut should be $330 billion. And they believe that extra $100 billion should go exclusively to the richest 0.2 percent of Americans. Interestingly, they have proposed absolutely no way to pay for this budget buster.

This seemingly odd situation came about as a result of a Bush-era budgeting gimmick concerning the estate tax. The estate tax is applied to the transfer of the property—such as stocks, cash, real estate, trust funds—from a deceased person to their heir. Very few estates are actually subject to this tax, however, because the tax only applies to estates that are worth more than a given exemption amount. In 2009, the exemption is $7 million for a married couple. In other words, any inheritance worth less than that is completely tax free. As a result, this year 99.7 percent of estates will pay no estate tax.

The 2009 estate tax is actually much smaller than it used to be. As part of the 2001 and 2003 Bush tax cuts the estate tax was gradually reduced—cut seven times over the past eight years, in fact—by both raising the exemption and lowering the tax rate itself. In 2010, the estate tax is scheduled to disappear completely.

But because President George W. Bush wanted to hide the true long-term costs of his enormous tax cuts, he employed a trick called sun-setting, by which the estate tax will reappear in 2011 in its pre-2002 form, which means a lower exemption—$2 million for married couples—and a higher rate. Simply put, current law has the estate tax going back to what it was when the federal budget was in surplus.

Instead of allowing the estate tax to disappear and then come roaring back, the House passed a bill last week that would make the 2009 parameters of the estate tax permanent. This represents a huge tax cut compared to current law, since in 2011 there will be about 40,000 estates that would be subject to the estate tax under current law, but won’t be under the bill passed by the House. Not only that, the 6,400 estates that will still pay the estate tax under the House proposal will be paying a much lower rate than they would under current law.

Making the 2009 parameters of the estate tax permanent will cost about $233 billon over 10 years. Unfortunately, there is a proposal in the Senate to spend even more money. Senators Blanche Lincoln (D-AK) and John Kyl (R-AZ) want to further slash the estate tax so that only estates worth more than $10 million have to pay the tax. The Lincoln-Kyl proposal would cost another $100 billion and benefit only about 3,000 estates a year. Proponents of this proposal argue that the estate tax hurts small businesses and family farms, that it represents double taxation, and that raising the exemption to $10 million is a fair compromise.

But these are weak arguments. First, the estate tax affects almost no small businesses or family farms. In fact, in 2009, there will be only 80 small business or farm estates that will owe any estate tax at all. And bear in mind that these 80 estates are worth at least $3.5 million, and they owe tax only on the value of the estate over the exemption level. The argument that anyone would have to give up their family farm to pay the estate tax is a complete fabrication. Even the American Farm Bureau Federation has admitted that itcouldn’t find a single example of a family having to sell its farm to pay the tax.

Second, much of the property in inherited estates has actually never been taxed at all. This is because of a tax provision known as “stepped-up basis.” Ordinarily, when someone sells a capital asset, like real estate or stocks, they pay capital gains taxes on the increased value of that asset compared to when they purchased it. The original purchase price is called the basis. But if that same asset is never sold, and instead passed on to an heir, the basis is “stepped-up” to the fair market value of the asset at the time of the inheritance. So when the heir sells the asset, he only pays capital gains taxes on the increase in value since the time of his inheritance, not since the original purchase. Any increase in the asset’s value before the inheritance is completely tax free.

The upshot of all this is that with more than half the value of huge estates being made up of capital assets that have completely avoided taxation, the estate tax provides a backstop against billions of dollars in hidden income being passed on from generation to generation.

It should also be noted that if Congress doesn’t act soon, then when the estate tax disappears in 2010, so too will the “stepped-up basis” provision for many smaller estates. This is because the Bush tax cut legislation included a repeal of “stepped-up basis” for everyone, with an exemption of up to $1.3 million. The effect of this will be that, in 2010, massive estates will pay very little tax when they otherwise would have paid more, large estates will pay some tax when they otherwise would have paid none, and small estates will be unaffected.

Congress has been debating the relative merits of the estate tax for decades and the arguments have not changed much over that time. The only question Congress should ask now is whether giving another $100 billion to people who have already inherited at least $7 million is a wise use of resources. Congress should keep in mind that a simple extension of the 2009 estate tax is already very generous to extremely wealthy heirs and heiresses. Those members of Congress who claim to be concerned about America’s fiscal future should refrain from supporting measures that would dramatically exacerbate our budget problems.

Michael Linden is the Associate Director for Tax and Budget Policy at American Progress.