The United States House of Representatives last week passed a bill repealing the estate tax, but with repeal staged over the next 10 years. The Senate appears unlikely to follow the House’s lead, preferring only to raise the threshold above which estate tax becomes payable, while leaving its rate on large estates, of over $20 million, at the punitively high level of 55 percent, and its marginal rate on smaller estates above the $650,000 tax threshold at a still more punitive 60 percent. Thus action taken this year is unlikely to change significantly the pernicious effects of this tax, which only pass unnoticed because the tax has been around since 1916.
The survival of the estate tax is due to its extraordinary political appeal; It is a tax on rich dead people, thus minimizing its vote-losing potential. However, as with most cheap populist fixes, the estate tax is both economically damaging and morally abhorrent.
A good tax should be cheap to administer, equitable in its incidence, and have as few as possible pernicious economic effects. The estate tax as presently constituted fails on all of these grounds.
The estate tax currently brings in approximately $23 billion a year in revenue, not a drop in the bucket, but less than 2 percent of total tax revenue, and less than 0.25 percent of gross domestic product. However, compliance costs, or rather non-compliance costs to taxpayers seeking to evade the tax, were estimated by a December 2000 congressional Joint Economic Committee study to cost the economy as much as the tax brings in, making it the least economically cost-effective of all major taxes.
In terms of equitability, the tax at first sight is sharply progressive, with its 55 percent rate, on capital not income, being far higher than any income tax.
However, in practice it discriminates heavily in favor of the really rich, who can better afford avoidance strategies, and against inheritors of illiquid small businesses, who are often suffering the economic cost of the loss of the founder at precisely the time they have to find large amounts of ready cash — the result is often the liquidation of the business with consequent economic and job losses. The idea that wealth tied up in a small family business should be subjected to tax at the ruinous rate of 55 percent is particularly abhorrent, and benefits only insurance companies and estate planners, neither of them admirable or productive groups.
As for pernicious economic effects, it’s difficult to know where to start. The principal problems in the U.S. economy are excessive consumption, inadequate saving, and an undue focus on short-term, as distinct from long-term, costs and benefits. The estate tax exacerbates all of these. It encourages elderly people to “spend their children’s inheritance” as the bumper sticker goes, because $2.50 of current spending can offset only $1 of net legacy. It discourages saving, because an elderly person who dies with substantial assets leaves his heirs a heavy estate tax problem to clear up before they can enjoy the benefit of them. An estate tax of 55 or 60 percent, for an older saver, is equivalent to a tax of 55 or 60 percent on deferred consumption.
To see the anti-saving effect of the estate tax, consider it as a wealth tax, levied once per generation. Its rate, then, based on an average generation length of 25 years, is 55/25 percent, or 2.2 percent, higher than any wealth tax that has been proposed in a civilized country. Wealth taxes at this level, or anything close to it, have gone definitively out of fashion even in overtaxed Europe since the 1980’s, because they manifestly have the perverse effect of killing capital formation; if local rates of return on capital are of the order of 5 percent in real terms, then a wealth tax of 2.2 percent is equivalent to a 44 percent surcharge on investment income tax.
It can hardly be doubted that the depressing effect of such a tax on the savings rate is far greater than the 0.23 percent of GDP of revenue that the U.S. estate tax brings in. Even if such a tax depresses saving by only 5 percent among the owners of the top one third of U.S. wealth, who themselves represent less than 1 percent of the nation’s population, then it affects the savings rate by something of the order of 1.2-1.5 percent of GDP, in other words enough if the tax were abolished to wipe out the current negative savings rate, restore savings to a modestly positive level, and improve the trade balance by about $50-70 billion per annum.
Thus, the economic damage done by the wealth tax is a substantial multiple of its nominal yield. Removing the tax would increase potential U.S. output by several times the tax’s yield, which increased output would of course then bring in substantial additional tax revenue. Abolition of the estate tax is thus the ultimate supply side tax reform.
However, the worst damage done by the estate tax is not its effect on consumption, nor that on saving, but its pernicious and immoral disincentive to families who want to think for the long term. Because it is set at such a punitive rate, it discourages families from constructing businesses that can last more than one generation. Further, it focuses the minds of businessmen on short term gains, and leads them to ignore the effect of long term trends that will be apparent only after the likely date of their death. If businessmen were all 25, this would not matter much. Bill Gates was able to build Microsoft into a giant, secure in the knowledge that he would have 30 or 40 more years of active life before estate tax became an issue. In the case of entrepreneurs whose success comes more slowly, or starts later in life, this luxury of timing is not available; once an entrepreneur passes 50, the family business must if it is to survive be ready at any time to face a huge tax bill brought on by an unlucky heart attack. Few family businesses are robust enough to do this.
One of the advantages claimed for the estate tax is that it encourages charitable giving. However, in reality as the Joint Economic Committee showed, this effect is unlikely to be significant; the income tax write-off from charitable giving during a wealthy person’s lifetime is worth very nearly as much as the estate tax write-off from a charitable donation.
What the estate tax does encourage is the charitable foundation, a thoroughly pernicious institution in which a testator’s wealth is diverted by professional foundation managers to purposes very different from that intended by the testator. There can be no question that those solid conservative Republicans John D. Rockefeller, Henry Ford and David Packard, to name just three, would be horrified by the leftist political activism undertaken by the foundations that bear their name, all of it in direct contradiction to the ideals by which those men lived. This perversion of a person’s life work and ideals by irresponsible ideologues, entirely without any control by his legitimate heirs, is utterly contrary to the moral precepts of a civilized country; it is nothing more nor less than legitimized armed robbery. This more than anything else, gives the estate tax an ethical stench uniquely its own.
As the United States has grown and aged, it has become increasingly necessary for Americans to think in the long term, considering the consequences of their actions 50 or even 100 years after their deaths. Environmentalists, in particular, regard this as essential, as witnessed by the global warming debate. Institutions that encourage such long term thinking, such as multi-generational wealth transfers, or even an hereditary House of Lords (what a dreadful mistake the Founding Fathers made in that respect!) are of the utmost importance. The Estate Tax, which negates it, is thus not only economically counterproductive, and immoral, it is Environmentally Unsound!
To remove the damage of the estate tax, it is not necessary to abolish it altogether. A tax at a much lower rate, say a maximum of 15 percent, with inheritors having up to 10 years to pay, would remove most of the economic and even the moral difficulties of the tax (particularly if the charitable foundation exemption loophole was closed.) It would also probably produce more revenue. What will not work is the Democrats’ current proposal of an increase in the thresholds, while keeping the current top rate — that will simply preserve the economic and moral damage while greatly reducing the revenue produced.
The issue is thus quite clear, and unambiguous. And it will NOT wait 10 years, Mr. President.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.