Economic Issues Surrounding the Estate and Gift Tax: A Brief Summary

Economic Issues Surrounding the Estate and Gift Tax: A Brief Summary

Order Code RS20609
Updated March 18, 2008
Economic Issues Surrounding the Estate and
Gift Tax: A Brief Summary
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Summary
Supporters of the estate and gift tax argue that it provides progressivity in the
federal tax system, provides a backstop to the individual income tax and appropriately
targets assets that are bestowed on heirs rather than assets earned through their hard
work and effort. However, progressivity can be obtained through the income tax and
the estate and gift tax is an imperfect backstop to the income tax. Critics argue that the
tax discourages savings, harms small businesses and farms, taxes resources already
subject to income taxes, and adds to the complexity of the tax system. Critics also
suggest death is an inappropriate time to impose a tax. However, the effect on savings
is uncertain, most farms and small businesses do not pay the tax, and complexity could
be reduced through reform of the tax. This report will be updated as legislative
developments warrant.
The estate and gift tax has been the subject of legislative interest for several years,
with increases in the exemption enacted in 1997. Proposals to reduce or eliminate the tax
were adopted in the 106th Congress, but were vetoed by the President. President Bush had
also proposed eliminating the tax and the Ways and Means Committee reported out a bill,
H.R. 6, that would phase out the tax. Similar provisions were included in the Senate bill
and the final tax cut bill, H.R. 1836, was signed by the President on June 7, 2001,
although this legislation retained a gift tax with a large exemption.1 The entire bill is to
sunset after 2010, but there are proposals to make the change permanent, including H.R.
8 which passed the House on April 13, 2005. Further consideration to making the tax
change permanent was originally scheduled for the fall of 2005, but was delayed because
Congress was considering legislation relating to Hurricane Katrina. There were also
1 For a more extensive discussion of estate and gift tax issues, see CRS Report RL30600, Estate
and Gift Taxes: Economic Issues, by Jane Gravelle and Steven Maguire. See CRS Report
RL34374, Estate Tax Legislation in the 110th Congress, by Nonna A. Noto for further
information on proposals. See also CRS Report 95-416, Federal Estate, Gift, and Generation-
Skipping Taxes: A Description of Current Law, by John R. Luckey.

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proposals to shift to a permanent estate tax with a larger exemption and lower rates and
these proposals were considered in 2006. H.R. 5970 in the 109th Congress, passed by the
House, would have increased the exemption to $3.5 million and taxed gains at the capital
gains tax rate (currently 15%, but scheduled to return to 20% after 2010).
The estate tax has not been directly addressed as of yet in the 110th Congress but a
number of bills have been introduced to make the estate tax permanent, or to modify the
estate tax.
The estate and gift tax is a comparatively small source of federal tax revenue,
accounting for about 1% of federal receipts, an amount which has declined following the
reduction in rates and the increase in exemptions enacted in 2001. Estates and gifts to
spouses are exempt from tax as are gifts to charity. The first $2 million of the net estate
value is exempt from tax. Gift taxes have a $1 million effective exclusion in addition to
an annual gift exclusion of $11,000 per donee. Taxable estates are subject to a 45% rate.
The exemption from tax is scheduled to rise and the tax rate to fall with the estate tax (but
not the gift tax) permanently eliminated in 2010, when a tax on capital gains in excess of
an exempt amount will be imposed. The 2001 tax cuts, absent legislation, will sunset
after 2010 and the rates and exemptions return to the values prior to the 2001 tax changes.
Arguments for the Estate and Gift Tax
Perhaps the principal argument in support of an estate and gift tax is its contribution
to progressivity in the income tax system. The estate tax is the most progressive of any
of the federal taxes. According to the latest data from the Internal Revenue Service
(2006), out of the approximately 2.4 million deaths per year, only 0.9 % of estates paid
the estate tax; that share will drop further as the exemption is rising. These numbers can
be contrasted with the income tax where about 70% of families and single individuals
owe tax. Because the exclusion has been rising, the share of decedents’ estates paying
estate taxes has been falling. Even prior to the 2001 tax cuts, however, only 2% of
decedents paid an estate tax. Progressivity in the tax system, however, could also be
altered through changes in the income tax.
Another argument made by proponents of the estate and gift tax is that, to the extent
that inherited wealth is seen as windfall to the recipient, such a tax source may be seen by
some as fairer than taxing earnings that are the result of work and effort.
Finally, many economists suggest that an important rationale for maintaining an
estate tax is the escape of unrealized capital gains from any taxation, since heirs receive
a stepped-up basis of assets. Families that accrue large gains through the appreciation of
their wealth in assets can, in the absence of an estate tax, largely escape any taxes on these
gains by passing on the assets to their heirs. The base of the estate tax is, however, quite
different from the base of the capital gains tax, and the rates are higher. The 2001 tax
revisions proposed to tax capital gains after allowing a significant exemption.

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Arguments Against the Estate and Gift Tax
An important criticism of the estate and gift tax is that it reduces savings and
economic growth. However, as is also the case for the income tax, neither economic
theory nor empirical evidence clearly indicate that the estate tax reduces savings. For
example, while the estate tax may discourage saving for bequests because the cost of
making a net bequest (in terms of forgone consumption) increases, the tax also requires
a greater amount of saving to achieve a net target. Estate and gift taxes are unlikely to
have much effect on assets accumulated for precautionary purposes. Bequests can also
reduce saving by heirs because they increase resources for consumption.2
A second major argument against the estate and gift tax is that it burdens family
businesses and farms and makes it more difficult to pass on these assets to the next
generation who can continue the business. However, only a small portion (less than 5%)
of businesses and farms are likely to be affected; many of those have sufficient liquid
assets to pay the tax. In addition, extensions of time to pay the tax are allowed.3
Critics also argue that death is not an appropriate occasion to impose a tax; indeed,
the tax is sometimes referred to as a “death tax.” Another argument is that wealth has
already been taxed through income taxes, though this is not the case for unrealized capital
gains. Finally, critics assert that the complexity of the tax not only imposes
administration and compliance burdens but undermines the progressivity of the tax.4 Of
course, this latter argument could also be a justification for reforming rather than reducing
or abolishing the tax.
2 For an analysis of these savings effects and indications of a limited and uncertain effect from
empirical data, see William G. Gale and Maria G. Perozek, “Do Estate Taxes Reduce Savings?”
and Wojciech Kopczuk and Joel Slemrod, “The Impact of the Estate Tax on Wealth
Accumulation and the Avoidance Behavior of Donors,” both in Rethinking Estate and Gift
Taxation, eds. William G. Gale, James R. Hines, Jr. and Joel Slemrod, Washington, D.C., The
Brookings Institution, 2001.
3 For analyses of the estate tax data, see CRS Report RL30600, Estate and Gift Taxes: Economic
Issues by Jane G. Gravelle and Steven Maguire; CRS Report RS20593, Asset Distribution of
Taxable Estates: An Analysis, by Steven Maguire; and Estate Taxes, Life Insurance, and Small
Business by Douglas Holtz-Eakin, John W. Phillips, and Harvey S. Rosen, National Bureau of
Economic Research working Paper 7360.
4 For a discussion of avoidance methods and an estimate that indicates reasonable compliance
and administrative costs, see Charles Davenport and Jay Soled, “Enlivening the Death-Tax
Death-Talk.” Tax Notes, July 26, 1999, pp. 591-629.

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Other Issues
Two other economic effects of the tax that might be considered in evaluating
changes are the possible negative effect on charitable contributions (because charitable
contributions are deducted from the estate and gift tax base) and the effect on state and
local estate taxes. A credit has been allowed against estate and gift taxes for state estate
taxes in the past, although this credit has now been eliminated; these changes may create
pressure on states to reduce these taxes which will now become a more visible burden on
their residents.