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Should It Stay or Should It Go?

Two industry experts share their thoughts about the advantages and disadvantages of the estate tax

On Sept. 8, 2016, the estate tax celebrates its 100th birthday. Over the past century, practitioners, lawyers and even laypersons have voiced their opinions on whether the estate tax should be retained or repealed.

Not to be outdone, we asked two of our esteemed board members, Jonathan G. Blattmachr, principal at Pioneer Wealth Partners LLC in New York City and Turney P. Berry, partner at Wyatt, Tarrant & Combs, LLP in Louisville, Ky., to weigh in on this 100-year-old debate. They share their thoughts in a lively back-and-forth discussion, reproduced below.

 

Turney. We’re here to discuss whether we ought to repeal the federal wealth transfer tax system—gift, estate and generation-skipping transfer (GST) taxes—with its accompanying income tax rules. Those rules essentially mean that the inclusion of an asset in an estate will generally reset the income tax basis to the fair market value of the asset on the date of death (or perhaps six months later, in some instances). My guess is that you and I will agree on much, but ultimately we’ll reach different conclusions about this matter.

 

It Ain’t Tax Reduction

Jonathan. I suspect you’re right. Let’s begin by seeing whether we agree on a basic point: We can’t discuss wealth transfer taxes as “tax reduction.” Everyone wants their taxes reduced, but ultimately, we have to pay for government services. Thus, my premise is that there’s no such thing as “tax reduction.” If you reduce or eliminate the tax on beer, the same amount of tax will fall elsewhere, such as on wine. Also, if you reduce or eliminate the tax on the wealthiest Americans, it will fall, in another form, on less wealthy Americans.

Our republican form of government works by having the populace elect representatives who decide what to spend and where to find the revenue. You can substitute borrowing in place of tax, but ultimately, the chickens will come home to roost, and you’ll need to impose taxes to pay off the debt. Although every one of us would choose a different level of tax and a different set of government expenditures if we were czar, that’s not the way our country operates. Saying you’d cut government expenditures doesn’t mean it will happen. We, as Americans, pay almost the lowest taxes compared with any modern nation in the world. And, the taxes we pay won’t go down. Even if they could, would the estate tax be the right tax to eliminate as opposed to, for example, an income tax for those who earn the least? 

 

Turney. I agree with that premise. Personally, I hope that taxes go down and that government spending does too—and I only want to cut programs that benefit you, Jonathan! But, I agree that if federal wealth transfer taxes go down, then some other taxes will go up.

 

Spurring Economic Growth

Jonathan. Well, what do you make of the argument that the elimination of the estate tax would spur economic growth, producing more income to tax. I don’t buy the theory, but its proponents make two points: First, that people accumulate wealth to allow their heirs to inherit more, but they stop trying to accumulate more wealth because any additional wealth will be eroded by tax when they die. Turney, have you EVER seen a client do that? Indeed, have you ever even HEARD of a client who behaves that way?

 

Turney. Nope. I knew we agreed on a lot! I think it’s cuckoo to think that folks behave that way. Undoubtedly, there’s someone who does behave that way—it’s a big world out there—but he’s truly the exception proving the rule.

 

Jonathan. Second, people seek wealth to benefit themselves. The whole premise of communism is that people want to help each other. And, that premise is wrong. People want to help themselves. Estate planners, every day, experience the tremendous resistance that property owners display on transferring wealth to their “loved” ones. They want to keep it for themselves.  

 

Turney. Let me interrupt to say that I wouldn’t argue with you, given the current 40 percent flat estate tax rate, but there must be some rate at which it would be true that lots of wealth accumulation would stop. Let’s suppose a gift and estate tax rate of 99 percent. Even though making money as a lawyer requires almost no effort, at 99 percent, we might cut back, right?

 

Jonathan. Well, I don’t practice law anymore, but I accept your point. There’s surely some truth to the Laffer curve—that is, that at some level of income tax, people produce less: “Generally, economists have found little support for the claim that tax cuts increase tax revenues or that most taxes are on the ‘wrong side’ of the Laffer curve.”1 Indeed, people have tried to make as much money as they could, even when the income tax rates were 70 percent or higher, as they were before 1970.

 

Turney. I wasn’t practicing law when rates were that high, but I do wonder sometimes whether the increased civic engagement and longer lunches—you have to drink those martinis—that some suggest were present in those early years, were a result in part of the higher marginal tax. But, that’s beyond the scope of our discussion here: No one is stopping wealth accumulation because at death, there’s a 40 percent tax.

 

Jonathan. To be complete, we ought to say that some believe that eliminating the estate tax would spur economic growth by allowing for more capital formation, which is necessary for plants and equipment, as well as all sorts of investments.  

 

Turney. Capital formation is important, right? Civilization itself began when a surplus enabled human communities to do other things (and those other things eventually became beach volleyball!).

 

Jonathan. But, needing capital doesn’t mean you need concentrated wealth. The argument that states that if really wealthy people are taxed, there won’t be capital to invest, means that if you take it to its logical extreme, all wealth will be held by a very small number of people, institutions or companies, or maybe even just one! But, the whole premise of capital having to be concentrated is wrong. The great wealth built in the United States often came from individuals who started out with almost nothing: Rockefeller, Carnegie, Gates, Buffett and Jobs. The capital necessary to start those empires came from a few individuals, and when they needed more to expand, many turned to public offerings and private equity. The money collected from the estate tax (or any other tax) isn’t locked away and prohibited from being used for capital formation. Rather, it’s instantly spent by the government and flows back into the economy.

 

Who’s In Charge?

Turney. I don’t want to drift too far here, but we shouldn’t prejudge the answer to the question of who should be in charge of capital allocation: individuals or the government.

 

Jonathan. I received dozens of “angry” letters after a story appeared in The New York Times in 2001 about an article Professor Mitchell M. Gans and I wrote regarding the ramifications of estate tax repeal. One man wrote that he, as an only child, would better know what to do with his father’s wealth than would the federal government. His letter reflected at least two things. First, it showed that he felt entitled to his father’s property merely on account of a familial relationship. Second, it showed that he saw no obligation to the country for his family to repay the nation for his father’s opportunity to accumulate wealth under our nation’s economy and laws. As Bill Gates, Jr., a renowned Seattle lawyer and the father of the more famous Microsoft founder Bill Gates III, has pointed out, few people would trade being an American in exchange for not having their property subject to tax at death. 

 

Turney. The “being an American” argument I think just doesn’t work. Few would trade being an American for the repeal of the Miranda case or maybe even the repeal of the whole Fourth Amendment apparatus. The question shouldn’t be, we hope, “What would make it so bad that we don’t want to be an American?” The question should be, “What sort of America do we want?” I’ve met very few folks, maybe none, who would argue that there should be no taxes at all. That’s not the issue. Similarly, the issue isn’t whether the government should allocate capital or whether individuals should; the issue is how much each of them should allocate.

 

Jonathan. One thing to remember is the multiplier effect, which holds that because the government always spends more than it receives, having the government collect more tax actually spurs the economy more than it would if it were left in the hands of private citizens.2

A footnote to the foregoing is what Trent Lott, majority leader of the Senate, and George W. Bush, former President of the United States, did when the economy got a little soft in 2004. They gave extra tax refunds to low income taxpayers. Why? Because they knew those poor folks would spend the money immediately, which would spur the economy. Basically, they were trying to trigger a super-multiplier effect.

 

Turney. The question of the amount of the multiplier effect is controversial, and lots of economists would say that the effort in 2004 was either misguided or ineffective, and, in any event, it was designed for speed: Low income taxpayers would spend their refunds sooner. I’m among those who would argue that if the government allocated less capital rather than more, then that would be a good thing. But, that’s really an argument for all federal taxation to be lower; it doesn’t specifically relate to the estate tax. I certainly agree with you that there’s nothing magical about the very rich accumulating capital versus anyone else. The United States benefits from diversity, and the very rich are a part of that diversity. New money, old money, self-made money, inherited money—they all have different interests and different outlooks. Having some of each in the system is a good thing. But, that only means that wealth transfer taxes have a negative side, not necessarily that we shouldn’t have them. Which brings us to another point of agreement perhaps, namely that the estate tax isn’t a threat to family businesses or farms.  

 

Threat to Family Businesses or Farms? 

Jonathan. I think there are two points to make. First, over the past generation or more, we’ve been hearing that estate taxes threaten farms and family businesses. There are no studies to my knowledge that document this perceived threat, which is surprising, if the threat were real. Anecdotally, my colleagues and I have asked dozens, maybe hundreds, of people sitting in the audience of our presentations whether they can identify a farm or business that’s been threatened by the estate tax. A response of “yes” has been unusual and indeed, very rare. 

 

Turney. The result isn’t surprising, given the nature of the estate tax system. For those readers unfamiliar with the system, I’ll summarize it here. Until you have assets in excess of $5.45 million (indexed for inflation), you’re exempt from the estate tax (that’s an exemption of $10.9 million for a couple). Plus, you can give $14,000 a year to anyone you want, which means that a couple with two children and five grandchildren can give away almost $200,000 every year. And, if you want to make the gifts in a certain way, a donee (the recipient of the gift) can be guaranteed a tax-free return on the investment of the property. You, as the donor, will pay the income tax on the earnings on what you’ve donated. There are also estate-planning tools that we can use, and I’ll boil them down to two. One has to do with valuation, which is uncertain in all events and can be manipulated if we divide property in certain ways that will make control of property hard to obtain. The other tool relates to earnings assumptions built into the Internal Revenue Code. Those assumptions are complicated, but they essentially ignore the increased earnings of closely held assets due to a risk premium, as compared with marketable assets.

 

Jonathan. Right. Let’s assume that the estate tax does cause certain closely held businesses and farms to be lost. Well, it’s not that those businesses will truly disappear; rather, it’s that they’ll be owned by others. For example, let’s assume a community needs three Italian restaurants. Suppose one goes out of business because the owner died, and the estate taxes were so onerous that the inheritors lost the business. A different person, or persons, will open another Italian restaurant. It’s all about the fundamental tenet of our capitalistic economy: the law of supply and demand. 

 

Turney. Obviously, that’s right as far as it goes, but that’s not quite the point. If the family farm is sold to a conglomerate or to a big box store, our public policy—having an estate tax—has disadvantaged the family farm. If the Italian restaurant that goes out of business is replaced by a national chain of Italian restaurants, then that affects the community. The effects may be positive or negative (and communities and their members will disagree about the impact), but we can easily see that there are effects. If you believe that diversity is a positive, then you would rather have fewer chain Italian restaurants, fewer big box stores and fewer farms owned by conglomerates. Of course, the counter-argument is that all of those types prosper because of consumer demand, which is true, but once again, that’s not the end of the story. Big companies have many more opportunities to prosper through government intervention, whether it’s called “rent seeking” as the economists call it, or “corporate welfare” as the politicos call it. The smaller companies just don’t have those opportunities. Relief from the estate tax can be looked at in part as “corporate welfare” for the family-owned company.

 

Jonathan. Fair enough. But, let’s remind our readers that family farms and businesses already have special provisions in the wealth transfer tax system that either reduce their taxes or allow taxes to be paid over a rather long period of time at favorable interest rates. Whether we want to call that “corporate welfare” or not, it’s a fact that we already favor those sorts of family enterprises. Repealing the whole system isn’t necessary just to favor them.

 

Interrelationships

Turney. So far, we haven’t much discussed the interrelationship of wealth transfer taxes and income taxes. But really, we can’t talk about one without talking about the other. Let’s start by noting that if we’re going to have a progressive income tax, it seems necessary to have some mechanism to prevent individuals with a lot of income from moving income-producing assets to lower income taxpayers, just to save income taxes. Today, that’s the gift tax. Jonathan, do you agree with that explanation?

 

Jonathan. Of course, the gift tax is a backstop to the estate tax but, Turney, you’re quite right in that the gift tax also backstops the income tax. Recall that the Bush administration in 2001 never wanted to get rid of the gift tax, only the estate tax (and the GST tax), because the income tax costs would be astronomical. So, Turney, even if you get out of the estate tax, you’re going to leave us with a gift tax.

 

Turney. That may be right. Presumably, we could adopt a different sort of gift tax, one that has as its primary goal not raising revenue but preventing income tax avoidance. For instance, suppose the gift tax regime allowed a donor to make gifts of any amount, to anyone, at any time, but the income tax system was modified to require that the donor continue to report the income from the gifted assets rather than having the donee report that income as we do today. I give my child my IBM stock, but continue to report the dividends and any capital gains from the sale of the stock, although my child would receive the dividends as the owner. Or, my child might be required to pay the tax at my income tax rate. The relation-back reporting could end after some number of years, and there could be exemptions that would reduce nuisance reporting for small amounts. The idea would be to prevent income tax savings through making gifts. Would that be more or less complicated than the current system? I’m actually always a bit skeptical about tax simplification. The American public likes the tax system to treat similarly situated taxpayers similarly, but it usually turns out that creating categories of similarly situated taxpayers requires quite a bit of complexity, and which taxpayers are similarly situated can vary, depending on the variable you’re looking at. Put another way, a simple system may look or be less fair than a more complex system.

 

Double Taxation?

Jonathan. While we’re discussing income tax, let me try to dispose of that canard that the estate tax is an unfair double tax. The estate tax is never imposed on the individual who’s earned the wealth. Whether income tax has been paid on the wealth doesn’t affect this conclusion. The estate tax is imposed, in effect, on the inheritors, not on the decedent.  

 

Turney. You mean because the decedent is dead, the estate tax reduces what the inheritors receive, so we should look at wealth transfer taxes as if the inheritors are receiving the whole estate and then paying the tax. Is that what you’re saying?

 

Jonathan. Yes. Let me analogize it to the income tax. Suppose a taxpayer earned income, paid tax and then expended the after-tax income by hiring someone—let’s say a worker—to do some tasks for the taxpayer. The dollars on which the taxpayer has paid income tax are the same dollars on which the worker will pay income tax. Isn’t that unfair double taxation? “I paid income tax, then paid you and you paid income tax.” No! Notice that the worker is a different taxpayer: Although they’re the same dollars that are subject to tax over and over again, as they’re transferred as gross income to the next taxpayer, the same income isn’t doubly or triply taxed. That is, when you look at the money in the hands of the taxpayer who earned the income, it’s taxed only once.

 

Turney. I think the double taxation argument goes to the property, not the person. That is, I earn $100, pay income tax on it, save what’s left and then what’s left is hit with an estate tax. The property is doubly taxed. Now, whether that’s unfair depends on with whom you’re speaking, but there’s a lot of double taxation. Suppose I inherit $100. Presumably my benefactor’s estate was subject to estate tax, and now I am, so that too is double taxation. Of course, what’s often said is that capital gains aren’t subject to tax but once. My $100 worth of stock grows to $1,000 and has never been taxed. That “proves” that the estate tax isn’t always double taxation! Often it is, but not always.

 

Jonathan. Let me try to explain my notion another way. In an economic sense, an inheritance is income to the inheritor. The government has chosen, under IRC Section 102, to exclude inheritances from income tax and instead imposes a wealth transfer tax. Many individuals think that their inheritance is included in their gross income—and economically, it is. But, whether the taxing authority decides to impose an income tax on the inheritance or an estate tax on it, there’s no more a double tax than when dollars are subject to income tax when earned by one taxpayer and again when that taxpayer buys good or services from another taxpayer and those dollars are taxed again.

 

Turney. Let me bolster your premise by pointing out again what we discussed above. In many ways, inherited property isn’t subject to tax at all. The first $5.45 million of assets isn’t subject to any tax at death, but does receive a reset of income tax basis. So for many people, in fact for most people, there’s neither income nor estate tax on wealth. There’s never a double tax of any sort on assets that are saved or inherited, and none on capital gains, unless the asset is eventually sold.  

 

Jonathan. Continuing that line of thought, back in 2010, the estates of those who died had a choice: 1) subject assets to estate tax and get the step-up in basis, or 2) exclude the assets from the tax but have the decedent’s basis carry over to the inheritors. The decision was, in general, very simple: Choose whichever would produce the lowest tax. Those decedents leaving their estates to their spouses generally chose the step-up in basis option, because the transfers were protected from the estate tax due to the marital deduction. Others, such as George Steinbrenner, owner of the New York Yankees, who couldn’t avoid the estate tax and whose inheritors wouldn’t sell their inherited property, typically chose the second option: They avoided the estate tax and accepted the decedent’s basis as their own.

 

Turney. What if you did both: continued the basis reset and repealed the estate tax?

 

Jonathan. Of course, some want both repeal of the estate tax and a step-up in basis. But, that would mean even more loss of revenue for the government, and an alternative source of funding would have to be found. Another idea that might be more promising is to let an individual choose to pay a transfer tax during his lifetime, but exempt the property from tax at his death. Given a choice, it’s doubtful that individuals would choose a higher income tax on themselves, as opposed to a tax on the inheritance their inheritors receive. Those proposals have received little traction and, of course, those who oppose the estate tax will oppose the lifetime transfer tax as well. They just don’t want to pay tax.

 

Repeal vs. Simplification

Turney. All of this brings me to my primary reason for suggesting that the estate tax should be repealed and the revenue found somewhere else: The estate tax is simply too complicated.

 

Jonathan. Before you go any further, why is repeal the only option? Why not simplification?

 

Turney. Sure, in principle, simplification is grand. But, I’m skeptical that simplification can be accomplished. First, it strikes me that one reason the estate tax is tolerated is because there are so many loopholes. Unless someone is just afraid of lawyers or refuses to do planning, there’s no need to face a 40 percent tax on all assets over $5.45 million. If simplification made the tax system work more like it was intended, then I think there would be enormous opposition because simplification would, in effect, be a tax increase. I can imagine a political scenario that would welcome that sort of tax increase, but scenarios like that wouldn’t last, and soon the loopholes would creep back in. My conversations with those who suggested a 40 percent estate tax rate indicated that many of them thought that at a low rate (at least “low” compared with the 55 percent rate before), estate planning in the sense of tax avoidance planning would wither, but I see no evidence of that. 

Second, on a more theoretical level, the problem with the wealth transfer tax system is that it taxes transfers of state law property interests. Those property interests can be changed to thwart the estate tax, in whole or part, and we need not go into that here. That practice isn’t going to stop. Further, the mismatch between the ability to define “property” and the desire to tax it seems to create complexity of necessity. Let me give you an example. Suppose a state legislated that anyone who lived on a particular acre of land couldn’t own any property at all; he only could have the right to use property. Most people would avoid being domiciled on that particular acre. But, if a person wanted to avoid estate tax, he might move to that acre and then argue to Uncle Sam that he was just “using” his yacht and securities, which might not be “property” for estate tax purposes. I know this is a facetious example (and one the Feds would have little trouble with), but the point is that I see continuing state efforts that will make simplification difficult. Note that I’ve avoided any discussion of political polarization or dysfunction, which are the most immediate enemies of simplification.

 

Jonathan. True, but in the current environment, the elimination of the estate tax is unlikely as well, unless it’s replaced with something else that’s similar. The most likely replacement would be an imposition of an income tax at death. That tax could be a capital gains-type tax, or we could make inheritances part of gross income. That option might actually produce much more revenue for the government (at least if there were no large exemptions and the inheritance was subject to ordinary income and net investment income tax). Exemptions could be reset; you could allow reporting over several years to reduce the run-up in brackets. A benefit would be that you could absorb the estate tax within the income tax, which might produce, on balance, a simplification.

 

Turney. I think that the estate tax has become a big enough hot button so that as part of other tax changes—simplification, reform, increases—repeal might be achieved. I agree that then, taxes would rise elsewhere. If you’re a cynic, you might say that taxes will rise for poor individuals; as evidence, you’d argue that right now, only the very, very rich pay the estate tax, so in essence, repeal will increase taxes on those economically lower than the very, very rich. But, that’s not necessarily true. Income tax increases and the elimination of various tax breaks (admittedly all with constituents) are equally likely. Jonathan, any last words?

 

Jonathan. I think we’re back to where we began: There’s no such thing as tax reduction; only tax burden shifting. Eliminating the tax on the richest Americans means it will fall on those with less. I understand why those who advocate for it do so, but on balance, I would leave the system in place and try some simplification efforts.                      

 

Endnotes

1. See https://en.wikipedia.org/wiki/Laffer_curve.

2. The multiplier effect is one of the chief components of Keynesian economic models. According to the Keynes theory of fiscal stimulus, an injection of government spending eventually leads to added business activity and even more spending. This theory proposes that spending boosts aggregate output and generates more income. If workers are willing to spend their extra income, the resulting growth in the gross domestic product stimulus amount could be even greater than the initial stimulus amount. See www.investopedia.com/ask/answers/032315/why-multiplier-effect-associated-keynesian-economics.asp.

 
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