Why the death tax lives

By Stephen J. Entin ~ From The Wall Street Journal

WASHINGTON -- Last week, the Senate kept the death tax alive. Due to phase down and then expire in 2010, the death tax will be miraculously resurrected in 2011 at its full punitive rate of up to 55 percent, thanks to the sunset provision imposed by Congress on the Bush tax bill last year. If supply-siders are going to have any success in driving a stake through the heart of this counterproductive tax in the future, we're going to have to change the way that the Treasury Department, the Congressional Budget Office and the Joint Committee on Taxation "score" the revenue effects of tax and spending bills.

Some of the senators who voted against permanent repeal expressed concern over the projected budget cost of more than $50 billion a year, given the return of budget deficits and the war on terror. (Where were these pillars of fiscal rectitude when the Senate padded the farm bill and the antiterrorism supplemental, among other recent budget busters?) The senators should have known better. Static estimate of lost revenues notwithstanding, the death tax probably costs the government more than it brings in. The death tax reduces revenue in two ways -- by encouraging estate planning and by hurting the economy.

The death tax induces wealthy individuals to begin distributing their assets long before they die. They may give $11,000 a year to as many beneficiaries as they wish without counting against the lifetime estate and gift tax credit. They may also take advantage of various forms of trusts. When upper-income parents give their assets to their yet-to-be upper income adult children, the subsequent earnings of the assets are taxed at lower tax rates than if the parents had kept the money.

The wealthy are also likely to give their money to charity. Charitable giving in response to the estate tax threat reduces the take from income taxes when the donors itemize their gifts and again when the charities receive income from the donated assets tax-free. B. Douglas Bernheim of Stanford University has written that the reduction in income tax revenue just from assets transferred before death may exceed the revenues raised by the estate tax.

The death tax also reduces revenues by weakening incentive to save and invest. Less investment means lower productivity and lower taxable wages, profits, interest, dividends and capital gains. Forced liquidations of family businesses do further damage by wasting the human capital of the families that have been running them and know them best. Economists Gary and Aldona Robbins estimate that repeal of the death tax would boost gross domestic product enough that, within 10 years, federal tax revenue would be higher than had the tax been retained.

If both sets of researchers are even half right, the death tax brings in nothing. If they are both fully correct, the tax will not bring in the projected $50 billion a year after 2010; it will lose $50 billion a year.

So why is it that last year the Joint Committee on Taxation made the startling assertion that repealing the tax would reduce government revenues by more than 150 percent of what the tax currently collects? Because the JCT did not use a "dynamic" scoring model that correctly estimates the economic and budget gains of repeal. This is the sort of mistake often made in the past. For example, JCT suggested that raising the capital-gains tax rate by nearly 50 percent in 1987 would increase revenues from about $26 billion in 1985 to about $65 billion in 1991. The actual figure in 1991? A mere $25 billion.

In this case, JCT increased the cost of repealing the estate tax by coming up with an implausible scenario under which, after repeal, everyone would dodge their capital gains taxes. How? By parking their assets, free of gift tax, with an elderly relative who was likely to die soon, and who would then return the assets as a bequest with the advantage of a lower capital gains tax rate. (Under the current law, an heir's cost basis for capital gains purposes is the price of the asset when the benefactor died; any unrealized gains accrued before death are erased.) What nonsense. Such revolving door transfers could have been blocked by regulations. Besides, such ploys are risky: If you give your assets to your Aunt Fanny, she may not die on schedule, or she may will the assets to your no-good cousin Fred. In short, the JCT assumed highly unlikely behavior changes that raised the apparent cost of the provision, and ignored far more certain changes in behavior that would have reduced its cost.

The death tax is punitive and immoral, because it is an extra tax on hard work and thrift. Income is taxed when earned. If used for consumption, there is generally no further federal tax, except for a few excise taxes. If saved, the returns are taxed as interest, dividends and capital gains, and, if put into corporate shares, there is the corporate income tax too. Even if the saving was in a tax-deferred retirement account, it will be subject to the heirs' income tax in the years following inheritance. Consequently, every penny in an estate has either been subject to income taxes, often more than once, or is about to be subject to income taxes. The death tax is always an extra layer of punishment.

However, the greatest immorality of the death tax may be that it is futile, yielding no net revenue to justify the damage that it inflicts. But until the revenue estimators in Congress and at Treasury begin reporting the real-world effects of tax and spending changes, Congress will legislate in ignorance and in error. President Bush and Republican leaders on the Hill need to make it a top priority to get better revenue estimators.

Stephen J. Entin is president of the Institute for Research on the Economics of Taxation.