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The Roosevelts Would Be Appalled

Friday, December 17, 2010

A history of the estate tax shows just how far both political parties are from the beliefs of Teddy and FDR.

Congressional Democrats and Independent Vermont Senator Bernie Sanders oppose the idea of a 35 percent estate tax on all estates with values above $5 million, as proposed by the president and congressional Republicans. The Democrats and Senator Sanders believe that a tax of 45 percent on estates with values over $3.5 million is more in keeping with both American political principles and political history. If no action is taken, on January 1, 2011, the estate tax will rise to a top rate of 55 percent and the starting point for estate taxes will be $1 million.

Senator Sanders recently gave a speech in which he offered a quote by Theodore Roosevelt from Roosevelt’s New Nationalism speech, delivered in 1910: “Therefore, I believe in ... a graduated inheritance tax on big fortunes, properly safeguarded against evasion, and increasing rapidly in amount with the size of the estate.”

The exemption started at $50,000, or 36 times the average income in 1920, and was $60,000 in 1976, or only 6 times that year’s average income.

Senator Sanders was clear that if the estate tax provisions advocated by the president and the Republicans were passed, it would violate the spirit of Roosevelt’s principle. It is this principle which appears to generate the anger of Senator Sanders and the House Democrats.

A review of the history of the estate tax, however, brings this view strongly into question. In fact, it appears that neither Theodore nor Franklin Roosevelt would have endorsed the Democrats’ preferred tax rate and top tax bracket choices.

America and the Estate Tax

Some history is useful here. There have been four different estate tax regimes: the Stamp Act of 1797; the Revenue Act of 1862; the War Revenue Act of 1898; and the Revenue Act of 1916. The first three estate tax regimes each lasted only a few years before being repealed. The Revenue Act of 1916, however, ushered in an era of continuous estate taxes, rising in the 1930s to a high maximum tax rate.

The Stamp Act of 1797: The first version of the estate tax was passed in 1797, to support the undeclared war with France that began in 1794. Widows, children, and grandchildren were exempt from the tax, but not widowers. Estates of less than $50 were free from the tax. All larger estates were taxed.

The initial estate tax did not last long. It was repealed in 1802, five years after being enacted.

The estate tax rates were different than those of recent times: For the entire estate, regardless of value, there was a fee of 60 cents for government administration and verification. Additionally, there was a tax based on the size of the estate that ranged from one-tenth of 1 percent to one-half of 1 percent.

The initial estate tax did not last long. It was repealed in 1802, five years after being enacted.

The Revenue Act of 1862: The second iteration of the estate tax was passed to support the cost of the Civil War. Estates of less than $1,000 were free from the tax. Once again, widows were exempt from the tax, regardless of the size of the estate. No one else was exempted, but certain beneficiaries got preferential rates. The estate tax rates were as follows (using the highest rates, enacted in 1864):

Ancestors, lineal descendants: 1 percent on property, 1 percent on legacies
Siblings: 2 percent on property, 1 percent on legacies
Descendants of siblings: 2 percent on property, 2 percent on legacies
Uncles, aunts, and their descendants: 4 percent on property, 4 percent on legacies
Great uncles, great aunts, and their descendants: 5 percent on property, 5 percent on legacies
Other relatives, unrelated individuals, and charities: 6 percent on property; 6 percent on legacies

Congress repealed this version of the estate tax in 1872, 10 years after being enacted.

The War Revenue Act of 1898: The estate tax was reinstated to support the cost of the Spanish-American War. Once again, widows were exempt from the tax, regardless of the size of the estate. In 1901, gifts to charitable, religious, literary, and educational organizations and gifts to organizations dedicated to encouraging the arts and preventing cruelty to children were also excluded from taxation. Estates of less than $10,000 were free from tax. Tax rates varied from 0.75 percent on small estates given to lineal descendents, ancestors, or siblings to 15 percent on estates of $1 million or more given to unrelated parties or nonexempt organizations.

To put this in perspective, an average worker’s income in 1900 was $438, so the size of the estate on which the maximum rate was charged was 2,283 times as large as that income. If the same ratio were in place today, given the 2009 average income of $32,051, the maximum rate would not be charged until an estate was valued at more than $70 million.

This version of the estate tax was repealed in 1902, four years after being enacted.

The second iteration of the estate tax was passed to support the cost of the Civil War. It was repealed 10 years after being enacted.

The Revenue Act of 1916: This version of the estate tax was passed before the United States entered World War I. The estate tax has been a permanent feature of U.S. taxation ever since, with the exception of 2010, when the estate tax lapsed. This version has been changed many times during its 94-year history, and the proposed change for 2011 is generating great interest.

While the details have changed over time, the basic structure of the estate tax has remained constant since 1916. There are four key features: The exemption (the amount at which the estate tax begins), the initial tax rate, the top tax rate, and the top bracket (the amount at which the top rate applies).

The exemption and initial tax rate affect middle- and working-class families directly. The higher the exemption relative to average earnings and the lower the initial rate, the better off middle- and working-class families are.

The exemption started at $50,000, or 36 times the average income in 1920, and was $60,000 in 1976, or only 6 times that year’s average income. Clearly, over time, this factor became more regressive, not more progressive. Middle- and working-class Americans paid more in taxes as a result.

Starting in 1977, the exemption has been rising. It was $675,000 in 2000, the last year of the Clinton administration, and was raised in a series of steps to $3.5 million in 2009, under the Bush administration. In 2000, the exemption was 27 times the average income, much less than it was when the tax was introduced and also less than at any time in the administration of Franklin Roosevelt. In 1940, the exemption was $40,000, or 30 times average earnings.

In 2006, the exemption reached $2 million, or 68 times that year’s annual income, finally reaching a “progressive” level in comparison to 1916.

In 1901, gifts to charitable, religious, literary, and educational organizations and gifts to organizations dedicated to encouraging the arts and preventing cruelty to children were excluded from the estate tax.

The initial rate was set at 1 percent in 1916. This rate fluctuated between 1 percent and 2 percent in subsequent years before being raised to 3 percent in 1941 during Franklin Roosevelt’s administration. In 1977, it was raised to 18 percent, where it remained through 2009.

Clearly the initial rate was “working-class-friendly” until 1977, when it became decidedly more regressive, just as the exemption was starting to become less regressive.

The combined effect of these factors has been highly regressive in recent years. In 1940, an estate of $100,000 (30 times the average income and $50,000 above the exemption) paid $1,000 to the government. In 2000, an estate of $750,000 (also 30 times the average income and only $75,000 over the exemption) paid $13,500 to the government, an 80 percent increase since the time of Franklin Roosevelt in the estate taxes paid by middle- and working-class Americans on similar estates.

The Bush administration’s changes in the estate tax structure gave middle- and working-class Americans the opportunity to leave a tax-free estate worth about three times as much as the initial estate tax in 1916. But this structure still taxed any estate above that amount at a rate 18 times higher than did the 1916 legislation, so it was favorable to middle- and working-class Americans in some ways but unfavorable in others, when compared to the original structure.

The top rate and top bracket work together to ensure that Theodore Roosevelt’s principle of “a graduated inheritance tax on big fortunes” is carried out. The top rate reduces the amount of the estate that can actually be passed on. The top bracket (combined with the exemption amount) determines the level at which a “big fortune” is felt to exist.

The top tax rate has been changed 10 times. In 1916, the top rate was set at 10 percent, similar to the top rates for earlier versions of the estate tax. In 1917, as World War I loomed, this rate was raised to 25 percent, where it remained for seven years. In 1924, the top rate was raised to 40 percent, but it stayed there only for two years before being lowered in 1926 to 20 percent. Six years later, in 1932, the top rate rose to 45 percent for two years. In 1934, the top rate was again raised, this time to 60 percent. The top rate was raised again in 1935, to 70 percent, where it remained for six years. In 1941, as World War II loomed, the rate reached its highest level at 77 percent, and held there for 36 years.

The higher the exemption relative to average earnings and the lower the initial rate, the better off working-class families are.

The top rate was reduced to 70 percent in 1977, to 65 percent in 1982, to 60 percent in 1983, and then to 55 percent in 1984, where it held for 18 years. Starting in 2001, the top rate was further reduced each year to a level of 45 percent in 2007, where it remains until reverting to 55 percent in 2011, unless Congress acts this month.

This factor has been highly “progressive” over most of the life of this version of the estate tax, with Franklin Roosevelt’s administration implementing the highest rate.

The top bracket amount has been changed six times, with two multi-year changes. Only two of the changes have been upward; four were downward changes. In 1916, the top bracket was set at $5 million, or more than 3 thousand times the average income in 1920. In 1917, the top bracket was raised to $10 million, or more than 7 thousand times the average income in 1920. This was done in conjunction with the rise in the top rate from 10 percent to 25 percent, so the total change in 1917 conformed to Theodore Roosevelt’s principle by being heavily graduated, but applied the top rate only to the wealthiest.

The top bracket remained at $10 million until 1935, when it was raised to $50 million, along with the rise in the top rate to 70 percent, another “progressive” change. In 1940, $50 million was more than 38,000 times the annual income. Clearly, only very large fortunes were affected, and Franklin Roosevelt was acting just as Theodore Roosevelt had urged.

In 1941, when the top rate was raised to 77 percent in anticipation of World War II, the top bracket was lowered to $10 million, or 7,600 times the average 1940 income. This change was mixed in terms of Theodore Roosevelt’s premise. A tax rate more than three times higher than the 1917 rate was applied to estates of similar size to those of 1917, when compared to average incomes. World War II was clearly visible in 1941 and may have influenced the choice of estate tax structures. In defense of FDR, average incomes in 1940 had not risen from 1920 levels, but a few had managed to prosper during the Great Depression, and there was considerable anger among Americans about this disparity.

This top bracket and its companion top rate remained in place for 36 years.

The initial rate was ‘working-class-friendly’ until 1977, when it became decidedly more regressive, just as the exemption was starting to become less regressive.

In 1977, Congress reduced the top bracket from $10 million to $5 million, a level only 500 times the average annual income in 1977, a large reduction from the 3,000 times average annual income that existed in 1916. The top rate was also reduced, from 77 percent to 70 percent. The year 1977 marks the beginning of the most regressive phase of the estate tax; and things only got worse, since none of the rates or balances was indexed to inflation on a regular basis.

As a result, by 2001, the $3 million top bracket had dropped to only 117 times the average annual income (143 times, if increases in the exemption amount are included), which clearly was contrary to Theodore Roosevelt’s principle of heavily taxing the extraordinarily wealthy. During this 18-year period, the 55 percent top rate remained constant, meaning that many less wealthy Americans were being taxed at rates formerly reserved only for those of immense wealth.

In 2002, as part of the Bush tax cuts, Congress reduced the top bracket by one-third, from $3 million to $2 million over a two-year period. This was a highly regressive change, which exposed smaller estates to the largest rate. Offsetting this regressiveness somewhat, over the six-year period from 2002 to 2007, the top rate also gradually fell from 55 percent to 45 percent.

In 2003, the top bracket was less than 75 times average earnings. Changes in the estate tax model included substantial rises in the exemption amount, but income had risen also, so the combination of exemption plus top bracket comparison to average annual wages was 111 times, still very low by 1916, 1941, or even 1977 standards. By 2009, the combined exemption plus top bracket to earnings ratio was again rising and stood at 156 times average annual earnings, still a historically low level, but at least an improving one.

Looking Forward

President Obama and Republicans have proposed the following estate tax structure:

Exemption: $5 million; initial tax rate: 18 percent; top tax rate: 35 percent, charged on amounts in excess of $500,000 more than the exemption.

The Democrats are countering with a slightly different estate tax structure:

Exemption: $3.5 million; initial tax rate: 18 percent; top tax rate: 45 percent, charged on every dollar in excess of $1,500,000 more than the exemption.

These proposals are both radically different than the 1916 structure. Rather than having a tax schedule that starts at a low rate and rises to a level 10 times higher as the estate’s value reaches 100 times the exemption, each has a much higher set of tax rates that is applied over a very narrow range after a somewhat larger exemption has been exceeded.

The president and Republicans’ proposal is closer to Theodore Roosevelt’s principle than that of the Democrats, since it has a higher exemption and therefore affects only wealthier estates. But it starts the top tax rate at only 172 times average income, while the 1916 structure put the top bracket at more than 3,500 times average income. And it places the top rate at 3.5 times that of the 1916 structure. Further, this proposal does not impose its graduated tax schedule only for the truly large fortunes that Theodore and Franklin Roosevelt stressed.

But the Democrats’ proposal is even farther from the Roosevelt principle. It starts its high tax rate at only 156 times average income, versus the 3,000 times of 1916 or the 38,000 times of Franklin Roosevelt’s pre-WWII policy. And its top rate, while only 58 percent of the peak of 77 percent for Franklin Roosevelt, is 4.5 times the 1916 level. Taken as a whole, the Democrats’ proposed structure is far more regressive than either the 1916 structure or that of Franklin Roosevelt. And, like the president and the Republicans’ proposal, the Democrats’ proposal also does not impose its graduated tax schedule only on truly large fortunes.

To claim that Theodore Roosevelt’s principle has been honored over the past 94 years is to ignore history and to ignore the hardships faced by middle- and working-class Americans, as Theodore Roosevelt’s idea of preventing abuses by the wealthiest gradually became a penalty tax on the entrepreneurial spirit of all Americans.

Claiming that either of the two 2011 estate tax proposals closely follows the “progressive” principle laid down by Theodore Roosevelt is simply wrong, but of the two proposals, the President and Republicans’ proposal is closer to that principle than the House Democrats’ proposal.

Kenneth Gould is a retired banker and former executive vice president at the Federal Home Loan Bank of Chicago.

FURTHER READING: Tim Kane strategizes “The Way to Cut Taxes and Deficits,” Veronique de Rugy offers a lesson on “Taxes and Presidential Math,” and Alex Pollock explains “Why the Fed Cannot Regulate ‘Systemic Risk.’” Kevin Hassett and Aparna Mathur trace “Taxes Around the World” and Michael Barone observes, “While His Base Rages, Obama Faces Tax-Cut Reality.”

Image by Darren Wamboldt/Bergman Group.

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