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An Immodest Proposal Regarding the Estate Tax

Thursday, January 7, 2010

Here’s a plan that both Republicans and Democrats should like.

The House voted 225-200 in December to make the 2009 estate tax permanent. It exempts the first $3.5 million ($7 million for an opposite sex married couple) and 45 percent on anything above that figure. But because the Senate failed to act, the estate tax dropped to zero for 2010 and in 2011 will rise to the old, pre-2001 rate of 55 percent with a $1 million exemption.

Most Democrats have long favored estate taxes and Republicans have generally opposed them, arguing that death is no reason to trigger a large tax liability that might force the break up of family businesses and farms. (Republicans might be interested to know that their argument has ancient roots. The Roman author and politician Pliny the Younger, 61–circa 112, thought the estate tax to be “an unnatural tax augmenting the grief and sorrow of the bereaved.")

The Republicans have logic on their side. A man who starts with nothing and dies rich has paid taxes already on the part of his net worth that he accumulated by spending less than he earned. Why tax it again just because he has died? But Democrats can point to the fact that the government is running huge deficits and needs every dime of revenue. The estate tax provides revenue of roughly $25 billion a year.

Very large estates almost always have a far larger component that, in fact, has never been taxed: capital gains.

So I have a modest proposal. It would give the Democrats the revenue they always crave and, at the same time, give the Republicans a permanent repeal of the estate tax and its unfair trigger. My proposal is logical, fair, and would cost nothing to administer. Indeed, it would save the government money, as the estate tax, unlike the capital gains tax, is very expensive to administer, often involving value judgments, much negotiation, and, if that fails, lawsuits.

Of course, as anyone who has studied American politics for more than five minutes knows, logic's writ does not run to Capitol Hill, especially on an issue so easily demagogued as a tax that falls largely on the affluent. And fairness and efficiency don't pull much weight there either. But, regardless, I will cast my bread upon the waters of the Potomac anyway.

A possible compromise would be to set the capital gains on inherited assets at a higher rate than on assets bought by the person himself.

While the part of an estate that is the result of savings (the excess of income over outgo) has already been taxed once, with the annual income tax, very large estates almost always have a far larger component that, in fact, has never been taxed: capital gains.

Let's take a concrete example. Say granddad founded Amalgamated Widget in his garage in his twenties and when he died in his eighties, he owned 100 million shares each worth $100, for a net worth of $10 billion. Under the law that was in force until January 1, the estate would have had to pay an estate tax of $4.5 billion on these shares. The heirs would then receive the 55 million shares left. This might cause the family to lose control of the company (unless expensive lawyers had arranged things to make sure they don't). If granddad's capital gains were largely in a family business or farm, rather than a publicly traded corporation, a sale of the entire enterprise might well be necessary to pay the estate tax due.

If granddad's capital gains were largely in a family business or farm, rather than a publicly traded corporation, a sale of the entire enterprise might well be necessary to pay the estate tax due.

But, under current law, a funny thing happens to the 55 million shares that the heirs inherit once the estate tax is paid. As a founder, granddad's "cost basis"—what he is judged to have paid for each share of Amalgamated Widget—was almost certainly close to zero. But once the stock passes to the heirs, its cost basis is raised to the price of the stock on the date of death, in this case $100 a share, not the few cents granddad paid for it.

In other words, the estate tax is really a capital gains tax, but triggered by death, not sale of the capital asset.

So why not eliminate the estate tax, but then have the heirs inherit not only the stock in Amalgamated Widget but granddad's cost basis as well? Then, when Junior sells a million shares in order to pursue his dream of winning back the America's Cup or whatever, he has to pay a substantial capital gains tax on those shares.

A possible compromise would be to set the capital gains on inherited assets at a higher rate than on assets bought by the person himself. This would allow the Democrats to feel all warm and fuzzy for having still socked it to the rich and allow the Republicans to claim credit for having eliminated an unfair, arbitrary, expensive, and economically pernicious tax.

What's not to like?

John Steele Gordon is the author of Hamilton’s Blessing: The Extraordinary Life and Times of Our National Debt; a revised edition of it will be published in early 2010.

FURTHER READING: Gordon most recently wrote “Debt Be Not Proud: The Sorry Tale of America’s Out-of-Control Spending” for THE AMERICAN. Leslie Lenkowsky explained another tax burden he calls “The Administration’s Threat to Philanthropy.” And Joel Kotkin discussed the differences in government policy towards the rich in “The Luxury City vs. the Middle Class.”

Image by Darren Wamboldt/Bergman Group.

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