How could we reform the estate tax?
Possible reforms run the gamut from repeal to modest fixes that would make the tax more difficult to avoid.
Proposals to reform the estate and gift tax range from comprehensive options, such as permanently repealing the estate tax or replacing the existing tax with a tax on inheritances, to more modest options, such as decreasing exemption amounts, increasing tax rates, and blocking avenues for avoiding the tax.
The federal estate and gift taxes (including the generation-skipping tax, or GST) have changed virtually every year since 2001. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) cut these taxes sharply but only through 2010. EGTRRA gradually phased out the estate tax and GST, and eliminated them entirely for 2010, leaving only the gift tax (at a reduced rate) in that year.
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 reinstated the estate tax and GST for 2010 and extended them through 2012, with a $5 million estate tax exemption (indexed for inflation after 2011) and a top rate of 35 percent. But it allowed executors to elect the EGTRRA rules for decedents who died in 2010. The 2012 rules were permanently extended by the American Taxpayer Relief Act of 2012 (ATRA), though with a new top rate of 40 percent. In light of numerous recent proposals to repeal these taxes or reform them in some manner, how “permanent” the ATRA changes are remains to be seen.
Many members of Congress have called for the repeal of the estate and gift taxes. That would be expensive, however. The Congressional Budget Office projects that these taxes will raise $266 billion in fiscal years 2015 through 2025.
Repeal would also be regressive—the benefits would go almost entirely to people at the top of the income distribution—and would invite significant sheltering of income. Further, gifts from an estate to charity currently qualify for full deduction from the estate’s taxable value, creating a substantial incentive to leave bequests to charities. Prior estimates indicate that repealing the estate tax would reduce charitable donations by 6 to 12 percent.
One option, the substitution of an inheritance tax, would tax wealth transfers somewhat differently. It differs from an estate tax and gift tax in that the tax rate depends on the amount of gifts and bequests the taxpayer receives rather than on how much the donor gives or bequeaths. Unlike estate and gift taxes, a progressive inheritance tax gives donors an incentive to spread their wealth more broadly, because each of any number of recipients can claim an exemption and take advantage of the progressive tax rates, thus reducing their effective tax rate. Most countries that tax wealth transfers do so with inheritance taxes rather than estate taxes.
A more modest reform could address the loopholes, such as special trust arrangements and valuation discounts. Those tax avoidance measures complicate estate planning and result in unequal taxes on comparable estates. Closing loopholes could increase revenues, moreover, allowing a higher estate tax exemption, lower rates, or deficit reduction.
The following reforms would only change the estate tax exemption level and rates, and the treatment of wealth transfer taxes paid to states (figure 1).
- Pre-ATRA Law: The old law had an exemption level of $1 million (not indexed for inflation) and a top statutory rate of 55 percent, along with a 5 percent surtax that phased out the benefit of lower rates for large estates and a credit (rather than a deduction) for state wealth transfer taxes. Making pre-ATRA law permanent starting in 2015 would increase the number of estate tax returns filed between 2015 and 2025 by 1.5 million and increase the estate tax liabilities of these decedents by nearly $450 billion.
- 2012 Law: The estate tax law in effect in 2012 had an exemption of $5 million (indexed for inflation from 2011) and a top rate of 35 percent, so it differs from current law only in the top rate. Making 2012 law permanent starting in 2015 would not affect the number of estate tax returns filed but would decrease estate tax liabilities by about $33 billion for decedents who died between 2015 and 2025.
- 2009 Law: The estate tax law in effect under EGTRRA for 2009 had an exemption of $3.5 million and a top rate of 45 percent. If 2009 law were made permanent starting in 2015, the number of estate tax returns filed between 2015 and 2025 would increase by 140,000, and estate tax liabilities of these decedents would increase by $135 billion.
- 2009 Law, Exemption-Indexed: If 2009 law, modified to index the exemption to inflation, were made permanent starting in 2015, the number of estate tax returns filed between 2015 and 2025 would increase by 72,000, and estate tax liabilities of these decedents would increase by $93 billion (about one-third less than the increase without indexing the exemption).
Urban-Brookings Tax Policy Center. Microsimulation Model, version 0515-1.
Bakija, Jon M., and William G. Gale. 2003. “Effects of Estate Tax Reform on Charitable Giving.” Washington, DC: Urban-Brookings Tax Policy Center.
Batchelder, Lily L. 2009. “What Should Society Expect from Heirs? A Proposal for a Comprehensive Inheritance Tax.” Tax Law Review 63 (1): 1–112.
Department of the Treasury. 2015. “General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals.” Washington, DC: Department of the Treasury.
Joint Committee on Taxation. 2015. “History, Present Law and Analysis of the Federal Wealth Transfer System.” JCX-52-15. Washington, DC: Joint Committee on Taxation.
Task Force on Federal Wealth Transfer Taxes. 2004. Report on Reform of Federal Wealth and Transfer Taxes. Washington, DC: American Bar Association.