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Incremental Reforms: How could we reform the estate tax?

The federal estate and gift tax has changed virtually every year since 2001, as the effective exemption has increased to $2 million in 2007 and the maximum tax rate has fallen to 45 percent. The exemption will rise to $3.5 million in 2009, and the tax will disappear entirely for one year in 2010, after which, unless renewed, it returns as under pre-2001 law, with a $1 million exemption and a 55 percent maximum tax rate. The continuing changes in the tax have made estate planning difficult because of uncertainty about what tax rules will apply when a person dies. Making estate tax law permanent with a modestly higher exemption and a lower tax rate would remove that uncertainty and would maintain some estate tax revenue while protecting all but the largest estates from the tax.

  • Reform should simplify the estate tax to make it easier for taxpayers to pay their fair share without complex estate planning. One simplification would allow married couples an exemption equal to twice that for singles, allocated between spouses as they wish. Tax planning already accomplishes this, but the change would make it automatic. The change would likely have little effect on revenue collections and would significantly reduce the need for estate planning.
  • Reform should attack the loopholes such as special trust arrangements and valuation discounts. Those tax-avoidance measures both complicate estate planning and result in unequal taxes on comparable estates. Closing loopholes could increase revenues, allowing a higher estate tax exemption or a reduction of the national debt.
  • The president and many members of Congress have called for immediate and permanent repeal of the tax. That would be expensive, however: immediate repeal would reduce revenue by about $350 billion over the next decade. Repeal would also be regressive-the benefits would go almost entirely to people at the top of the income distribution-and would invite significant tax sheltering. 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. Economists have estimated that repealing the estate tax would cause charitable donations to fall by between 6 and 12 percent, or as much as $25 billion annually.
  • If current 2009 law were made permanent in that year (exempting $3.5 million of assets and taxing any excess at 35 percent), it would yield roughly $134 billion in revenue between 2009 and 2016, about 45 percent of what current law would raise. Most of the gains would accrue to the wealthiest 1 percent of households, whose average after-tax income would rise by 0.4 percent in 2011.
  • The proposed Permanent Estate Tax Relief Act of 2006 (H.R. 5638) would have fixed the effective estate tax exemption at $5 million after 2009 and set the estate tax rate equal to the rate on long-term capital gains (15 percent through 2010 and 20 percent thereafter). The congressional Joint Committee on Taxation estimated that the bill would have reduced revenue by $282 billion through 2016. The Tax Policy Center estimated that more than one-third of the proposal’s benefits in 2011 would have gone to the top 1 percent of the income distribution, raising their average after-tax income by nearly 1 percent.
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   Entry 4 of 5