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Options to Reform the Estate Tax

Leonard E. Burman, William G. Gale, Jeff Rohaly

Published: March 23, 2005
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Brief #10 from the series Tax Policy Issues and Options

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in the Portable Document Format (PDF).


Under current law, the estate tax is reduced gradually through 2009, repealed in 2010, and then reinstated in full force in 2011. Few expect things to actually play out that way.

The president and many members of Congress would like to repeal the tax permanently, and many would like to do so before 2010. Repeal would be expensive, however: immediate repeal would reduce revenues by over $400 billion over the next decade. Even making repeal permanent as of 2010 would cost $270 billion in the next 10 years. Repeal would also be regressive, would reduce charitable giving by over $15 billion a year, and would invite significant tax sheltering. It would increase the concentration of wealth, and may increase the political power of a wealthy elite.

Critics of the estate tax counter that it burdens small farms and businesses with confiscatory tax rates, discourages work and thrift, and retaxes money taxed under the income tax. In fact, few small farms and businesses appear to be subject to the estate tax, although many families may undergo costly planning to avoid it. The empirical evidence on saving behavior is ambiguous: The tax may discourage work and saving for people subject to it, but it has the opposite effect on heirs who—expecting smaller bequests—choose to work harder and save more. And while the tax may "double tax" income in some cases, much of the wealth subject to estate tax was earned through untaxed capital gains and so has never been subject to the income tax.

In contrast to repealing the tax, retargeting the estate tax to very wealthy households and lowering its rates would blunt much of the criticism against it while retaining many of its advantages. This brief explains how the estate tax works and examines who is affected by it under current law. It discusses how reform would affect tax revenues, the distribution of tax burdens, farms and small businesses, and charitable giving and bequests. A concluding section discusses ways to reduce the tax's complexity.

Background

According to federal law, the executor of an estate must file a federal estate tax return within nine months of a person's death if the gross estate exceeds an exempt amount—currently $1.5 million. The exempt threshold has been phasing up and tax rates have been phasing down since 2001, when the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) enacted a gradual phaseout of the tax.1 After a scheduled elimination in 2010, the estate tax returns in 2011 with an exemption of $1 million and a top statutory rate of 55 percent.

The estate tax allows deductions for transfers to a surviving spouse, charitable gifts, debts, funeral expenses, and administrative fees. About 90 percent of married decedents who file estate tax returns avoid the tax entirely, largely because of the unlimited spousal deduction. Aunified credit exempts taxes on the first $1.5 million of taxable transfers in 2005 (including gifts made during life and transfers at death), a figure scheduled to rise to $3.5 million in 2009. In addition, the valuation of assets can often be discounted through careful tax planning, so the effective exemption far exceeds the statutory amount for many estates (Schmalbeck 2001).

Family-owned farms and closely held businesses receive especially generous treatment under the estate tax.2 Farmers and small business owners may reduce the value of their real estate using a special formula as long as their heirs maintain its use as a family-owned farm or business and do not sell it to a nonrelative for at least 10 years. Special use valuation can reduce the value of the real property portion of most farms by 40 to 70 percent of its market value. In addition, estates in which farm and business assets make up more than 35 percent of the gross estate may pay their estate tax in installments over 14 years at reduced interest rates. Only interest is due for the first five years. In 2003, the interest rate on the first $493,800 of estate tax was 2 percent; the interest rate on amounts above that was 45 percent of the interest rate that applies to underpayment of tax (which was 4 percent for the third quarter of 2004).


Notes from this section

1. Burman and Gale (2001) provide more background on the EGTRRA estate tax changes and the economic issues raised by that legislation.

2. See Durst, Monke, and Maxwell (2002) for a detailed summary of rules that affect farmers. (Most also apply to family-owned businesses.)


Note: This report is available in its entirety in the Portable Document Format (PDF).