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Estate and gift tax, federal

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

David Joulfaian
U.S. Department of the Treasury

The federal tax treatment of wealth transferred in contemplation of, or at the time of, death.


The estate and gift tax is the only wealth tax levied by the federal government. The estate tax was first enacted in 1916 and applied to the wealth of decedents with estates in excess of $50,000. It has undergone numerous changes, especially in 1976, 1981, and 1997. Significant temporary changes were introduced in 2001 and are set to expire in 2011.

The gift tax was enacted in 1924, repealed in 1926, and reenacted in 1932 in an attempt to reduce estate tax avoidance via the initiation of inter vivos gifts. In 1976, the gift tax was integrated with the estate tax under the unified transfer tax and a common tax rate schedule. Cumulative transfers, inter vivos gifts, and testamentary bequests below $1 million in 2011 are exempt from taxation. Both estate and gift taxes are complemented by a generation-skipping transfer tax (GSTT) with a flat rate of 55 percent for cumulative transfers in excess of $1 million per donor in 2011.

Purpose of the tax

The enactment of the estate and gift tax, and its evolving structure over the decades, serve a number of legislative objectives. First and foremost, estate and gift taxes were enacted for their revenue yield. In 2003, these taxes yielded about $22 billion and accounted for about 1.2 percent of federal government receipts. Although the estate tax is levied on only the wealthiest 2 percent of decedents’ estates, the significance of this revenue source should not be understated.

A second objective is for these taxes to act as a backstop to the income tax by reducing the erosion of its base. Much of the capital income that escapes the income tax passes through the estate tax. Under the personal income tax, accrued capital gains are taxed only when realized, and interest income from state and local bonds, as well as proceeds from life insurance policies, among others, are tax-exempt. In contrast, all assets owned by decedents are likely to be included in their gross estates.

A third objective is to reduce wealth concentration. By taxing the wealthiest estates, the estate and gift taxes are expected to reduce the size of bequests, thus reducing the wealth accumulated over generations. This is also accomplished by subjecting capital income that has escaped the personal income tax to estate taxation.

Another objective is to tax each generation’s wealth. Wealth transfers to grandchildren are taxed under the estate and gift taxes. However, because of the emphasis on taxing each generation, an additional tax-the GSTT-is also levied on these transfers. The rationale for the GSTT is that a tax should be levied on wealth transfers to children, coupled with another tax when they, in turn, transfer wealth to their children.

To minimize state objections to the enactment of death taxes by the federal government, the estate tax provides a tax credit for state death taxes, thereby keeping the state tax base intact. Effectively, the federal estate tax acts to minimize interstate competition for the wealthy, as the state death tax credit virtually offsets taxes levied by states on the wealthiest of estates.

The tax base

The estate tax is levied on wealth held at death. This includes real estate, cash, stocks, bonds, businesses, pensions, and life insurance policies owned by the decedent, which form the gross estate. Estates may value these assets at their market value on the date of death or six months from that date. Similar property is also taxed under the gift tax when transferred during life. Cumulative lifetime gifts are added back to the taxable estate.

Exclusions

The gift tax provides for an annual exclusion of $11,000 per donee, indexed for inflation. The estate tax provides for an exclusion of up to $750,000 for real property used on farms or in businesses, indexed for inflation. The exclusion is based on the difference between the market value of a property and the capitalized income from its use in business. Proceeds from life insurance policies on the life of the decedent but owned by others are also excluded from the estate. The GSTT provides an exemption of $1 million per donor, indexed for inflation, for transfers in 2011 and beyond.

Deductions

The following statutory deductions are allowed:

  • 1. Marital deduction. All transfers of property between spouses, either through inter vivos gifts or bequests, are deductible from the estate and gift tax base.
  • 2. Charitable bequest deduction. All money donated to charitable organizations are deductible from the gross estate.
  • 3. Debts. The gross estate is reduced by the amount of debts held at death. These debts include mortgages and outstanding medical expenses.
  • 4. Other expenses. These consist mostly of funeral expenses and expenses involving the settlement of the decedent’s estate, such as attorney and executor commissions. They, too, are deductible from the estate tax base.


Rate structure

The tax rate schedule in effect in 2011 ranges from 18 percent on the first $10,000 of the combined taxable gifts and estates to 55 percent for the excess over $3 million. Generationskipping transfers are taxed at a flat rate of 55 percent, in addition to the estate and gift taxes.

Tax credits

Several tax credits are available under the estate and gift tax. The largest of these is the unified credit.

Through 1997, the value of the unified credit was fixed at $192,800 - equivalent to an exemption of $600,000 - for combined estate and gift taxes. In 2011, the credit is set at $345,800, which will exempt the first $1 million from taxation.

The second largest credit is that for state death taxes. This credit is limited to a maximum of 16 percent of the federal taxable estate. State gift taxes do not benefit from a similar credit. The estate tax also provides for a credit for previously paid death taxes in order to minimize double taxation. In computing the heir’s estate tax, the credit is set equal to the parent’s estate tax on bequeathed wealth phased out over 10 years from the parent’s date of death. The credit is not available for the estates of heirs dying more than 10 years after the parent’s date of death.

Tax deferral

Estates with farmers and closely held businesses may defer a fraction of the estate tax. This fraction is equal to the share of such assets in the estate, provided that it is in excess of 35 percent. The tax is deferred for a period of 15 years from the date of death, with the principal payable over the last 10 years. The benefit of this deferral is also available to estates that are subject to severe liquidity constraints, at the discretion of the Internal Revenue Service Commissioner.

Temporary provisions

Under temporary legislation enacted in 2001, the reach of estate and gift taxes is curtailed through 2009, with the estate tax, including the GSTT, completely repealed in 2010. However, in 2011, the estate tax is reinstated to reflect the law as enacted in 1997. More specifically, the maximum estate, GSTT, and gift tax rates are reduced to 45 percent by 2009, and the size of exempted estate is expanded to $3.5 million under the estate tax and GSTT.

Income distribution

The potential effect on income and wealth distribution is an important consideration when levying estate and gift taxes. These taxes are levied on wealth and typically apply to the top wealth holders. The revenue obtained from the estate and gift taxes, when redistributed, could reduce the concentration of wealth in the hands of a few people. More important, if the tax were designed to stimulate inter vivos gifts and bequests to a wider number of recipients, then it could be thought of as a tool to discourage concentrations of wealth.

However, there are some instances in which the estate and gift tax could cause greater inequality. If the estate tax, for instance, were to reduce savings, it would lead to lower levels of capital and lower the real rate of return to labor. Lowering labor income may exacerbate existing inequalities between those who receive income from capital and those who receive income from labor.

Another possible scenario occurs when wealth is transferred by donors who are better off than the recipients. If such transfers are reduced by the estate and gift tax, then the level of inequality increases under the tax.

Behavioral effects

Estate taxes have incentive effects for both donors and heirs. Higher estate taxes may reduce the work effort and savings of parents motivated to leave large bequests to their children. This substitution effect is the result of the tax raising the price of bequests. An offsetting effect is the income effect, whereby parents may have to increase their work efforts and savings to cover the higher taxes. There is some empirical evidence that suggests that high tax rates may have adverse effects on wealth accumulation.

Estate taxes also affect the heirs’ work effort and savings. Recent evidence suggests that large inheritances may speed up the retirement decision. Even for those who remain in the labor force, one may also observe a reduction in labor supply. However, labor supply effects are generally small. Similarly, consumption is also observed to rise in the aftermath of inheritance. But, again, these effects are small.

Taxes may also affect the timing of transfers between parents and children. Differences in the tax treatment of lifetime gifts and bequests may create incentives for parents to accelerate, or alternatively postpone, intergenerational transfers. Similarly, taxes may alter the division of bequests. High tax rates, for instance, may stimulate giving to charity at the expense of bequests to children.

ADDITIONAL READINGS

  • Bakija, Jon, William Gale, and Joel Slemrod. "Charitable Bequests and Taxes on Inheritance and Estates: Aggregate Evidence from across States and Time." American Economic Review 93, no. 2 (May 2003): 366-70.
  • Bernheim, B. Douglas. "Does the Estate Tax Raise Revenue?" In Tax Policy and the Economy 1, edited by Lawrence H. Summers. Cambridge, MA: MIT Press, 1987.
  • Cooper, George. "A Voluntary Tax? New Perspectives on Sophisticated Estate Tax Avoidance." Washington, DC: The Brookings Institution, 1979.
  • Davies, James B., and Peter Kuhn. "Intergenerational Transfers and the Distribution of Income and Wealth." In Modeling the Accumulation and Distribution of Wealth, edited by Denis Kessler and Andre Masson. New York: Oxford University Press, 1988.
  • Gale, William G., and James R. Hines Jr. Rethinking Estate and Gift Taxation. Washington, DC: Brookings Institution Press, 2001.
  • Holtz-Eakin, Douglas, David Joulfaian, and Harvey Rosen. "The Carnegie Conjecture: Some Empirical Evidence." Quarterly Journal of Economics (1993): 413-36.
  • Joulfaian, David. "A Quarter Century of Estate Tax Reforms." National Tax Journal53, no. 3 (September 2000): 343-60.
  • ---. "Taxing Wealth Transfers and Its Behavioral Consequences." National Tax Journal 53, no. 4 (December 2000): 933-57.
  • ---. "Charitable Giving in Life and at Death." In Rethinking Estate and Gift Taxation, edited by James R. Hines and William G. Gale Jr. (350-75). Washington, DC: Brookings Institution Press, 2001.
  • ---. "Gift Taxes and Lifetime Transfers: Time Series Evidence." Journal of Public Economics 88, nos. 9-10 (August 2004): 1917-29.
  • Joulfaian, David, and Gerald Auten. "Bequest Taxes and Capital Gains Realizations." Journal of Public Economics 81, no. 2 (2001): 213-29.
  • Joulfaian, David, and Kathleen McGarry. "Estate and Gift Tax Incentives and Inter Vivos Giving." National Tax Journal 57, no. 2 (June 2004): 429-44.
  • Joulfaian, David, and Mark O. Wilhelm. "Inheritance and Labor Supply." Journal of Human Resources (1994): 1205-34.
  • Kopczuk, Wojciech, and Joel Slemrod. "Estate Tax on Wealth Accumulation and Avoidance Behavior of Donors." In Rethinking Estate and Gift Taxation, edited by William G. Gale, James R. Hines Jr., and Joel Slemrod. Washington, DC: Brookings Institution Press, 2001.
  • Kotlikoff, Lawrence, and Lawrence Summers, "The Role of Intergenerational Transfers in Aggregate Capital Accumulation." Journal of Political Economy (1981): 706-32.
  • McGarry, Kathleen. "Inter Vivos Transfers or Bequests? Estate Taxes and the Timing of Parental Giving." Tax Policy and the Economy 14 (2000): 93-121.
  • Page, Benjamin R. "Bequest Taxes, Inter Vivos Gifts, and the Bequest Motive." Journal of Public Economics 87 (2003): 1219-29.
  • Pechman, Joseph A. Federal Tax Policy, 4th ed. Washington, DC: Brookings Institution Press, 1987.
  • Poterba, James. "The Estate Tax and After-Tax Investment Returns." NBER Working Paper no. 6337. Cambridge, MA: National Bureau of Economic Research, 1997.
  • ---. "Estate and Gift Taxes and Incentives for Inter Vivos Giving in the United States." Journal of Public Economics 79 (2001): 237-64.
  • Stiglitz, Joseph E. "Notes on Estate Taxes, Redistribution, and the Concept of Balanced Growth Path Incidence." Journal of Political Economy 8 (1978): 5137-50.