The Estate Tax and the Economy

Unless Congress acts in the next six months, the estate tax will be repealed in 2010 and then revert to its 2001 parameters — substantially more burdensome than current levels — in 2011. This bizarre policy makes it very likely that Congress will reform the levy by the end of this year, but it’s unclear exactly how.

A recent paper co-authored by Doug Holtz-Eakin, former CBO Director and chief economist for the McCain Campaign, argues that Congress should permanently repeal the estate tax and reap the economic rewards. Among them: higher national saving, creation of over one million new jobs, and billions of dollars in new investment. Unfortunately the paper — perhaps because it relies on back-of-the-envelope analysis rather than empirical data — gets the economics all wrong.

Holtz-Eakin and co-author Cameron Smith hypothesize that the estate tax reduces economic growth because small-business owners, who are motivated to bequeath wealth to their heirs, are less inclined to generate wealth when their estates face high marginal rates. Thus, they claim estate tax repeal will increase small business payrolls by 2.6 percent (1.5 million new jobs!) and boost investment by 3.0 percent, while reducing the nationwide cost of capital by between 0.1 and 0.4 percentage points and unemployment by almost a full percentage point. These are fairly remarkable claims for a tax that directly falls on only 0.2 percent of decedents, or 6,000 estates.

In truth, while we don’t really know the exact impact of the estate tax on saving and job growth, most studies suggest that the impact is small—it may modestly increase saving and job growth or it may actually reduce them by a bit. The biggest reason for this ambiguity is that taxpayers accumulate wealth for many reasons. The opportunity to bequeath it to their heirs is one, for sure. But they also do so to pay children and others for services, protect against high retirement related expenses, and to donate to charity. Only in the first case would the estate tax be expected to reduce saving. And even in that case, the effect is ambiguous.  If a taxpayer intends to give a certain amount to his heirs, an estate tax requires more saving, not less, to meet the after-tax bequest target.

More important, the estate tax can’t have much effect on hiring by small business because hardly any owners ever face the estate tax. Most small businesses are worth far less than the exemption level (currently set at $7 million per couple and higher for many small business owners who value their firms at below market price). We estimate that only 100 small businesses and family farms would pay any tax in 2009, assuming current law is extended.

Holtz-Eakin and Smith also fail to account for the net effects of repealing the estate tax. With no tax on estates, the lost revenue will have to be made up elsewhere. Not only would Treasury lose nearly half-trillion dollars over ten years that would have been collected directly by the levy, but also billions more that would be lost due to the new gaping hole in the tax code if the estate tax no longer serves as a backstop. JCT estimates that the reduction in income tax receipts accounts for about 20 percent of the cost of repeal. Depending on how this other revenue is generated — or if it’s collected at all — the estate tax repeal could depress future economic growth.

When Congress addresses estate tax reform in the next six months — and it will — I hope the wide body of economic evidence, and not opinion, will help guide its decision.