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Death and taxes. Tax planning can help reduce state inheritance and estate taxes, but can be complicated and time consuming. In this article, the Tax Foundation's Jared Waczak discusses the economic effects these taxes have, and how they reduce investment and business expansion, and encourage wealthy individuals to go elsewhere.
By Jared Walczak
Jared Walczak is a senior policy analyst with the Tax Foundation.
“Pray don't be uneasy,” shouts the steward in one of Ivan Turgenev's novellas, his voice carrying across the rising waves to a man in a boat, his little craft darting toward impending doom. “It's of no consequence! It's death! Good luck to you!” But human beings have always treated death as a matter of the greatest consequence. They anticipate it, fear it, try to bargain with it, and seek to avoid it.
They exhibit similar behaviors when it comes to taxes imposed at death. Ben Franklin's famous aphorism conjoins death and taxes in a shared certitude, but frequently the primary fact of estate taxation is the existence of uncertainty. Death may be certain; its timing is not. Estate planning is complicated by this fundamental uncertainty, along with ancillary concerns ranging from the volatility of markets to the liquidity of assets to changes in intended beneficiaries to the tax exposure of heirs. The multiplicity of state inheritance and estate tax regimes further complicates matters, though with competent planning and avoidance techniques, it is frequently possible to largely evade their sting.
A new Tax Foundation report shows that state inheritance and estate taxes are a shadow of their former selves, but the shadow they cast—much like death itself—can become a preoccupation. Because they exist, economic opportunities are foregone, inferior investments are made, and capital migrates across state borders. Sometimes people, too.
Taxes can be imposed on the entirety of a decedent's bequests (an estate tax) or on the receipt of an estate's proceeds (an inheritance tax). Estate taxes are imposed on the net value of an estate, after any exclusions or credits, at the rate indicated by the total value of all taxable bequests and before any distribution to heirs. Inheritance taxes are paid by legatees based on their share of the inheritance and, often, their relationship with the deceased.
Whereas inheritance taxes once predominated, today estate taxes—following the federal approach—are more prevalent. Fourteen states and the District of Columbia impose estate taxes, while six states levy an inheritance tax. Of these, two states (Maryland and New Jersey) impose both estate and inheritance taxes, though New Jersey is in the process of repealing its estate tax.
Until recently, the federal government provided a credit against state inheritance and estate tax liability up to a certain amount, designed to blunt interstate tax competition. Consequently, all fifty states adopted estate taxes designed, at the very least, to capture all revenue up to this threshold (commonly called the “pick-up tax”), since they could do so without increasing anyone's tax liability. Although the credit has since been repealed and most states now forego estate taxes altogether, several states' estate taxes still mirror the structure of the old pick-up taxes. A deduction now takes the place of the credit, but it is innately less generous.
State inheritance and estate taxes typically only apply to larger transfers of wealth, with an exemption for smaller estates and bequests. Most commonly, only estate or inheritance amounts above a given threshold are subject to tax. Occasionally, however, a credit may be offered which effectively eliminates taxation of income below a certain amount, which is functionally the same, but has the implicit effect of eradicating the lower tax brackets. Other variations abound. Although New York offers a generous exemption, it taxes the entire value of estates that exceed it (a “clawback” provision).
Inheritance taxes tend to have different rate schedules for distinct classes of heirs, with relatives receiving preferential treatment compared to nonrelated individuals, and direct lineal descendants sometimes exempted altogether. Transfers from decedents to surviving spouses are not subject to inheritance tax in any state. Unlike estate taxes, inheritance taxes tend not to feature substantial exemptions.
Amounts remitted under estate and inheritance taxes represent only a portion of their cost. Many individuals who expect to leave sizable legacies employ sophisticated estate planning techniques to limit future liability. These avoidance strategies impose their own costs, both in terms of time and resources spent on estate planning and in economic opportunities foregone to reduce future tax exposure. These costs can be substantial, and they are economically inefficient, as they reduce wealth without increasing government revenues.
Some scholars have estimated that compliance costs may approach revenue yield, with George Cooper writing for the Brookings Institution that “because estate tax avoidance is such a successful and yet wasteful process, one suspects that the present estate and gift tax serves no purpose other than to give reassurance to the millions of unwealthy that entrenched wealth is being attacked.” Other experts have disputed these estimates, but there can be no doubt that estate and inheritance taxes create deadweight losses and cause higher-tax states to lose out on revenue from other taxes by driving away wealthy seniors.
Estate and inheritance tax planning activities can be classed under four headers: making tax-advantaged gifts and transfers, shifting assets and investments, exploiting tax valuation provisions, and hedging against future expenses. Most wealthy individuals engage in some combination of these practices, all of which impose their own costs.
1. Tax-advantaged gifts and transfers. Charitable contributions are tax-exempt and reduce the value of the estate, whether made during a person's lifetime ( inter vivos) or as a bequest, where they can be taken as a deduction against the taxable value of the estate. At the federal level, inter vivos transfers to others, including children, are tax-exempt up to an annual exclusion amount (currently $14,000). There is also a lifetime exclusion, which tracks with—and reduces the threshold of—the federal estate tax exemption, and several states tax gifts made “in anticipation of death,” while Connecticut has a stand-alone gift tax. Even though inter vivos gifts reduce the estate tax exemption, they are still attractive compared to bequests at death, as they are assessed on a tax-exclusive basis, while bequests are assessed on a tax-inclusive basis. A countervailing consideration, however, is that bequests are taxed on stepped-up basis, whereas gifts are not.
2. Shifting assets and investments. Assets and investments can be shifted for tax planning purposes. To avoid liquidity concerns or reduce future tax liability, one might arrange for the purchase of one's business after death; shift wealth into tax-advantaged vehicles; or bring children on as owners of a home or coinvestors in a business, allowing subsequent profits to accrue directly to intended heirs. More sophisticated tax avoidance techniques also exist, though some methods have been rendered less effective by reforms to the federal estate tax. That these asset allocations are precipitated by tax strategies suggests that they involve efficiency losses. They may also involve a loss of control that might otherwise be undesirable. By reducing the value of marginal increases in wealth, such taxes may also induce wealthy individuals to earn or save less.
3. Exploiting tax valuation provisions. Family-owned farms and small businesses are permitted to reduce the assessed value of their real estate for estate tax purposes if the heirs maintain it as a family-owned operation for at least ten years. This limits the future value of the bequest by constraining its possible uses. Astute estate planners can find other ways to obtain more favorable valuations as well, particularly regarding closely held corporations where valuations are inherently uncertain.
4. Hedging against future expenses. One common criticism of estate and inheritance taxes is that inheritors of illiquid assets—like a business or farm—may have to liquidate the operation to pay the taxes. Although certain policy developments over the years have sought to ameliorate this concern, and federal estate tax liability can be paid on an installment basis, individuals concerned about the ability of heirs to make estate tax payments may frequently take out life insurance and maintain a high proportion of liquid assets to meet these burdens.
A study by the Joint Economic Committee, a standing joint committee of Congress, concluded that “by affording so many tax avoidance options, the estate tax encourages owners of capital to shift resources from their most productive uses into less efficient (though more tax-friendly) uses.” Avoidance techniques are costly and often sophisticated, but given that estate and gift taxes chiefly fall on wealthier taxpayers, it is reasonable to expect most potential payors to have access to tax planning resources, even if they do not always implement successful strategies.
These estate planning techniques have real-world costs. Since tax liability at death is at least partially an artifact of poor estate planning or differing circumstances which do not necessarily indicate actual disparities of wealth, similarly-situated families can face vastly different tax burdens. The costs of inheritance and state tax avoidance also extend far beyond the event itself, given that the timing of one's passing is inherently uncertain.
Not only does this encourage otherwise inefficient resource allocation beginning what could be many years before death, but it also suggests that a miscalculation of one's longevity can be the undoing of an otherwise intelligent estate plan. Even those with clear exposure to estate and inheritance taxes, moreover, may fail to take obvious steps to mitigate liability, whether this is an expression of time preference, indifference, procrastination, or lack of knowledge. At the same time, many people deemed unaffected by the estate tax because their death incurred no liability may have spent considerable sums avoiding it.
Studies show that economic decision-making is affected by inheritance and estate tax regimes. This is consistent with the expectations of those likely to be affected by these taxes, which can drive costs in their own right, above and beyond actual tax liability. The process can be cumbersome, confusing, and time-consuming as well.
A 1995 survey of owners of family businesses found that an average of 167 hours and $33,137 (over $55,000 in 2017 dollars) was spent planning for estate taxes. Sixty percent of respondents also claimed that if estate taxes were eliminated, they would immediately hire new employees (42 percent said they would hire 10 or more workers). Among respondents with closely-held businesses worth more than $10 million, 67 percent felt that paying estate taxes would limit growth, and 41 percent feared that estate tax burdens would require selling all or part of the business, a view also held by 33 percent of respondents across businesses of all sizes (Astrachan & Tutterow, 1996). These self-reported estimates must be taken with a grain of salt, but strongly suggest that small, family-owned businesses adjust their decisions based on the existence of estate and inheritance taxes.
Historically, owners of family-owned farms and small businesses have been particularly opposed to the estate tax, frequently citing the concern that the tax would require the farm or business to be broken up to afford the liability. Examples of this transpiring are relatively rare, which has led some critics to dismiss the concern, but there is good reason to believe that this reflects conscious—and often costly—economic planning on the part of potentially affected individuals. A significant amount of estate planning is driven by the simple and unavoidable fact that, unlike income taxes, estate and inheritance taxes pertain to capital values rather than income flows.
Businesses may be divested prior to death, or ownership transitioned to prospective heirs during one's lifetime, or expensive insurance policies may be taken out to provide liquidity. Each of these has costs and can result in the dissolution or sale of a family business even if the estate tax does not itself force a farm or business to be disbanded. The Joint Economic Committee has estimated that “perhaps as many as 28 percent” of family firms are sold or discontinued with the death of an owner.
Gifts rise steadily in the years before death, and there is evidence that the frequency and intensity of inter vivos giving is highly responsive to estate tax changes. Economists have also sought to calculate the deadweight losses associated with estate and inheritance tax avoidance, though ranges can vary widely. It is generally held, however, that the tax deters investment in a variety of ways, and has a particularly deleterious effect on entrepreneurship.
Simulations indicate that the federal estate tax has roughly the same effect on entrepreneurial incentives as a doubling of income tax rates even though the federal estate tax is responsible for less than 1 percent of federal revenue (Fleener & Foster, 1994). James Poterba, an MIT economist, has estimated that the federal estate tax increases the effective tax burden on capital by somewhere between 1.3 to 1.9 percent, with an effective rate increase of 19 percent for persons aged 80 or older, suggesting a high sensitivity for older individuals. Especially toward the end of one's life, estate and inheritance taxes can have a significant impact on if and how people choose to invest. While federal taxes are highly significant here, state burdens are often high and contribute meaningfully to such decisions as well.
The Joint Economic Committee highlights the tax's distortionary incentives which discourage savings and investment and lower after-tax returns on investment, and estimates that over the course of the 20th century, the existence of the federal estate tax reduced the stock of capital in the economy by $493 billion, or 3.2 percent. This estimate does not take state inheritance and estate taxes into account, though for much of the period under consideration, most such taxes were creditable against federal liability.
The Tax Foundation's Taxes and Growth model estimates that the outright repeal of the federal estate tax would grow gross domestic product by 0.8 percent, increase capital investment by 2.3 percent, and increase labor force participation by the equivalent of 159,000 full-time jobs over the ten-year budget window. The static revenue loss would be a projected $240 billion over a decade, but the tax's significant inefficiencies would lead to a mere $19 billion, ten-year revenue loss on a dynamic basis, taking increased economic activity into account. Economists Doug Holtz-Eakin and Donald Marples have calculated that even replacing the federal estate tax with a capital income tax would enhance economic efficiency, reducing deadweight loss by 1.8 cents per dollar of wealth.
California inheritance tax reform in the early 1980s provided a useful case study of responsiveness to state taxes on inheritances and estates. Average inheritance tax effective rates declined from 14.5 percent in 1981 to 9.8 percent in 1982, while the median effective rate decreased from 12.6 percent to 4.6 percent. The reduction correlates with a dramatic reduction in the number of businesses sold in San Francisco County, from 29 percent in 1981 to less than 15 percent in 1982. A study found that the reduction “translate[d] into a large and statistically significant reduction in the fraction of business sales”—from 35 percent to 16 percent—for estates worth at least $225,000 (Brunetti, 1976).
Finally, when state inheritance and estate taxes induce individuals—chiefly wealthy retirees—to relocate for tax purposes, states lose out not only on anticipated estate or inheritance tax revenue, but potentially also on years of general tax revenue. Economists Jon Bakija and Joel Slemrod calculated that if the typical wealthy retiree who would otherwise be subject to state inheritance and estate taxes moves out of state five years prior to death, the state's revenue losses could be as much as 1.73 times as large as the tax revenues that might have been collected from that person's estate. If state inheritance and estate taxes drive migration, the adverse effects for states that impose them could be significant.
Numerous studies have found evidence that high state inheritance and estate taxes discourage in-migration. For instance, Bakija and Slemrod find that a 1 percentage point increase in a state's average estate or inheritance tax rate is associated with a 1.4 to 2.7 percent decline in the number of federal estate tax returns filed in a given state, with estates over $5 million particularly responsive to rate differentials. These estates declined by nearly 4 percent in response to a 1 percentage point rate increase.
Significantly, it is not always necessary for individuals seeking to escape high estate and inheritance taxes to move or even change their existing behavior that significantly. Depending on state domicile laws, it can often be possible to establish legal residence in another state without moving there, particularly if an individual—often a retiree with significant flexibility—is willing to reside elsewhere for part of the year.
The elimination of the credit for state inheritance and estate taxes, combined with a rising federal unified credit which exempts a growing number of estates, is gradually bringing the focus back to where it was a century ago: the states. Once largely irrelevant to overall tax burdens on inheritances and estates, the taxes levied by the eighteen states (and the District of Columbia) which elect to impose estate or inheritance taxes now account for a substantial portion of total liability at death for residents of those states.
In fiscal year 2016, state inheritance and estate taxes raised $5.1 billion in revenue, accounting for 0.6 percent of state tax collections, while the federal estate tax brought in $21.4 billion, worth a little less than 0.7 percent of federal tax collections. Thirty-two states, however, forego both estate and inheritance taxes; in those which impose them, they account for 1.4 percent of tax collections in aggregate. Even though state rates are lower than the federal estate tax rate, lower exemptions in many states lead to a significantly larger number of individuals facing inheritance and estate tax liability at the state level.
Estate and inheritance taxes place states and their residents on less competitive footing. They reduce investment, discourage business expansion, and sometimes drive wealthy taxpayers out of state. Little wonder that, with the federal credit gone, states are once again under pressure to reduce or eliminate their estate and inheritance taxes, just as they were a century ago. History may not repeat itself, but it often rhymes.
Copyright © 2017 Tax Management Inc. All Rights Reserved.
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