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No Need for States To Fear Estate Taxes

By Albert B. Crenshaw
Sunday, July 3, 2005

Here's some news: A couple of economists from top colleges have found that rich old people tend to move out of states with high estate taxes and into states with low or no estate taxes.

But wait. Before you say, "Well, duh, more economists proving the blindingly obvious," and before you wave their study at your local elected officials, be warned -- the study provides much less comfort to tax cutters than you might expect.

And that, in turn, is notable because estate taxes, which are levied on assets a person leaves behind at death, are now a serious issue for many states.

For decades, federal law gave states a free ride via a special credit that in effect allowed states to tax estates without actually costing the estate any money. Then in 2001, Congress changed the law to phase out the special credit, thus potentially subjecting a growing number of estates to meaningful state taxes. In some cases, those state taxes are on top of federal taxes. In others, estates have to pay state taxes when they owe nothing to the feds.

If the federal estate tax is repealed, which it is scheduled to be for a single year (2010), and which some in Congress would like to make permanent, states that now tax estates will face the choice of repealing their own tax and losing that revenue, or keeping the tax and perhaps seeing wealthy residents pack up and move.

In fact, that choice will likely be there even if the federal tax is not repealed. If, as seems increasingly likely, Congress opts to keep the estate tax but with a greatly increased exemption, states with much smaller exemptions will have to choose between raising theirs or taxing estates that the federal government does not.

For policymakers, the question therefore is, which is more costly, repealing or cutting their own tax, or risking the departure of upper-bracket taxpayers?

This the question that Joel Slemrod of the University of Michigan Business School and Jon Bakija of Williams College have tried to answer by looking at past changes in state estate taxes and correlating them with the number of estate tax returns filed from the various states.

Their conclusion: Higher taxes do cause some people to move and take their taxes with them, but the number is modest and not nearly enough to offset the revenue gained by keeping an estate tax.

Their findings, as they put it, "while admittedly rough, do suggest that although behavioral responses can be expected to reduce the net revenue raised by [keeping an estate tax], it is unlikely that states would put themselves anywhere near the wrong side of the Laffer curve by doing so."

(The Laffer curve is named after economist Arthur Laffer, who posited that higher taxes produce higher revenue only up to a certain point, beyond which higher taxes actually produce less revenue because taxpayers work less or flee or do other things that don't generate taxes.)

This isn't great news if you've been hoping your lawmakers would decide to go with the federal flow toward elimination of the estate tax, or at least toward a much larger exemption.

Thus, if you live around here and you're nearing retirement, you may want to start thinking about the flip side of the policymakers' question: Do I want to stay and pay higher taxes, or move when I retire?

For many years, federal law allowed estates to take a credit against federal estate taxes for their state estate taxes, up to a point. States typically imposed a "soak-up" or "pick-up" tax designed to tax an estate up to the level of the federal credit. Such a tax cost the estate nothing, but simply shifted a portion of its tax from the federal government to the state.

But until the 1970s, many states also imposed their own individual -- the two economists call them idiosyncratic -- taxes parallel to the pick-up tax, and if the individual tax turned out to be more than the pick-up tax, the estate had to pay the higher tax.

"When the state's idiosyncratic [estate] tax exceeded the soak-up tax liability, the excess was an incremental burden relative to other states," the study said.

But over time, most states repealed these idiosyncratic taxes, so there were periods when their taxes were out of line with other states' and when they were in line. The study looked at variations in the number of federal estate tax returns filed from each state over time, figuring that if the rich elderly did in fact flee higher taxes, that ought to be reflected in a declining number of federal returns from higher-tax states.

Since estate tax returns are required only of relatively large estates, they reflect only well-to-do individuals. Further, the rich elderly are highly desirable from a fiscal point of view, since they generally don't have children in public schools, can pay for their own medical and long-term care, and have a lot of taxable income.

The study also looked at other types of taxes -- income, property and sales -- and in all cases found that, indeed, "the number of federal estate tax return filers reported as residing in each state is negatively influenced by the level of taxes imposed on high-income and high-wealth people in that state."

The case is clearest for estate and sales taxes, since there are other factors that might be involved in property and income taxes, but overall "our evidence is consistent with the idea that some rich individuals flee states that tax them relatively heavily," the study said.

The report acknowledged that some tax evasion may be involved -- such as claiming you live at your beach house in Delaware or your country place in Virginia when you actually live in the District -- but the impact is the same: lost revenue to the high-tax jurisdiction.

Even so, a net gain remains from keeping the estate tax, the study found. At worst, assuming the rich flee 10 years before death, and the state loses 10 years' worth of their other taxes as well as their estate, the loss would be 33 percent of the gain from keeping the estate tax, the report said.

That seems to be the conclusion that many lawmakers have reached, whether through serious calculation or simple political expediency. Many states, including Virginia and Maryland, and the District, have already "decoupled" their estate taxes from the federal law.

In many cases, this means estates of more than $1 million (a common state exemption) and less than $1.5 million (the federal exemption) would pay state but not federal estate taxes. And the gap will rise. The federal exemption climbs to $2 million next year and, if the law isn't changed, $3.5 million in 2009, before becoming moot when the federal estate tax disappears -- at least for one year -- in 2010.

Federal law does allow estates to deduct state taxes from the federal, but that isn't very helpful if the estate doesn't owe any federal taxes.

The very large gap presumably would create a greater incentive to flee than perhaps was created by the changes in state taxes that the study looked at. When the 2001 law was passed, some critics said they feared a "race to the bottom" among states cutting taxes to try to attract or retain wealthy residents.

Slemrod agreed in a telephone conversation last week that "it's reasonable to say" that if the difference in the state and federal taxes becomes larger, one would "expect a somewhat larger effect" on the behavior of the wealthy.

"I wouldn't want to say there's no limit. . . . At some point you may have gone too far," he said, but so far it doesn't appear that states have reached it.

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