Tax Inheritance, Not 'Death'
Tuesday, July 4, 2006; 12:00 AM
Something is missing from the current debate over the hundred-year old estate tax. Instead of eliminating it or merely scaling it back to a point beyond recognition, we should instead be considering expanding the tax on money passed from one generation to the next.
Proponents of repealing the so-called death tax, which oftentimes taxes a person's earnings twice -- once when earned and then at death¿argue that it is unfair (not to mention morbid.)
Rather than pointing out the flaws in this fairness argument, opponents of estate tax repeal have fallen back on a divisive class-warfare approach. The estate tax affects fewer than two percent of the richest Americans. Thus, they argue, the other ninety-eight percent of the population should oppose repeal. In an effort to buy more support by peeling off the millionaires from the mega-millionaires, they are pushing a compromise that would exempt all but the absolute largest estates.
The public that continues to support ending the tax, isn't biting; to their credit, the soak-the-rich-argument has not proven to be persuasive. That is a good thing since it would be extremely harmful to the economy if general tax policy were based on the majority shifting the entire burden onto the small richest majority.
There is, however, a compelling argument based not on class-warfare but simple fairness, to expand the tax.
While it may seem perverse to tax one person's earnings twice, a key feature of inherited wealth is that upon transfer it goes from being one person's income to another's. There is nothing unreasonable then, about asking the person who receives an inheritance to pay their fair share on their new income -- particularly when all other earners, including minimum wage workers, pay taxes on the very first dollar they earn. To discuss whether to increase the size of estates exempted from taxation to $3 million, $10 million, or to make it unlimited is to move in the wrong direction in a society that values hard work. The current favorable treatment of inherited versus earned income is the opposite of what it should be.
A far better approach would be to tax people equivalently on all the income they receive, whether it be from earned or inherited income, by replacing the estate tax with an income tax on inheritances. Under such a tax, inheritances would be treated the same as other forms of earned income and taxed in the same manner.
Whereas under an estate tax, the tax owed is based on the size of the estate regardless of how it is distributed, under an inheritance tax, how much an individual inherits along with their economic circumstances would be considered. The result would be much fairer. The housekeeper and the wealthy niece who each receive a $50,000 windfall would pay taxes based on their own different tax rates. Likewise, two middle-class workers, one of whom inherits $10,000 and another who inherits $1,000,000, would be taxed at the rates that apply to their total income.
Changing from an estate tax to an inheritance tax would not only be fairer, it would be better tax policy. A general objective of tax policy is to create the broadest base with the lowest possible rates to minimize economic harm. Under the inheritance tax, the base would be significantly broadened by taxing all inheritances (except for, say, those less than $10,000) rather than narrowed as under the proposed estate tax compromises. At the same time, the estate tax rate, which ran as high as 55%, would be lowered significantly to current income tax rates, which range from 0% to 35%.
And creating an inheritance tax rather than eliminating the estate tax would save the Treasury hundreds of billions of dollars at a time when it desperately needs the money.
There will be the predictable arguments about the effects on businesses and family farms handed down from one generation to the next. But few family farms are actually hit by the estate tax. While certainly a greater number would be affected by a broader inheritance tax, these concerns can be addressed by allowing recipients to pay the tax over time, or better yet, by having business owners purchase insurance policies to match the value of their estates to pay off the tax in full at the time of transfer.
It speaks well of the American public that the argument that the estate tax hits only a tiny sliver of the population has not produced a groundswell of support. The politics of envy should not dictate tax policy but fairness and efficiency should. Taxing all forms of income equally, through a broad-based inheritance tax would be an important step in that right direction.
Maya MacGuineas is the Director the Fiscal Policy Program at the New America Foundation, where Ian Davidoff is a Research Associate.