On June 7, 2001, President George W. Bush signed into law
the Economic Growth and Tax Reform
Reconciliation Act of 2001 (EGTRRA),1 a
package of tax reductions and policy changes that include temporary
reductions in three federal estate transfer taxes (FETTs). The
law mandates the phaseout of the federal estate tax and the federal
generation-skipping tax by January 1, 2010, and the reduction of
the federal gift tax. The provisions of the law, however, are
scheduled to expire on January 1, 2011, at which time all three
federal estate or wealth transfer taxes will return to their 2001
pre-tax cut levels. Analysts in the Center for Data Analysis
(CDA) at The Heritage Foundation estimated the effects of an
immediate and permanent repeal of all three federal estate transfer
taxes. These effects include changes in tax revenue, gross domestic
product (GDP), interest rates, employment levels, personal income,
and inflation. Any of these macroeconomic changes could affect tax
revenues significantly.
The
findings of the CDA analysis show that eliminating the taxes
entirely would yield strong economic and fiscal benefits for the
country. Immediate and permanent repeal of the FETTs would improve
the nation's economic performance over the next 10 years,
create thousands of jobs, and raise disposable income without
increasing cumulative federal deficits or publicly held debt by the
end of the 10 years. Moreover, under the current tax code,
repealing the FETTs would, over the following 10 years, not
reduce federal revenues, but would increase them and provide
further opportunity for additional tax relief. Specifically, compared with what would
occur under the current law, an immediate and permanent repeal of
the three FETTs on January 1, 2003, would have the following
beneficial effects. For example, in fiscal year (FY) 2012
alone, repeal would:
Add $14.7 billion
(adjusted for inflation)2 to the
GDP;
Add 118,000 jobs to
the U.S. economy;
Reduce
nationwide unemployment by 27,000 persons;
Raise U.S.
personal disposable income by an inflation-adjusted $11
billion;
Increase
non-residential net capital stock by $25.1 billion and lower the
user cost of capital by 0.3 percent;
Leave
relative price levels and key interest rates unaffected, in spite
of the stimulating effect repeal would have on economic activity;
and
Reduce
the nation's
publicly held debt by $5.7 billion.
The current plan to
restore the FETTs in 2011 will substantially curtail these
substantial benefits.
How Estate Transfer
Taxes affect Economic Behavior
Several studies have found that the
federal estate transfer taxes reduce economic growth. For example,
in a 1998 study, former DRI/McGraw-Hill economists Richard F.
Fullenbaum and Mariana A. McNeill cited three reasons for this
overall effect.3
According to these
experts, the FETTs:
Cause considerable resources
to be diverted away from economically productive activities and
toward tax avoidance activities;
Raise the user cost of capital, biasing affected owners of
capital toward consumption and away from investment; and
Reduce labor force participation.4
Henry J. Aaron, a Brookings
Institution scholar, and Alicia Munnell, a former Clinton
Administration economic adviser, pointed out in 1992 that the
FETTs created substantial rewards for tax avoidance activities.
They echoed Columbia law school professor George Cooper's
description of the levies as "voluntary taxes." Out of $123 billion
transferred across generations in 1986, a mere $36 billion was
reported on estate tax returns, resulting in $6 billion in federal
collections that year. "Informed observers," these experts noted,
"think that decedents could have avoided even this modest toll
if they had taken the time to do so."5 Tax
avoidance requires the services of skilled estate planners. The
federal estate transfer taxes nurture an industry that employs
thousands of highly educated and highly remunerated
professionals. In the early 1990s, the American Bar
Association reported that approximately 16,000 (5 percent) of
its members described their area of concentration as trust,
probate, and estate law. This total does not include the number of
accountants and financial planners who offer
estate-planning services.6
Tax avoidance activity has several
facets. All involve reducing the size of the estate by the time the
property owner dies to avoid the death tax- basically a second tax
on assets purchased with after-tax income. Common methods of tax
avoidance include making direct transfers from the estate to
such legal entities as trusts or limited partnerships, or as
carefully planned gifts.7
Another is replacing monetary compensation for highly paid
corporate executives with life insurance. Yet another is the
use of experts to procure a low estimate of the value of the
estate.
8 Heritage economist William Beach argues
that the FETTs are a significant determinant of the cost of
capital-the higher the level of such taxes, the higher the required
rate of return on capital investments. The reason, he
explains, is that "when individuals begin to see that their
income and investment efforts will produce a future taxable estate,
they…increase their earnings requirements to build the funds
needed to pay the future wealth transfer taxes."9 This
higher earnings requirement can be observed in the national economy
as a higher user cost of capital than would otherwise prevail. The
higher user cost of capital discourages investment and creates a
bias among affected property owners in favor of consumption. MIT
economist James M. Poterba estimates that federal estate transfer
taxes add at least 1.3 percent to the cost of owning capital
in the United States.10 Fullenbaum and McNeill describe estate
transfer taxes as reductions in the after-tax wages of affected
workers.11 Economic
theory suggests that, all other things being equal, public policies
that broadly reduce after-tax wages reduce labor force
participation rates.
12 According to
Beach, this reduction reached 97,200 persons in 1996.
13 Eliminating the FETTs permanently and
immediately would reverse these damaging effects on the
national economy. Thousands of federal estate tax lawyers would be
freed to engage in activities more closely associated with economic
growth; the user cost of capital in the national economy would
fall, making more types of investment immediately attractive and
thus spurring investments overall; and a disincentive that keeps
thousands of Americans out of the labor force would
disappear.14
The 2011
phaseout and restoration of the federal estate tax (FET) and
the federal generation-skipping tax (GST) enacted in last year's
tax cut law will do very little to alter the tax avoidance
behaviors described above. No estate holder with a reasonable
expectation of living past January 1, 2011, will expect to realize
the tax relief, since the phaseout affects only the estates of
those who die before that date. A person expecting to live past
2010 will adjust his economic behavior as if the FET and the GST
had not changed at all. Consequently, the smaller the share of
prospective estate tax filers expecting to die between 2002
and 2010, the less the national economy will benefit from the
one-year repeal. CDA analysts estimate that under current law at
least 3 million FETT returns will be filed during the period 2003-
2027.15 Of these returns, less
than 16 percent are expected to be filed before 2011.
16 Thus,
EGTRRA provides no estate tax relief at all for the vast majority
of taxpayers who should expect to be affected by FETTs, in addition
to which the bulk of potential economic benefits that the nation
could see from estate tax reform will not be observed under the
current law. However, Congress could unlock these effects
through an immediate and permanent repeal of the federal
estate transfer taxes.
The Heritage
Analysis of FETT Repeal
In addition to these behavioral aspects of tax
policy changes, the CDA analysts considered the interaction between
FETT repeal and capital gains tax collections, as well as between
FETT repeal and federal spending.
Capital Gains Offset.
Without further tax reform, repealing the FETTs immediately and
permanently would mean higher capital gains tax revenues.
The reason: The current statute regarding the FETTs exempts
inheritors from taxes on gains unrealized, during the decedent's
lifetime, on the transferred property. Inheritors are allowed to
raise the base value of the transferred property to its fair market
value at the time the decedent dies. This exemption is known as the
"step-up" of the basis on transferred property. According to the
Joint Committee on Taxation (JCT), this exemption would amount to
$216.6 billion in uncollected capital gains tax revenue in the five
years from 2002-2006.17 The
mere repeal of the FETTs would abolish this capital gains tax
exemption and could subject the inheritors to this increased tax
levy.
To relieve the tax burden at
death and reduce the need for the heir to liquidate assets
prematurely, CDA analysts incorporated a capital gains
exclusion of $1 million on transferred estates and a $3 million
exclusion on spousal transfers. Such a provision severs "the link
between payment of the tax and death and allows heirs to select the
timing of the realization of capital gains."18 CDA analysts estimated the amounts
of this exclusion for the years 2003-2012 using JCT estimates and
incorporated them into the economic impact study of FETT
repeal. (These estimates are shown in Table 1 in the Appendix.)
Congress could eliminate this
capital gains offset, of course, by repealing the capital
gains tax or, at a minimum, ensuring that any additional tax
revenue arising from the capital gains offset is used for further
tax relief.
Federal Spending.
CDA analysts assumed that overall
federal government spending would be adjusted according to changes
in tax collections caused by eliminating the FETTs. This assumption
assures that there would be virtually no change in the cumulative
federal surplus during the 10-year period from fiscal years
2003-2012.19 Year-to-year
variations in surpluses do occur. CDA analysts channeled these
spending changes through adjustments in federal non-defense
spending and federal grants-in-aid to state and local
governments.
A Dynamic Analysis of Immediate
FETT Repeal
CDA analysts
used the DRI-WEFA U.S. Macroeconomic Model to conduct the
dynamic simulation of the elimination of the FETTs.20 They performed the simulation using
a version of the September 2002 DRI-WEFA long-term forecast, which
they modified to incorporate the economic and budgetary assumptions
published by the Congressional Budget Office (CBO) in August
2002.
21 This adapted forecast can be
used to find the effects of policy changes on the economy and the
federal budget through a dynamic rather than a static analysis.
A static analysis of the potential
effects of a tax policy change would examine only its effects on
tax collections. This method could omit important effects that
changes in tax policy exert on the economy. For example, if a
proposed tax reduction is likely to improve national economic
performance, that performance could in turn increase tax
collections, which could partially offset the federal
revenue losses caused by the tax reduction. Static analysis
would be likely to omit the policy's beneficial effect on the
economy and therefore overestimate the cost of that particular
tax reduction. A dynamic analysis, which considers the effects of
the tax policy change on the economy, would more accurately
estimate the overall effects of the tax policy change on both the
national economy and on tax collections.22
Heritage
economists performed a dynamic analysis of FETT repeal by
changing policy-related variables23 in the adapted DRI-WEFA model to
simulate the effects on the national economy. They then conducted
an economic simulation using the adapted model and the changed
policy-related variables to find the effects of the policy change
on the U.S. macroeconomy. They compared the values of key
macroeconomic quantities before and after simulation, attributing
the observed differences to the policy change. This method
allowed CDA analysts to identify the effects on the national
economy of that change, in this case FETT repeal. (See Appendix,
Table 2.)
24Take, as an example, the dynamic
analysis of a hypothetical tax policy change. Suppose the
simulation corresponding to that policy change yields a GDP
for 2005 that is $1 billion higher than its value in the original
CBO projection. In this case, the tax policy change would be said
to have added $1 billion to the GDP for 2005. In other words, one
may say that the GDP would be $1 billion higher in 2005 under the
tax policy than without it.
Benefits of
Eliminating Estate Transfer Taxes
Table 2 in the Appendix displays the
difference in economic results between the policy of repeal and the
current-law policy as reflected in the adapted DRI-WEFA model. The
table shows that immediate and permanent FETT repeal would increase
the nation's economic growth compared with what would happen under
the currently planned temporary phaseout of such taxes. In the
absence of further tax reform, immediate and permanent repeal
would increase federal revenues over the following 10 years as well
as:
Strengthen economic growth. By the end of FY 2012, GDP would
be $14.7 billion higher (after adjusting for inflation) under FETT
repeal than it would under current law (as projected by the
CBO). Moreover, average GDP between 2003 and 2012 would run $10.6
billion higher.
Create more job opportunities. With the FETTs eliminated,
the economy would support 118,000 more jobs by 2012 than it would
under current law. Between 2003 and 2012, the average national
employment level would run 104,000 jobs higher under repeal than it
would otherwise.
Reduce unemployment. Immediate and permanent repeal of
the FETTs also would reduce unemployment by 27,000 persons in 2012.
The average number of unemployed for the 10 years following repeal
would be 13,000 lower than without repeal.
Raise
disposable personal income. Under elimination of the FETTs,
personal disposable income would be $11.0 billion higher by the end
of FY 2012, with immediate repeal, than it would without it.
Average personal disposable income during 2003-2012 would be $10.3
billion higher under repeal.
Increase non-residential investment. Repeal of the estate
tax would improve the investment environment enough to raise
investment by $7.3 billion (adjusted for inflation) by 2012.
Non-residential capital stock would be $25.1 billion higher. The
user cost of capital would be 0.3 percent lower by 2012 than it
would be if the FETTs were not eliminated.
Leave
relative price levels and key interest rates unaffected. In
spite of the stimulating effect FETT repeal would have on economic
activity, it would not significantly affect either the consumer
price index (CPI) or key government interest rates.
A
slight decline in the federal publicly held debt during 2012.
During the first years after repeal of the FETTs, the decline in
federal revenue would raise the federal publicly held debt
above where it would be under current law, reaching an
inflation-adjusted $22.1 billion above the CBO's projection for
2007. This margin would then decline, reaching $5.7 billion
below the CBO-projected level by 2012.
Conclusion
The tax cuts President Bush signed into
law last year incorporate the phasing out and temporary abolition
of the federal estate tax (FET) and generation-skipping taxes
(GST). This move signaled Congress's willingness to consider key
reforms of this tax.
However, the law allows the FET
and other estate or wealth transfer taxes to return in 2011. These
estate taxes have damaging economic effects, slowing economic
growth and reducing potential increases in employment. A temporary
phasing out of the federal estate transfer taxes will not address
either of these detriments. As this CDA analysis shows, after just
10 years, an immediate and permanent repeal of the FET and other
federal estate transfer taxes would strengthen economic activity,
create hundreds of thousands of new jobs, bolster disposable income
by $11 billion, reduce unemployment, and raise revenue while
leaving the nation with a lower federal publicly held debt by
FY 2011. -Alfredo B.
Goyburu is a Policy Analyst in the Center for Data Analysis at The
Heritage Foundation.
APPENDIX
Methodology
Heritage Foundation economists in the
Center for Data Analysis (CDA) followed a two-step procedure
in identifying the 10-year economic and budgetary impact of an
immediate and permanent repeal of the federal estate transfer taxes
(FETTs) effective January 1, 2003.
First, CDA analysts applied Congressional
Budget Office (CBO) projections for FETT collections under
current law.25 As a working
assumption, they used the negative of these collection estimates as
a preliminary estimate of the federal revenue that would be lost
under FETT repeal. To this estimate, CDA analysts applied a
projection of the additional capital gains taxes that would be
collected as a result of an FETT repeal, with a first
$1 million exemption plus a $3 million spousal exemption,
which produced a modified preliminary estimate for federal
revenue loss. (See Table 1.)26
Using
this modified preliminary estimate as an ultimate forecast of the
federal revenue loss resulting from FETT repeal, however,
would be to implement an erroneous static approach to an analysis
of the effects of that tax policy change. The more correct
(dynamic) approach is to take account of the macroeconomic effects
of the tax policy change. These effects include changes in gross
domestic product (GDP), interest rates, employment levels, personal
income, and inflation. Any of these macroeconomic quantities
could affect tax revenues significantly.
Second, CDA analysts introduced the modified
preliminary estimate of tax revenue change into an especially
adapted version of the DRI-WEFA U.S. Macroeconomic Model.27 They then processed the simulation and
noted changes in key macroeconomic and budget variables
compared with their values in the original adapted version of the
model. Differences in these key variables were attributed to the
response of the U.S. economy and federal budget to the tax policy
change-that is, the dynamic response. (See Table 2.)
The
Simulation28
The DRI-WEFA model contains a number of
variables used to simulate policy changes. CDA analysts introduced
static tax revenue and economic behavior change estimates to
the model in order to find the dynamic responses of the U.S.
economy and federal budget during 2003-2012 to immediate and
permanent repeal of the FETTs. These include:
Civilian Labor Force. Heritage
economist William W. Beach estimated in 1996 that the FETTs reduced
the labor supply by 97,200 in 1996.29
CDA analysts revised this estimate to 103,900 using more recent
information on the nation's civilian labor force growth rate from
the Bureau of Labor Statistics. They adjusted the variable
controlling labor supply in the model accordingly, phasing in the
103,900-worker increase over two years.
Non-NIPA30 Federal Government
Revenue. This variable measures taxes paid to the federal
government not coming from income flows in the economy, such as the
estate tax and the capital gains tax. CDA economists adjusted this
variable according to the net static change in federal collections
of these two types of tax resulting from the tax policy
reform.
Business Sector Price
Index. CDA analysts reduced this variable during the
forecast period in order to reflect lowered compliance costs for
the business sector resulting from FETT repeal. The adjustments
corresponded to a reduction in business sector costs of 30 cents
for every dollar that would have been collected in federal estate
transfer taxes. This ratio is based on previous research cited by
former DRI/McGraw-Hill economists Richard Fullenbaum and
Mariana McNeill.31
Corporate AAA Bond Rate. MIT economist James M.
Poterba estimated in a 2000 study that eliminating wealth transfer
taxes would reduce the required yield on investment by at least 1.3
percent.[32] CDA analysts lowered the corporate AAA bond
rate within the model in order to reflect this 1.3 percent
reduction.
Federal Non-Defense Spending Variables. CDA
economists adjusted federal spending in order to compensate for the
projected changes in federal collections resulting from FETT
repeal. This adjustment assured that the tax policy reform would
not cause a substantial change in cumulative federal deficits
during the forecast period. The adjusted variables controlled
direct federal non-defense spending and federal grants-in-aid to
state and local governments.
[1]Public Law
107-16.
[2]All
inflation-adjusted dollars referenced in this report are indexed to
the 1996 overall price level and thus represent 1996
dollars.
[3]Richard F. Fullenbaum and Mariana A.
McNeill, "The Effects of the Federal Estate and Gift Tax on the
Aggregate Economy," Research Institute for Small and Emerging
Business, Working Paper Series No. 98-01, 1998, pp.
10-11.
[4]William W. Beach, "The Case
for Repealing the Estate Tax," Heritage Foundation
Backgrounder No. 1091, August 21, 1996, p. 26.
[5]Henry J. Aaron and Alicia Munnell, "
Reassessing the Role for Wealth Transfer Taxes," National
Tax Journal, Vol. 45, No. 2 (June 1992), pp. 133-134, at
.
[6]Ibid., p. 138.
[7]A number of financial counseling firms
list transfers to trusts and carefully planned gifts on their
Internet sites as key estate planning techniques. See, for example,
Prudential Financial at
http://www.prudential.com/productsAndServices/0,1474,intPageID%253D1350%2526blnPrinterFriendly%253D0,00.html;
Dana S. Beane & Company, P.C., at ;
and Deborah A. Malkin, Attorney at Law, at
(October 25, 2002).
[8]Aaron and Munnell, "Reassessing the Role
for Wealth Transfer Taxes," pp. 135, 137.
[9]Beach, "The Case for Repealing the
Estate Tax," p. 24.
[10]James M. Poterba, "Estate Tax and
After-Tax Investment Returns," in Joel M. Slemrod, ed., Does
Atlas Shrug? (Cambridge, Mass.: Harvard University Press,
2000), p. 339. Beach estimates that the FETTs add 3 percent to the
cost of owning capital. See Beach, "The Case for Repealing the
Estate Tax," p. 24.
[11]Fullenbaum and McNeill, "The Effects of
the Federal Estate and Gift Tax on the Aggregate Economy," p.
10.
[12]All other things held constant, economic
theory suggests unambiguously that reductions in after-tax wages
reduce the number of participants in the labor force, since both
the wealth and the substitution effect reinforce one another,
rather than offset one another, in this case.
[13]Beach, "The Case for Repealing the
Estate Tax," p. 24.
[14]Ibid.
[15]Estimated by extrapolating unpublished
projections for estate tax filings by fiscal year performed by the
Statistics of Income Program of the Internal Revenue
Service.
[16]Projections for estate tax filings
through 2010 from unpublished Statistics of Income Program
projections.
[17]Joint Committee on Taxation, "Estimates
of Federal Tax Expenditures for Fiscal Years 2002-2006," January
17, 2002, p. 23, at .
[18]Fullenbaum and McNeill, "The Effects of
the Federal Estate and Gift Tax on the Aggregate Economy," p.
9.
[19]See Appendix, Table 2.
[20]The Center for Data Analysis used the
Mark 11 U.S. Macroeconomic Model of DRI-WEFA, Inc. (now known as
Global Insight), to conduct this analysis. The model was developed
in the late 1960s by Nobel Prize-winning economist Lawrence Klein
and several colleagues at the University of Pennsylvania. It is
widely used by Fortune 500 companies, prominent federal
agencies, and economic forecasting departments. The methodologies,
assumptions, conclusions, and opinions herein are entirely the work
of Heritage Foundation analysts. They have not been endorsed by,
nor do they necessarily reflect the views of, the owners of
the model.
[21]Congressional Budget Office, "The Budget
and Economic Outlook: An Update," August 2002, at .
[22]For a discussion of the shortcomings of
static analysis of the effects of tax policy changes, see Daniel J.
Mitchell, "The Correct Way to Measure the Revenue Impact of
Changes in Tax Rates," Heritage Foundation Backgrounder No. 1544,
May 3, 2002, at http://www.heritage.org/Research/Taxes/BG1544.cfm;
see also "The Argument for Reality-Based Scoring," Heritage
Foundation Web Memo No. 92, March 29, 2002, at http://www.heritage.org/Research/Taxes/WM92.cfm,
and Daniel R. Burton, "Reforming the Federal Tax Policy Process,"
Cato Policy Analysis, forthcoming December 2002.
[23]The variables changed in this simulation
for the purpose of modeling FETT repeal are enumerated in the
Appendix.
[24]Table 2 shows year-by-year estimates of
how repeal of the FETTs would likely change major economic
indicators.
[25]Congressional Budget Office, "The Budget
and Economic Outlook: An Update," p. 48.
[26]CDA economists applied a staged process
to calculate the additional capital gains tax collections. The
first stage was to combine historical averages on federal estate
tax returns from the IRS Statistics of Income Program and modified
projections from the Joint Committee on Taxation on the
current-law capital gains tax exclusion at death. These together
yielded a projection of the amount of taxable capital gains held in
estates over and above the $1 million exemption, without taking
into account the higher spousal exemption. The second stage was for
CDA analysts to use historical averages to find how much the higher
$3 million spousal exemption would subtract from the first
projection of taxable capital gains. The final stage involved
applying the long-term capital gains tax rate to the modified
projection for non-exempt taxable capital gains to create a
projection of the additional capital gains tax collections under
FETT repeal.
[27]This version of the model is especially
adapted to embody economic and budgetary projections published by
the CBO in August 2002.
[28]Readers interested in
replicating this analysis should contact the author for further
information on how the model was applied.
[29]Beach, "The Case for Repealing the
Estate Tax," p. 26.
[30]NIPA stands for National
Income and Product Accounts.
[31]Fullenbaum and McNeill, "The Effects of
the Federal Estate and Gift Tax on the Aggregate Economy," pp. A1
and A2. These two authors cited four sources for this estimate. The
first estimate, by Guest and Associates, L.L.C., was based upon
survey data to find the amount that estate holders spent on federal
estate tax planning and preparation during 1995; this amount was
compared with 1995 FETT collections and yielded a ratio of 30
percent. The second estimate was based upon calculations for
FETT compliance costs by Kennesaw State University scholars Joseph
Astrachan and Craig Aranoff; the cost was divided by an annual FETT
collection total, resulting in a ratio of 32 percent. The third
estimate was from Christopher E. Erblich of the Tax and Estate
Planning Practice Group, who calculated both compliance and
economic disincentive costs resulting from the U.S. federal tax
system; Erblich's amount was divided by an annual total for FETT
collection, yielding a ratio close to 31.2 percent. Finally, CDA
economist William W. Beach provided an estimate of the 1995 cost of
compliance with FETT that, when compared to 1995 FETT collections,
resulted in a ratio of 29.8 percent.
[32]Poterba, "Estate Tax and After-Tax
Investment Returns," p. 339.
APPENDIX
Methodology
Heritage Foundation economists in the
Center for Data Analysis (CDA) followed a two-step procedure
in identifying the 10-year economic and budgetary impact of an
immediate and permanent repeal of the federal estate transfer taxes
(FETTs) effective January 1, 2003.
First, CDA analysts applied Congressional
Budget Office (CBO) projections for FETT collections under
current law.25 As a working
assumption, they used the negative of these collection estimates as
a preliminary estimate of the federal revenue that would be lost
under FETT repeal. To this estimate, CDA analysts applied a
projection of the additional capital gains taxes that would be
collected as a result of an FETT repeal, with a first
$1 million exemption plus a $3 million spousal exemption,
which produced a modified preliminary estimate for federal
revenue loss. (See Table 1.)26
Using
this modified preliminary estimate as an ultimate forecast of the
federal revenue loss resulting from FETT repeal, however,
would be to implement an erroneous static approach to an analysis
of the effects of that tax policy change. The more correct
(dynamic) approach is to take account of the macroeconomic effects
of the tax policy change. These effects include changes in gross
domestic product (GDP), interest rates, employment levels, personal
income, and inflation. Any of these macroeconomic quantities
could affect tax revenues significantly.
Second, CDA analysts introduced the modified
preliminary estimate of tax revenue change into an especially
adapted version of the DRI-WEFA U.S. Macroeconomic Model.27 They then processed the simulation and
noted changes in key macroeconomic and budget variables
compared with their values in the original adapted version of the
model. Differences in these key variables were attributed to the
response of the U.S. economy and federal budget to the tax policy
change-that is, the dynamic response. (See Table 2.)
The
Simulation28
The DRI-WEFA model contains a number of
variables used to simulate policy changes. CDA analysts introduced
static tax revenue and economic behavior change estimates to
the model in order to find the dynamic responses of the U.S.
economy and federal budget during 2003-2012 to immediate and
permanent repeal of the FETTs. These include:
Civilian Labor Force. Heritage
economist William W. Beach estimated in 1996 that the FETTs reduced
the labor supply by 97,200 in 1996.29
CDA analysts revised this estimate to 103,900 using more recent
information on the nation's civilian labor force growth rate from
the Bureau of Labor Statistics. They adjusted the variable
controlling labor supply in the model accordingly, phasing in the
103,900-worker increase over two years.
Non-NIPA30 Federal Government
Revenue. This variable measures taxes paid to the federal
government not coming from income flows in the economy, such as the
estate tax and the capital gains tax. CDA economists adjusted this
variable according to the net static change in federal collections
of these two types of tax resulting from the tax policy
reform.
Business Sector Price
Index. CDA analysts reduced this variable during the
forecast period in order to reflect lowered compliance costs for
the business sector resulting from FETT repeal. The adjustments
corresponded to a reduction in business sector costs of 30 cents
for every dollar that would have been collected in federal estate
transfer taxes. This ratio is based on previous research cited by
former DRI/McGraw-Hill economists Richard Fullenbaum and
Mariana McNeill.31
Corporate AAA Bond Rate. MIT economist James M.
Poterba estimated in a 2000 study that eliminating wealth transfer
taxes would reduce the required yield on investment by at least 1.3
percent.[32] CDA analysts lowered the corporate AAA bond
rate within the model in order to reflect this 1.3 percent
reduction.
Federal Non-Defense Spending Variables. CDA
economists adjusted federal spending in order to compensate for the
projected changes in federal collections resulting from FETT
repeal. This adjustment assured that the tax policy reform would
not cause a substantial change in cumulative federal deficits
during the forecast period. The adjusted variables controlled
direct federal non-defense spending and federal grants-in-aid to
state and local governments.
[1]Public Law
107-16.
[2]All
inflation-adjusted dollars referenced in this report are indexed to
the 1996 overall price level and thus represent 1996
dollars.
[3]Richard F. Fullenbaum and Mariana A.
McNeill, "The Effects of the Federal Estate and Gift Tax on the
Aggregate Economy," Research Institute for Small and Emerging
Business, Working Paper Series No. 98-01, 1998, pp.
10-11.
[4]William W. Beach, "The Case
for Repealing the Estate Tax," Heritage Foundation
Backgrounder No. 1091, August 21, 1996, p. 26.
[5]Henry J. Aaron and Alicia Munnell, "
Reassessing the Role for Wealth Transfer Taxes," National
Tax Journal, Vol. 45, No. 2 (June 1992), pp. 133-134, at
.
[6]Ibid., p. 138.
[7]A number of financial counseling firms
list transfers to trusts and carefully planned gifts on their
Internet sites as key estate planning techniques. See, for example,
Prudential Financial at
http://www.prudential.com/productsAndServices/0,1474,intPageID%253D1350%2526blnPrinterFriendly%253D0,00.html;
Dana S. Beane & Company, P.C., at ;
and Deborah A. Malkin, Attorney at Law, at
(October 25, 2002).
[8]Aaron and Munnell, "Reassessing the Role
for Wealth Transfer Taxes," pp. 135, 137.
[9]Beach, "The Case for Repealing the
Estate Tax," p. 24.
[10]James M. Poterba, "Estate Tax and
After-Tax Investment Returns," in Joel M. Slemrod, ed., Does
Atlas Shrug? (Cambridge, Mass.: Harvard University Press,
2000), p. 339. Beach estimates that the FETTs add 3 percent to the
cost of owning capital. See Beach, "The Case for Repealing the
Estate Tax," p. 24.
[11]Fullenbaum and McNeill, "The Effects of
the Federal Estate and Gift Tax on the Aggregate Economy," p.
10.
[12]All other things held constant, economic
theory suggests unambiguously that reductions in after-tax wages
reduce the number of participants in the labor force, since both
the wealth and the substitution effect reinforce one another,
rather than offset one another, in this case.
[13]Beach, "The Case for Repealing the
Estate Tax," p. 24.
[14]Ibid.
[15]Estimated by extrapolating unpublished
projections for estate tax filings by fiscal year performed by the
Statistics of Income Program of the Internal Revenue
Service.
[16]Projections for estate tax filings
through 2010 from unpublished Statistics of Income Program
projections.
[17]Joint Committee on Taxation, "Estimates
of Federal Tax Expenditures for Fiscal Years 2002-2006," January
17, 2002, p. 23, at .
[18]Fullenbaum and McNeill, "The Effects of
the Federal Estate and Gift Tax on the Aggregate Economy," p.
9.
[19]See Appendix, Table 2.
[20]The Center for Data Analysis used the
Mark 11 U.S. Macroeconomic Model of DRI-WEFA, Inc. (now known as
Global Insight), to conduct this analysis. The model was developed
in the late 1960s by Nobel Prize-winning economist Lawrence Klein
and several colleagues at the University of Pennsylvania. It is
widely used by Fortune 500 companies, prominent federal
agencies, and economic forecasting departments. The methodologies,
assumptions, conclusions, and opinions herein are entirely the work
of Heritage Foundation analysts. They have not been endorsed by,
nor do they necessarily reflect the views of, the owners of
the model.
[21]Congressional Budget Office, "The Budget
and Economic Outlook: An Update," August 2002, at .
[22]For a discussion of the shortcomings of
static analysis of the effects of tax policy changes, see Daniel J.
Mitchell, "The Correct Way to Measure the Revenue Impact of
Changes in Tax Rates," Heritage Foundation Backgrounder No. 1544,
May 3, 2002, at http://www.heritage.org/Research/Taxes/BG1544.cfm;
see also "The Argument for Reality-Based Scoring," Heritage
Foundation Web Memo No. 92, March 29, 2002, at http://www.heritage.org/Research/Taxes/WM92.cfm,
and Daniel R. Burton, "Reforming the Federal Tax Policy Process,"
Cato Policy Analysis, forthcoming December 2002.
[23]The variables changed in this simulation
for the purpose of modeling FETT repeal are enumerated in the
Appendix.
[24]Table 2 shows year-by-year estimates of
how repeal of the FETTs would likely change major economic
indicators.
[25]Congressional Budget Office, "The Budget
and Economic Outlook: An Update," p. 48.
[26]CDA economists applied a staged process
to calculate the additional capital gains tax collections. The
first stage was to combine historical averages on federal estate
tax returns from the IRS Statistics of Income Program and modified
projections from the Joint Committee on Taxation on the
current-law capital gains tax exclusion at death. These together
yielded a projection of the amount of taxable capital gains held in
estates over and above the $1 million exemption, without taking
into account the higher spousal exemption. The second stage was for
CDA analysts to use historical averages to find how much the higher
$3 million spousal exemption would subtract from the first
projection of taxable capital gains. The final stage involved
applying the long-term capital gains tax rate to the modified
projection for non-exempt taxable capital gains to create a
projection of the additional capital gains tax collections under
FETT repeal.
[27]This version of the model is especially
adapted to embody economic and budgetary projections published by
the CBO in August 2002.
[28]Readers interested in
replicating this analysis should contact the author for further
information on how the model was applied.
[29]Beach, "The Case for Repealing the
Estate Tax," p. 26.
[30]NIPA stands for National
Income and Product Accounts.
[31]Fullenbaum and McNeill, "The Effects of
the Federal Estate and Gift Tax on the Aggregate Economy," pp. A1
and A2. These two authors cited four sources for this estimate. The
first estimate, by Guest and Associates, L.L.C., was based upon
survey data to find the amount that estate holders spent on federal
estate tax planning and preparation during 1995; this amount was
compared with 1995 FETT collections and yielded a ratio of 30
percent. The second estimate was based upon calculations for
FETT compliance costs by Kennesaw State University scholars Joseph
Astrachan and Craig Aranoff; the cost was divided by an annual FETT
collection total, resulting in a ratio of 32 percent. The third
estimate was from Christopher E. Erblich of the Tax and Estate
Planning Practice Group, who calculated both compliance and
economic disincentive costs resulting from the U.S. federal tax
system; Erblich's amount was divided by an annual total for FETT
collection, yielding a ratio close to 31.2 percent. Finally, CDA
economist William W. Beach provided an estimate of the 1995 cost of
compliance with FETT that, when compared to 1995 FETT collections,
resulted in a ratio of 29.8 percent.
[32]Poterba, "Estate Tax and After-Tax
Investment Returns," p. 339.