Until recently, estate taxes (also known
as death taxes) were the almost exclusive headache of the super
rich, their tax attorneys, and their estate planners. But a strong
economy, an ever-widening distribution of wealth--both good
things--coupled with tax policy that has failed to keep up with
economic growth have extended the reach of estate taxes well into
A Brief History of the Estate Tax
Estate taxes are not a new phenomenon;
they date back almost three thousand years. As early as 700 B.C.,
there appears to have been a 10 percent tax on the transfer of
property at death in Egypt.1 In the first century A.D., Augustus
Caesar imposed a tax on successions and legacies to all but close
Transfer taxes during the Middle Ages grew
out of the fact that the sovereign or the state owned all assets.
Although the king owned all real property in feudal England, he
would grant its use to certain individuals during their lifetimes.
When they died, the king would let the estate retain the property
upon payment of an estate tax.
the United States, the tradition of taxing assets at death began
with the Stamp Act of 1797. While the first Stamp Act on tea helped
precipitate the Revolutionary War, the second was far less
dramatic. Revenues from requiring a federal stamp on wills in
probate were used to pay off debts incurred during the undeclared
naval war with France in 1794. Congress repealed the Stamp Act in
set a pattern for the next hundred years or so in which estate
taxes were used as a sporadic, and temporary, way to finance wars.
When hostilities ceased, the tax was repealed.
help finance the Civil War, the Tax Act of 1862 imposed a federal
inheritance tax. As costs mounted, the Congress increased the
inheritance tax rates and added a succession tax in 1864. When the
need for added revenue subsided after the war, the inheritance tax
was repealed in 1870.
1874, a taxpayer challenged the legality of the Civil War estate
taxes, arguing they were direct taxes that, under the Constitution,
must be apportioned among the states according to the census. The
Supreme Court disagreed saying that direct taxes pertained to
capitation taxes and taxes on land, houses, and other permanent
Another legal decision bearing on, but not
directly related to, estate taxes concerned the Income Tax Act of
1894, which included gifts and inheritances as income subject to
tax. The Supreme Court struck down the whole bill because the tax
was imposed on, among other things, real estate gains and,
therefore, was considered a direct tax.3 This decision is particularly notable
because it set the stage for the Sixteenth Amendment that allows
the federal government great latitude in the types of taxes it can
The Modern Estate Tax
Evolves: 1916 to 1975
In the early 20th century, worldwide conflict cut into
trade tariffs--a mainstay of federal revenues--and Congress turned
to another revenue source. The Revenue Act of 1916, which
introduced the modern-day income tax, also contained an estate tax
with many features of today's system. After an exemption of $50,000
(over $11 million in terms of today's wealth), tax rates started at
1 percent and climbed to 10 percent on estates over $5 million
(over $1 billion in terms of today's wealth). Estate taxes were
increased in 1917 as the U.S. entered World War I.
However, this time the estate tax did not
go away after the war ended. Despite sizable budget surpluses,
Congress increased rates and introduced a gift tax in 1924. Like
the estate tax, the gift tax is a levy on the transfer of property
from one person to another. During the 1920s through the 1940s,
estate taxes were used as another way to attempt to redistribute
income. Tax rates of up to 77 percent on the largest estates were
supposed to prevent wealth becoming increasingly concentrated in
the hands of a few. Chart 1 shows the starting and top estate tax
rates since 1916.
While the Internal Revenue Code of 1954
overhauled the federal income tax, it made a seemingly minor
structural change to estate taxation. Specifically, it expanded the
tax base to include most life insurance proceeds, which could
substantially raise an estate's tax bill.
Federal Transfer Taxes: 1976 to the Present During the
late 1960s and early 1970s loophole closing preoccupied tax
reformers. These efforts culminated in a 1976 tax bill that
overhauled estate taxation, giving us the system we still have
today. Perhaps the biggest change was combining the previously
separate exemptions for estate and gift taxes and transforming them
into a single, unified estate and gift tax credit.
1981 tax bill brought some relief. The top rate went from 70
percent to 50 percent, and an increase in the unified credit took a
lot of smaller estates--those under $600,000--off the tax rolls.
But, after that, the search for revenue to close budget deficits
led to more than a decade of bills that largely increased estate
1997, Congress provided some relief with the first increase in the
unified credit since 1987. Gradual increases, which began in 1999,
are slated to raise the unified credit to $1 million by 2006.
Economic Growth and Tax Relief Reconciliation Act of 2001 was the
first step toward totally eliminating the death tax. It provides
for a scheduled phase-out of rates and an increase in the unified
credit, finally repealing the tax for calendar year 2010.
Unfortunately, the provisions sunset in 2011 and the estate tax
reverts back to the 1997 law with a top rate of 55 percent and a
unified credit of $1 million.
Estate Taxes and the Economy
estate tax has a large dead-weight loss. Because the estate tax
falls on assets, it reduces incentives to save and invest and,
therefore, hampers growth. Along with income taxes, estate taxes
help raise the tax rate on income from assets relative to income
from working. This unequal treatment of income leads to an
inefficient mix of capital and labor.
size of the dead-weight loss depends on how much of a nation's
assets are subject to the tax and the amount of distortion. The
estate tax exemption determines the proportion of wealth covered
and the rate structure determines the degree of the distortion.
rough measure of the distortion is the ratio of marginal to average
rates for those paying the tax. The average rate is a proxy for the
amount of revenue raised, while the marginal rate is a proxy for
the overall price distortion. Under a uniform tax, the ratio would
be one and the amount of distortion would be minimized. The greater
the difference between the marginal and average tax rates, however,
the greater the distortion and, therefore, the larger the
Currently, the marginal estate tax rate is
nearly three times higher than the average. Even though the estate
tax rate structure is progressive, the high ratio is due mostly to
the unified credit. In 1916, the statutory exemption was $50,000.
Adjusting the exemption for the growth in wealth between 1916 and
2003 indicates that estates under $11 million (in today's wealth)
would not be taxed. In 1931, the exemption was worth even
more--$14.1 million (in today's wealth). As Chart 2 shows, however,
since then the real value of the exemption has fallen dramatically.
The low of about $356,000 was reached in 1976.
bills in 1981 and 1997 provided modest increases in the exemption.
However, the exemption of $675,000 in 2001 is still a far cry from
its $11 million counterpart in 1916. This failure of the estate tax
exemption to keep up with rising wealth is the main reason
increasing numbers of average Americans face the prospect of having
their heirs presented with an estate tax bill. A middle class
family that owns a home and has IRAs, 401(k)s, or other retirement
accounts could easily have assets exceeding $675,000 today or even
$1 million five years from now.
While the eroding exemption has greatly
expanded the estate tax base, both the lowest and highest tax rates
also have gone up significantly since 1916. As a result, more of a
taxable estate is taxed at the highest marginal rate. As Chart 3
shows, in 1916, only estates over $1 billion (in today's wealth)
would have been taxed at the top rate of 10 percent. Contrast that
with the top rate of 55 percent on estates of $3 million in place
in 2001 (and possibly again in 2013).
applicable rates are more compressed than Chart 1 suggests because
of the unified credit. Under an exemption system, the estate would
begin paying tax at the lowest statutory rate. Under the credit,
however, the effective bottom rate is not the statutory 18 percent
shown in the graph, but 39 percent. While effective tax rates under
the 1997 law ranged from 39 percent to 55 percent, as the credit
continued to erode in value, the lowest effective rate rose to 41
percent by 2002 and will appear again in 2011.
Effect on Family Business
estate tax is particularly harmful to families that own businesses
or farms. Even though the amount of the tax is based on asset
value, the simple fact is that the tax must be paid out of
us look at two small business examples. Take a family-run store
yielding a 10 percent return each year. Taxes reduce the return to
5 percent.4 If the
owner dies and his estate is subject to the 55 percent estate tax
rate, how do the heirs pay the bill? They could send 55 percent of
the store's inventory or other physical assets to Washington,
except Treasury does not accept payment-in-kind, only cash.
Devoting the entire 5 percent annual return, the heirs could pay
off the estate tax in only 11 years, except Treasury wants the
money now. The heirs could borrow from the bank at 9 percent (4.5
percent after tax) and pay off the loan in 50 years, but rather
than run the store for 50 years for free, they probably would
example is not as outlandish as one might think. Consider the small
farmer who owns land near an urban area. His farm would yield a 10
percent return only when it is valued as farmland. But tax law
requires that the asset be valued at its "best use," lowering the
pre-tax return to 5 percent (2.5% after tax). In this case, even
the 50-year bank loan will not save the farm.
lesson to be learned here is that all taxes are paid out of income.
Even if the estate tax is a "rare" event, only one chance in a
lifetime, its average impact is very large--large enough that for
some the combined effects of income and estate taxes approach 100
prospect is that as much as 55 percent of the principal of any
investment will be taken in estate taxes on top of income taxes. In
cases like these, the clear message is "don't invest, consume."
Congress has tried to address the hardship circumstances for
farmers and small business in general. But the remedy effectively
has the government standing in for the bank. The final result is
the same--heirs are left with a choice of owning a nonperforming
asset for a number of years or simply selling. What is more, the
IRS has taken these half measures as an excuse to raise appraised
estate values, thereby reducing the tax relief.
investment decision becomes even more complicated if there are ways
to organize holdings to pass the income stream to heirs. Tax
planning can significantly mitigate the effect of the estate tax.
Because amounts involved tend to be large, estate planning richly
rewards taxpayers who can anticipate that they might be subject to
the tax. Those that do not plan or cannot anticipate are caught and
pay the tax. This is simply unfair.
is one reason why the largest estates do not pay the highest tax
rates. Who does? Typically they are owners of small businesses,
family farms, and savers who amass wealth during their lifetimes
through hard work and thrift. Because wealth is often unexpected,
these people may not be aware of, or take full advantage of, ways
to reduce estate taxes. As a result, those who come late, or not at
all, to estate planning end up paying most of the tax.
estate tax is one of the most inefficient features of the current
tax system. Its sheer complexity results in high compliance
costs--as much as estate taxes raise by some estimates. High
compliance costs along with distortions to economic activity
warrant outright elimination of estate taxes before the sunset
Failing repeal after 2010, the exemption
should be raised significantly. Increasing the exemption to the
range of $5 million to $10 million would restore eroded value and
reduce the proportion of wealth subject to tax to be more in line
with the 1920s and 1930s.
would only partially address the impact of the tax, however. Under
the unified credit structure, raising the exempt amount above $3
million would make the lowest marginal rate 55 percent, meaning the
tax would be even less efficient than current law. While the amount
of wealth subject to tax would be reduced, the rate structure would
be harsher, increasing the ratio of marginal to average rates. The
way to avoid this result is to convert the exemption from a credit
to a deduction.
Another desirable change would be to
expand the rate brackets and lower rates. As we have seen the
current rate brackets have become compressed when compared to prior
law. Expanding the brackets would reduce the marginal rate relative
to the average and produce a more efficient system. Similarly,
reducing estate tax rates would also help to improve the system.
The best solution, however, would be to eliminate the estate and
gift tax altogether before the sunset.
Robbins is Visiting Fellow in Tax Policy at The Heritage
Foundation and president of Fiscal Associates. This study is based
on a presentation at a Department of the Treasury Roundtable on
Jobs, Growth, and Abolition of the Death Tax, November 6,
Scholey v. Rew, 23
Wall. (90 U.S.) 331 (1874).
Pollock v. Farmers'
Loan and Trust Company, 158 U.S. 429 (1895).
A tax rate of 50
percent might seem high, but we calculate the economy-wide,
marginal tax rate on private business capital at roughly 67
The impact of a tax
imposed on assets must be multiplied by one divided by the
after-tax rate of return. Thus, the impact of the estate tax is
magnified by 10 for an asset with an after-tax return of 10 percent
and by 20 for an asset with a 5 percent return.
The 108th Congress has
the chance to permanently repeal this burdensome and inefficient
tax in the current session. The House already has voted to do so,
and the Senate should not let this opportunity to build on the
momentum of the 2001 tax cuts slip away.
The presentation was
heavily based on Gary and Aldona Robbins, The Case for Burying the
Estate Tax, Institute for Policy Innovation, TaxAction Analysis,
Policy Report No. 150, March 1999. This report is available at the
Web site www.ipi.org.