Originally published in The Wall Street Journal

July 14, 2000

Kill the Death Tax Now...

By Martin Feldstein

Last month, by an overwhelming bipartisan majority, the House passed legislation to phase out the estate and gift tax. The Senate was moving toward passage of similar legislation yesterday as this newspaper went to press. President Clinton says he will veto the bill. He shouldn't.

The estate and gift tax is bad tax policy by every standard. It is an unfair tax on income that has already been taxed. It discourages work and saving. It is complex and imposes high compliance costs. And because of its incentive effects, it probably reduces personal income tax revenue by more than the estate tax itself collects, causing a net decrease in total federal tax revenue.

Double Taxation

To see how punitively unfair the estate tax is, think about someone who is now 50 and will die at 80. Suppose his income increases by $1,000. If there were no tax, he could invest the $1,000 in a bond paying 7% interest and bequeath $7,600. In reality, though, the combination of a 31% marginal personal income tax rate and the 2.9% Medicare payroll tax cuts the original $1,000 in earnings to $660. Since a 31% income tax rate also reduces the 7% interest to a net-of-tax return of 4.8%, that $660 would grow only to $2,717 at age 80. So the combination of the tax on the original earnings and on the interest payments reduces the potential bequest by nearly 65%. Such is the effect of double taxation.

It seems very unfair to add an additional tax on top of this 65% burden. For someone with a taxable estate of $1 million, the marginal estate tax rate of 37% would cut the $2,717 bequest to a net bequest of l,712. The overall tax on the potential $7,600 bequest would therefore exceed 77%. And with an estate of $3 million, the overall tax would rise to 84%.

Such tax rates not only are unfair but also reduce the incentive to work and save. Why not consume the extra incentive to work and save. Why not consume the extra $1,000 of earnings instead of saving those dollars to finance a bequest when taxes would take 77% or more of it? And if you're planning to leave your money to your heirs instead of spending it yourself, why make the extra effort to work when so little can actually be bequeathed?

While some high-income professionals or managers may like their work enough not to care about marginal compensation, many are encouraged by the high estate tax on top of the high income tax to retire early or simply to work less, save less and take less investment risk. The result is not only to waste their talents but also to hurt those who would otherwise benefit from their efforts, their entrepreneurship, their management skills and their saving and investment.

The high estate tax rates inevitably encourage tax-planning actions aimed at reducing the government's bite. It's hard to imagine how many millions of hours of legal and accounting skills are wasted in this process. And whenever the government closes one path of tax avoidance, clever lawyers and accountants find other ways to mitigate the burden. But even when they have done so, the marginal tax rates individuals face on extra dollars of bequests remain high.

Mr. Clinton has said he would veto the House legislation because the nation could not afford the revenue loss. But estate and gift tax revenue in 1998 was just $23 billion, only about 1 % of total federal tax revenues, and virtually nothing compared to the projected 10-year budget surpluses of more than $4.2 trillion.

In fact, when the incentive effects of the tax are taken into account, the net impact of the estate tax is probably to reduce overall tax revenue. One way this happens is by inducing wealthy individuals to make large charitable gifts, both before death and as charitable bequests. These charitable gifts are tax-deductible and thus reduce income-tax revenues. A gift of appreciated stock or other assets also avoids the capital gains tax, further increasing the revenue loss caused by the estate tax. The charitable gifts induced by the estate tax also shift the income generated by these assets from taxable income to the tax-exempt status enjoyed by charitable organizations. The Treasury thus loses that revenue permanently. And because of the estate and gift tax rules, individuals are induced to give some of their assets to children and grandchildren before dying. In many cases, this shifts the income on these assets from the top 39.6% marginal tax rate to lower brackets. These and other losses of income tax and capital gains tax revenue can easily exceed the revenue collected by the estate tax itself. Eliminating the estate and gift tax would probably raise total tax revenue. Thankfully, the Senate rejected a bipartisan compromise that would have excluded some types of property (family farms and small businesses) from the taxable estate and raised the size of the bequest that can be made before any tax is due. Such partial estate tax cuts are bad tax policy. For the remaining estates, the tax would still be an unfair tax on previously taxed income, a disincentive to work and to save, a waster of legal and accounting talent, and a net reducer of the combination of income and estate tax revenue. Once it is acknowledged that there are good reasons to eliminate the estate tax on some estates, only a desire to punish the rich could justify the remaining estate tax on high-income taxpayers. No Phase-Out Congress hasn't yet gone far enough. If the estate tax is to be eliminated, it should be eliminated immediately rather than phased out over 10 years. Because the estimated revenue loss is so small, there is nothing to be gained by stretching out the elimination. Doing so would only keep the ultimate repeal an uncertain political issue. And until the estate tax is completely gone, it will continue to distort behavior and lose federal tax dollars. The best policy would be to eliminate the estate and gift tax and to do so immediately.

By Martin Feldstein. Mr. Feldstein, a member of the Journal's Board of Contributors, is a professor of economics at Harvard. He is an adviser to the George W. Bush campaign.