There has been a great deal of discussion in the last several years about possible elimination of the federal estate and gift tax. As the above congressional study noted, there is no real justification for these taxes. However, it is not economics, but politics, which will assure the tax is not eliminated. Some history may be important to understand this issue.
When Congress re-enacted the estate tax in the early 1900s, (there was an estate tax during the Civil War), lawmakers designed it to be a wealth redistribution system on the super-rich. Congress wanted a tax (at a paltry 15% top rate!) stiff enough to discourage the creation of an upper class of super-wealthy people. By the early 1980s, though, much of the middle class was subject to the tax, since transfers between spouses that exceeded just $250,000 were subject to an estate tax.
The Reagan administration pushed through a massive overhaul of the transfer tax system, including the unlimited marital deduction, an increase in the unified tax credit (UTC) to $600,000, and an increase from $3,000 to $10,000 of the annual gift exclusion. For a while, these measures effectively pushed the middle class out of the estate and gift tax system. However, Congress did not adjust the increase in the UTC for inflation and, over time, inflation eroded the benefit of the $600,000 credit.
The Taxpayer Relief Act of 1997 increased the UTC from $600,000 to $1 million, phased in from 1998 to 2006. Although helpful, there are serious problems with this increase. First, $300,000 of the $400,000 rise is scheduled to occur in the last three years because that gets the lost revenue out of the five-year budget window. Second, the UTC increase barely keeps up with all the past and expected inflation up to 2006. Third, after fully phasing in, the $1 million is not continually inflation-adjusted, so its benefit will erode again after 2006. Finally, with the UTC increasing from $600,000 to $1 million, the starting estate tax rate will move from 37% to 41%, which we call “estate tax bracket creep,” and it’s largely the result of inflation, low as it is now compared to what happened in the 1970s and 1980s.
Today, much of the upper middle class and many entrepreneurs face taxes that are effectively confiscation. The combined income and estate tax hit on retirement plan assets can take over 70% of a plan. Estate taxes can take 55% of the capital of a family business. Despite the fanfare over the new business estate tax deduction of $650,000 (reduced to $300,000 in 2006), it is so complex to be barely understandable or usable.
With the transfer tax starting at 37% and going to a top effective rate of 55% (versus a top income tax rate of 39.6%), the IRS is often able to obtain a much greater “rate of return” for its time auditing estate tax returns than income taxes. And with $10 trillion to $20 trillion likely to pass in the next few decades, this area is guaranteed to receive more attention from Congress and the IRS.
Will the estate and gift tax be eliminated? It is highly unlikely for the following reasons:
The politics of wealth will allow opponents of elimination (or advocates of preserving the tax) to attack those who want it abolished. Political expediency, not economics, will assure the survival of the transfer tax system.
To eliminate the tax, Republicans would have to control the presidency, the House of Representatives, and the Senate. GOP control of the Senate would have to be filibuster-proof. The Republican majority would have to be large enough to pass such a tax bill over Democratic objections, even while losing the votes of those Republican legislators who will want to reform, but not eliminate, the tax. No one realistically believes this political lineup is possible in the near future.
Estate tax elimination would most likely be a part of a comprehensive overhaul of the federal tax system. But until campaign finance reform occursand it just failed againthere is little likelihood for any comprehensive tax overhaul. Contributions drive the system, and varying political contributors’ influences will continue to negate any possibility of real reform.
No one has figured out how a reform or elimination of the income system would affect the government’s continuing revenue needs. Although estate taxes made up only 1.1% to 1.3% of the federal budget during the 1990s, expect this percentage to grow rapidly as the single wealthiest generation that has ever lived starts to die and passes those trillions to heirs the next 20 to 30 years. Given the concerns, many of the elderly will or have already taken more out of the entitlement systems than they put into it in taxes, that’s another argument why Congress will not eliminate the estate tax.
Even if the Republicans were successful in taking over Congress and eliminating estate taxes, there is a great likelihood that the Democrats (possibly with Republican help if an economic downturn occursremember George Bush’s 3% “read my lips” tax increase) will reinstate the tax if and when they regain control of the legislature.
If your clients are concerned that they bought life insurance that may prove unnecessary if the estate tax is eliminated, tell them they must be living in a different reality. Steve Forbes and Donald Trump notwithstanding, the estate tax is not going to be eliminated any time soon.
This does not mean estate and gift tax reform is not possible. We anticipate growing political pressure to reduce the number of people who are subject to the tax. This can be accomplished by including cost of living adjustments to the UTC to eliminate imposition of the tax on the middle class. Also, certain sectors of the economy, such as farms, may see their estate taxes reduced as part of very specific legislation.
Reform is possible. Elimination is a fantasy.
John J. Scroggin, a graduate of the University of Florida law school, practices tax and estate planning at his own firm, John J. Scroggin & Associates, in Roswell, Ga. He can be reached by phone at (770) 640-1101 or by e-mail at email@example.com.