Wednesday, July 05, 2006

A Case for a Federal Inheritance Tax

Category: Estate and Inheritance Tax

In a different look on the estate tax repeal (or virtual repeal debate) Maya MacGuineas and Ian Davidoff in's Think Tank Town discuss the merits of repealing the estate tax and replacing it with an inheritance tax in "Tax Inheritance, Not 'Death'".

Under current law, the federal estate tax is a tax on the amount of assets you own at death. The estate pays the tax, and the net balance is distributed to the beneficiaries. A person does not pay any tax on his or her inheritance.

While I disagree with the article's summary of estate tax repeal opponents that "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." (see my prior posts of Truths about the Estate Tax - Debunking the Popular Myths, Effects of the Federal Estate Tax on Farms and Small Businesses - Congressional Budget Office Paper, and other similar posts at Estate Tax - You and Yours Blawg where I discuss the cost passthrough of a repeal of the estate tax to other taxpayers - most likely in the middle brackets), the authors' thoughts about the alternative of a federal inheritance tax are intriguing.

In "Tax Inheritance, Not 'Death'", the authors propose that any inheritance should be treated as income and taxed as income. This would be in keeping with the theoretical underpinning of our current system of progressive taxes (ie: lower tax rates for lowers earners and higher tax rates for higher earners) on earned income. As for the argument that this is "double taxation" the article says "so what", new money coming to you is income, and income should be taxed. Recall that the current estate tax tends to act to tax all theretofore untaxed capital gains at a person's death, and rewards the beneficiaries with a new "stepped up" basis.

The heart of the argument for an inheritance tax is excerpted below:

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.

This argument does have an appeal to me in that it treats an inheritance as earnings - new money in your pocket, and new money means a new tax to you.


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