The U.S. Tax Code in the 21st Century: Does the Estate Tax Fit?

By Margo Thorning Ph.D.*
Senior Vice President and Chief Economist
American Council for Capital Formation**

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INTRODUCTION

When Ronald D. Aucutt, President of the American College of Trust and Estate Counsel, approached me about delivering the 2004 Joseph Trachtman Lecture, he suggested that I present an economist’s perspective on how the estate tax fits in with the U.S. tax code in the 21st century. As you know, the estate tax has been with us for many centuries,
the question is, should it continue as part of the U.S. tax base?

Rules specifying the government’s share of an estate have been a feature of western law for many centuries as it has been in other parts of the world. By way of illustration, while the first clause of the Magna Carta of 1215 focuses on the spiritual side of life by proclaiming the freedom of the English church, the second through seventh clauses pertain to the material side of life — the taxation of inheritances. For example, the second clause specifies the tax rate: 100 pounds on an inheritance received by an adult heir upon the death of an earl, baron or knight. Foreshadowing the spousal deduction in the U.S. tax code, the seventh clause of the Magna Carta specifies that: “after her husband’s death, a widow shall have her marriage portion and her inheritance at once and without hindrance; nor shall she pay anything for her dower, her marriage portion, or her inheritance which she and her husband held on the day of
her husband’s death…” Clearly, estate and inheritance taxes have been key issues for at least the last 800 years in the English-speaking world and even with the distractions of modern life interest in the subject remains strong.

CHALLENGES FOR THE U.S. ECONOMY IN THE 21ST CENTURY

Before addressing the question of a role for the estate tax in the 21st century, it may be useful to describe the ways in which the tax burden in particular and fiscal policy in general can affect U.S. economic competitiveness and job growth.

Several key factors are already impinging on U.S. economic growth and federal budget receipts or will shortly. For one thing, the trend toward outsourcing of U.S. manufacturing, service and even construction employment is unlikely to disappear. Second, in the next 10 - 15 years, the
current ratio of U.S. workers to retirees will drop from the current 3 to 1 to 2 to 1, which will mean either higher taxes or reduced benefits for retirees. The aging U.S. population will also require increased outlays for health care. Third, it seems unlikely that all of the recent increases in military
outlays will be reversed, even after U.S. forces in Iraq and Afghanistan are cut back. The perceived need to combat terrorism globally will maintain the pressure for U.S. military spending. These and other issues will keep up the pressure for higher levels of government spending and therefore higher federal and state taxes.

THE IMPACT OF TAX POLICY ON SAVING AND INVESTMENT AND ECONOMIC GROWTH

In analyzing tax systems, public finance economists tend to focus on two key factors:

1. How does tax policy impact a country’s saving, investment and
growth?

2. How large a share of GDP is absorbed by federal and state spending?

How do U.S. taxes on Capital Compare to our International Competitors?

Many recent academic studies have concluded that the U.S. taxes saving and investment, which are important determinants of economic growth, relatively harshly. For example, a 2001 analysis by Harvard University Professor Dale Jorgenson (a member of the board of scholars of the ACCF Center for Policy Research) and Yonsei University Professor Kun-Young Yun calculates the significant increase in the effective tax rate faced by most assets after the passage of the Tax Reform Act (TRA) of l986 (see Table 1). Their study found that in 1982, after the enactment of the 1981 Economic Recovery Tax Act, producers of durable equipment had the equivalent of expensing (first year write off ) with a zero effective tax rate. TRA ‘86 raised the effective tax rate from 0 to 32 percent. By l996, the rate had risen to 36 percent due to corporate and individual income tax increases. Even with the reductions in federal individual income tax since 2001, the effective tax rate likely remains close to 36 percent.

Another study by Willi Leibfritz, John Thornton and Alexandra Bibbee, published by the Organization for Economic Cooperation and Development (OECD) in 1997, shows that U.S. average effective tax rate on capital over the 1985–94 period was 40 percent, the sixth highest in
the list of 20 countries included in the international comparison (see Table 2). In contrast, taxes on labor and consumption (sales taxes) were significantly lower in the U.S. than in most of the other countries. Similarly, corporate income tax rates in the European Union have fallen from an average of 34.4 percent in 1995 to 31.7 percent in 2001, while the U.S. corporate rate has remained at 35 percent during that period. (See www.accf.org for November 28, 2001 testimony before the Joint Economic Committee for more details.)

The corporate alternative minimum tax (AMT) is also a factor in raising effective tax rates and raising the cost of capital for new investment. The AMT is pro-cyclical. That is, the AMT makes any downturn in the business cycle more pronounced by requiring companies to pay higher taxes when profits are down. The individual AMT is also raising tax rates on middle- and upper-middle income taxpayers, which increases the effective tax rate on investment. To my knowledge, no other industrial country places this
type of burden on its corporate and individual taxpayers.

Danger of Higher Levels of Government Spending

Another aspect of fiscal policy that can have a powerful effect on U.S. economic growth is the overall level of government outlays. The economic and demographic trends currently impacting our country or about to do so will tend to promote higher levels of federal and state outlays on
retraining, unemployment benefits, maintaining social security benefits and providing health care for the soon-tobe-retired baby boomers. Similarly, military expenditures (in real terms) are likely to remain above the levels of recent years. Policymakers need to be aware of a substantial body of economic research indicating that as the share of Gross Domestic Product (GDP) absorbed by government spending rises, productivity and economic growth slows.

In a recent (2001) econometric analysis of the major factors influencing economic growth in 21 countries (including the U.S.) published by the OECD, Andrea Bassanini and Stefano Scarpetta suggest that the taxes necessary to finance government spending can negatively affect the allocation of resources and thus slow growth in GDP. Although at low levels, the productive effects of government spending are likely to exceed the social costs of raising the funds, at higher levels of spending the negative effects may dominate. Bassanini and Scarpetta note that in the
1980s and 1990s the size of the public sector increased in most OECD countries (OECD nations are the top 30 or so industrialized countries). In 1999, for example, government outlays were in the range of 40 to 50 percent of GDP in many OECD counties and less than 20 percent of those outlays could be classed as directly “productive,” meaning that they paid for education, transport, communication or R&D (see Table 3). Bassanini and Scarpetta’s econometric analysis examined the impact of five factors, including an increase in the tax burden, on economic growth. Their results show that a one percent increase in the tax burden (measured as a percent of GDP) reduced per capita GDP by 0.6 to 0.7 percent. In other
words, for each additional percent of GDP absorbed by government spending, GDP per capita declined by almost one percent.

Other OECD studies, including the Liebfritz, Thornton and Bibbee analysis cited above, have examined the effect of higher levels of government spending on economic growth. The authors conclude that about one-third of the slowdown in OECD countries (from around 5 percent in 1965-73 to around 2 percent in 1989-95) can be explained by higher taxes. Figure 1 highlights the positive correlation between low government outlays (federal and state) and economic growth for major OECD countries.

HOW DOES THE ESTATE TAX AFFECT U.S. SAVING, INVESTMENT, JOB GROWTH AND COMPETITIVENESS?

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, which provides for reductions in the estate and gift taxes for 2002 through 2009 and repeal in 2010, is certainly a positive step forward in many respects. In 2010, the law repeals the estate tax but retains the gift tax with a top rate of 35 percent. As you know, unless repeal is made permanent, the estate tax returns in full force in 2011 with a top marginal rate of 55 percent. The instability of the current law as well as the perception that it is unfair to have no tax in 2010 and a 55 percent rate in 2011 are strong forces pushing for yet another change in the U.S. estate tax law.

From the perspective of many top public finance economists including Douglas Holtz-Eakin, Chief Economist for the Congressional Budget Office, N. Gregory Mankiw, Chairman of the President’s Council of Economic Advisers (CEA), and Allen Sinai, President and Chief Global
Economist with the macroeconomic consulting firm, Decision Economics, the estate tax exerts a negative impact on the U.S. economy. These scholars have concluded that the estate tax raises the cost of capital for new investment, makes it harder for a business to survive the death of its
founder, reduces overall employment, and is biased against those who choose to save out of income rather than consume all of their savings during their lifetimes. A brief discussion of these issues follows.

Who Really Pays the Estate Tax?

As Dr. Mankiw of the CEA noted in the 2004 Economic Report of the President, the issue of who benefits from repeal of the estate tax is the subject of much controversy. For example, the U.S. Treasury allocates the burden of estate and gift taxes to the decedents and donors. The Joint Tax Committee (the congressional committee charged with providing estimates of the revenue cost and distributional impact of tax policy changes) used to allocate the burden the same way as Treasury but has now stopped doing so due to uncertainty about the incidence of the tax. Allocating the estate tax burden to the decedents supports the common view that the tax is quite progressive since it applies to only the largest two percent of estates. In fact, it is virtually certain that little of the economic burden of the estate tax is borne by the decedents. The only way decedents could bear the burden of the estate tax is if the existence of the tax prompts them to reduce their lifetime consumption and accumulate larger estates so that the tax can be paid without reducing the after-tax bequest to heirs. This condition is unlikely to hold, Dr. Mankiw notes, because empirical research shows that the estate tax reduces the amount that decedents accumulate and pass on to their heirs. A reduction in estate building induced by the tax is likely to take the form of a reduction in U.S. capital accumulation. Since estate and gift taxes are taxes on capital, reduced capital formation means that part of the burden is shifted to workers through a reduction in wage rates or fewer employment opportunities. The estate tax has wide ranging impacts on economic activity by sole proprietors and entrepreneurs, according to two econometric analyses (1999 and 2001) by Dr. Holtz-Eakin, which were sponsored by ACCF Center for Policy Research (see www.accf.org). His studies show that several features of the estate tax negatively impact saving and investment and the small business community:

Impact on the Return to Saving — The estate tax is a tax on capital accumulation, with the tax base as the individual’s accumulated wealth (net of allowed deductions and exemptions). To see how this works, consider an individual who starts with $25,000 and earns an average return of 15 percent over 30 years. With the effects of compounding after 30 years, he will have accumulated $1.6 million dollars. A simple 50 percent estate tax reduces the net accumulation to just over $800,000, which is equivalent to lowering the annual return to 12.4 percent. Thus, the estate tax is similar to all taxes levied on capital income.

Impact on the cost of capital — Taxes on the return to capital make capital markets less efficient and thus reduce investment by placing a “wedge” between the return offered by profitable business opportunities and the return received by suppliers of funds. To continue the example, if the return to capital is taxed at a rate of 33 percent, firms may offer a 15 percent return, but suppliers of funds will receive only a 10 percent return after tax. As a result, the cost of capital is higher and fewer investments can meet the required internal rate of return. Using data from the Health and Retirement Survey, a nationally representative sample of individuals aged 51 to 62, Dr. Holtz-Eakin found that entrepreneurs face an expected tax liability that is typically nearly five times as large as non-entrepreneurs because of the type of investments they make. As a result, they face capital costs for new investments that are significantly higher than those of nonentrepreneurs. For example, the top 10 percent of entrepreneurs face capital costs that are over eight percent higher than they would be in the absence of an estate tax; for the top one percent the cost of capital is over 14 percent higher. (See Figure 2.)

Impact on Investment — The estate tax and its impact on the cost of capital have a negative impact on investment. For example, Dr. Holtz-Eakin estimates that the estate tax reduces annual investment by sole proprietors and partnerships by about two to six percent. To give a sense of the magnitudes involved, in 2001 there was approximately $118 billion in investment by sole proprietors and partnerships, suggesting a decline of $2.4 to $6.6 billion in investment in 2001 in this narrow category of small business alone.

Impact on Job Growth — Sole proprietors and other entrepreneurs are unusually sensitive to their personal tax situations when making business decisions. Dr. Holtz-Eakin’s analysis shows that there are large and statistically significant impacts of personal taxes on the employment decision. Drawing on research by Massachusetts Institute of Technology Professor James Poterba, which shows that the estate tax raises the tax rate on capital income by as much as 3 percentage points for older individuals, Dr. Holtz-Eakin’s research shows that each one percent increase in the tax rate (including the estate tax) causes sole proprietorships to reduce their desire to employ a worker by 0.2 percent. As tax rates rise, the risk of additional hiring increases due to the need to meet a higher hurdle rate, thus fewer jobs are created. For sole proprietors who already have an employee on board, each one percent increase in the tax rate reduces the desire to employ additional workers by 0.4 percent.

Macroeconomic and Revenue Effects of Repeal or Reduction of the Estate Tax

Shortly before the enactment of EGTRRA, the ACCF Center for Policy Research sponsored an analysis by Dr. Sinai on the overall impact on the U.S. economy of reducing or repealing the estate tax. The Sinai-Boston Econometric Model of the U.S. is a large-scale quarterly econometric model that includes considerable detail on aggregate demand, financial markets, sectoral flows of funds and balance sheets, interactions of the financial system with the real economy, and detailed trade and international financial flows.

Macroeconomic Impacts — Dr. Sinai estimated the impact of five different reform and repeal options, including: 1) immediate repeal coupled with elimination of the step-up in basis; 2) immediate repeal of the estate tax with step-up in basis retained; 3) phaseout of the estate tax over eight years; 4) reduction of the top estate tax rate from 55 percent to 20 percent (the highest capital gains tax rate in 2001); and 5) reduction in the top estate tax rate from 55 percent to 39.6 percent (the top current individual
income tax rate).

Preliminary results from early simulations suggest the following effects from immediate elimination or reform of the estate tax, retroactive to January 1, 2001:

• GDP increases a cumulative $90 billion to $150 billion over the 2001–2008 period, or 0.1 percent to 0.2 percent compared with the baseline for several years out of the eight years in the preliminary runs (see Table 4).
• Job growth ranges from 80,000 to 165,000 per year and the unemployment rate is slightly lower as a result (by 0.1 percent), with essentially no change in the inflation rate (see Table 4).
• Both consumption and personal saving rise, as does national saving, despite the loss in estate tax receipts to the federal government.
• The level of potential output is somewhat higher, by an average $6 billion to $9 billion per year.
• Total federal receipts, excluding estate tax receipts, rise in response to the stronger economy and financial system, feeding back approximately $0.20 per dollar of estate tax reduction, to some extent helping to pay for the estate tax reduction. Thus, dynamic revenue estimates which take account of total receipts after all factors of production adjust to the estate tax rate reductions, show much smaller effects than the static revenue estimates provided by the Joint Committee on Taxation. For example, reducing the top estate tax rate to 20 percent was estimated to cost only $12 billion per year when the top marginal rate was 55 percent under prior law. (See Table 4.) Now that the top marginal rate is 48 percent, the revenue loss would likely be under $10 billion per year.

Dr. Sinai’s findings about the positive economic impact of estate tax repeal and rate reduction support the effort to either permanently repeal the tax or achieve a permanent, significant rate reduction

International Comparison of Estate and Inheritance Taxes

Many countries tax estates or (inheritances) more lightly than does the U.S., according to a survey of 24 industrialized and developing countries. For example, fast-growing countries like China, Indonesia, India, have no tax on estates and inheritances. In fact, the current U.S. marginal tax rate of 48 percent is higher than every country except Japan and Taiwan (see Figure 3).

A U.S. TAX SYSTEM FOR THE TWENTY-FIRST CENTURY

Reforming the U.S. federal tax system will not be easy, but some experts think reform should move toward the “front burner” for policymakers in light of the difference it could make for economic growth in the U.S. Policymakers must move the U.S. forward with a viable tax code designed for the challenges of the 21st century, including globalization of business and greater use of e-commerce and the Internet to conduct operations from anywhere in the world.

For example, switching to a tax on consumption such as the cash flow tax described in the U.S. Treasury’s 1977 volume “Blueprints for Basic Tax Reform” could have a very positive impact on future economic growth. Under the cash flow tax, consumption, rather than income, is the tax base. There is no corporate income tax, interest is neither taxable nor deductible and transfers at death would not be taxable until the funds were withdrawn and spent for consumption by the heirs.

Many top public finance economists, including Dr. Jorgenson, Stanford’s John Shoven, Boston University’s Laurence Kotlikoff have analyzed the effects of switching to a tax system based on consumption. Their studies demonstrate that relying on a consumption tax would have significant, positive effects on the U.S. growth rate. A recent analysis by Dr. Sinai examining fundamental reform of the U.S. tax system by switching to a tax system where all saving is tax exempt, all new investment is written off in the first year, and interest expense is not tax deductible, shows strong increases in GDP, investment, employment, and federal tax receipts. If
this tax system had been in place from 1991 on GDP would have been 5.2 percent higher by 2004, consumption and investment would have been greater, and employment higher by over 2.4 million jobs. (See Table 5.)

If, instead of fundamental tax reform, political reality requires an incremental approach to tax reform, there are several steps that could help encourage the saving and investment needed for continued strong U.S. economic growth and international competitiveness. For example, lowering corporate income tax rates, shortening the depreciable lives of assets, repealing the alternative minimum tax, removing ceilings on contributions to IRA’s and 401k’s and repealing the estate tax or substantially reducing its rate would all have positive effects on economic growth. All of these measures would reduce the tax “wedge,” lower the cost of capital and promote economic growth.

THE OUTLOOK FOR PERMANENT ESTATE TAX REFORM

One proposal for estate tax reform, which was presented to ACTEC members at the 2001 Trachtman Memorial Lecture by John A. Wallace, deserves serious consideration. The plan offered by Wallace calls for a “mini-reform” consisting of an increase in the exemption and a tax rate reduction. This plan has drawn considerable enthusiasm and support from both the private sector and policymakers who see it as a viable compromise to the current stalemate.The “CAPTAX,” a variation of the Wallace proposal,has been put forward by the American Council for Capital Formation as a way of bringing together supporters of total
repeal and those who wish to retain a high estate tax rate. The CAPTAX reduces the estate tax rate to the top individual tax rate on capital gains, now at 15 percent, and retains step-up in basis. The CAPTAX and similar variations are now being seriously considered by top policymakers in the U.S. Congress.

CONCLUSIONS

While tax policy is not the main determinant of U.S. economic growth and prosperity, well chosen polices can significantly affect our future and that of our children. Policymakers must try to design a system that is more favorable to the capital formation (both physical and human) needed for strong U.S. growth and also guard against letting the overall federal and state tax burdens rise in the face of demographic and other challenges. Scaling back taxes on capital and wages and replacing them with more reliance on consumption taxes will promote stronger economic growth. In order to move in this direction, the estate tax should also be scaled back substantially, if not completely eliminated.

*This special report served as the basis for Dr. Margo Thorning’s remarks at the 2004 annual meeting of the American College of Trust and Estate Counsel in San Antonio, Texas, where she delivered the annual Joseph Trachtman Lecture on March 12, 2004.

**The mission of the American Council for Capital Formation is to promote economic growth through sound tax, trade and environmental policies. For further information, contact the ACCF, 1750 K Street, N.W., Suite 400, Washington, D.C. 20006-2302; telephone: 202/293-5811; fax: 202/785 8165; e-mail: info@accf.org; Web site: www.accf.org.

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