Repealing the estate tax is dumb

Repealing the estate tax is dumb. 

By Matthew Yglesias. SlowBoring.com. 

March 17, 2021. 

37 min ago

Hildene mansion and formal garden at Manchester in Vermont.

(Photo by: John Greim/Loop Images/Universal Images Group via Getty Images)

If you die, then your assets will pass tax-free to your spouse. And if you don’t have a spouse, then your assets will almost certainly pass on tax-free to your heirs. But if you are very rich and have over $11 million in assets as a single person or $22 million assets as a married couple, then you will need to pay a federal estate tax.

Most — though not all — Senate Republicans are very fired up about this and have introduced legislation to help out the heirs to large fortunes by eliminating this tax.

Twitter avatar for @SenJohnThune

In light of recent Republican protestations to be the true party of the working man, this level of solicitude for wealthy heirs is of course odd. Naturally, everyone prefers to pay less tax rather than more. But of all the taxes to fight fervently against, they came up with the one that impacts the smallest and richest group of people. It’s absurd.

And the rhetoric about “family farms and ranches” is especially absurd. That said, when you delve into it, I think there’s a perfectly fair point about it being strange to make death into a taxable event. If you weren’t just doing a random giveaway to a super-privileged and not-especially-deserving set of people, you could easily come up with a better way of taxing rich people.

The rhetorical case against the estate tax

Jeff Bezos is incredibly wealthy because he owns a lot of shares of Amazon stock. If Bezos died, he would owe somewhere in the neighborhood of $75 billion in estate taxes. Though Bezos is worth about $180 billion, that doesn’t mean he has tens of billions of dollars sitting in a checking account that can be handed over to the IRS. To pay the tab, his estate would need to liquidate some Amazon stock to raise cash, then the cash could go to the government.

The rhetorical case against the estate tax leans heavily on this idea but shrinks it down. Suppose that instead of owning 10% of a $1.6 trillion corporation, you own 100% of a company that’s worth $50 million. Well, you’re not Jeff Bezos rich, but you’re still pretty rich. So when you die, you owe estate tax. And you face the same basic problem that even though the company you own is valuable, that doesn’t mean you have cash for the IRS in a sock drawer. You’d need to sell a partial interest in the company to someone. That might be logistically difficult, because unlike stock in a publicly-traded company, there isn’t necessarily a market of active buyers for a minority interest in your car dealership or whatever.

Since “family farms and ranches” sounds more sympathetic than “car dealerships or whatever,” they tend to talk about family farms. But it’s all the same — the idea is that the estate tax is a logistical burden on the owners of closely-held businesses.

But as various estate planning attorneys will tell you, the United States Congress is actually not indifferent to the interest of rich people. Members of Congress are on average very rich, and they also spend a fair amount of time on the phone with rich donors. So there is a provision to make the estate tax workable for multi-millionaires whose vast fortunes are structured as closely-held businesses rather than shares of publicly traded corporations:

Under one statutory provision, which was enacted for the express purpose of helping to preserve closely-held businesses, the estate of a deceased owner may elect to pay the estate tax attributable to the value of the decedent’s interest in the closely-held business over a period of ten years. Furthermore, these payments are due beginning five years after the estate tax return is filed (with only interest payable until the fifth year). In this way, the profits from the business itself may assist the estate is satisfying the tax liability.

In order to qualify for this benefit, the value of the decedent’s interest in the closely-held business must exceed 35% of the decedent’s adjusted gross estate (which may restrain a lifetime gifting program), and the decedent must have owned at least a 20% interest in the business. In addition, the business entity must be carrying on an active trade or business (as opposed to a passive or portfolio investment-type activity).

So this whole objection is basically fake — nobody has to liquidate a profitable business to pay the estate tax, what they have to accept is a reduced after-tax income to pay off loans. In other words, the estate tax makes rich heirs less rich than they otherwise would be. I would further note that “small farms” are themselves mostly fake. As Maggie Koerth explained a while back for 538, all kinds of large rural landowners are “farmers” under the U.S. government definition of a farm.

The Agricultural Census defines farms as “any place from which $1,000 or more of agricultural products were produced and sold, or normally would have been sold, during the reference year.” That $1,000-a-year threshold was low when it was set in 1975; it’s even lower today because it was never adjusted for inflation, said Allan Gray, professor of agricultural economics at Purdue. If it had been, the cutoff would be closer to $5,000 today.

What’s more, the USDA interprets “normally would have been sold” broadly, so it includes land that could, theoretically, produce agricultural income — even if the owners never had any intention of donning a pair of overalls and a co-op hat. “I own three acres where my house is built,” Gray said. “I’m right on the edge of being considered a farm because my yard would have almost the potential to create $1,000 in revenue. I’m not quite a small farmer, but I almost could be.” These little spreadsheet farms aren’t anyone’s primary source of income, Gray said. In fact, the people who own them tend to have incomes above the median for America as a whole. These aren’t the farms of the poor; they’re the yards of the upper-middle-class.

I sometimes troll myself by looking at real estate listings in the Texas Hill Country where my wife’s parents live. And sometimes you come across a property like this one, a $15 million estate with a nearly 9,000 square foot mansion sitting on 800 acres of land. The owners appear to raise horses, which is a popular hobby for rich people who live in the country, and consequently, I think it counts as a farm. You could live out there on your estate in Boerne and drive to San Antonio for your job as a law firm partner or whatever and characterize your large fortune as a family farm.

It’s all neither here nor there. And also kind of wildly detached from the actual economic argument about the estate tax.

What conservative economists think about the estate tax

The threshold at which the estate tax kicks in has been raised several times in the past 20 years, so most old articles about it have the wrong numbers. And as a result of education polarization or something, opponents of the estate tax seem to have largely stopped even bothering to make highbrow arguments against it.

But if you go back and read old Greg Mankiw articles or this 1994 paper from the Tax Foundation, you get a really different kind of argument.

As you know, conservatives in general feel that tax incentives are a big issue. They also feel that the tax incentives facing rich people are a particularly big issue, because rich people’s labor is valuable. And the way they see it, the estate tax is essentially a tax on entrepreneurial effort. If you’re a salaried worker, then effort translates into income which translates into wealth indirectly through savings. But if you own a local chain of restaurants, then the additional effort it takes to expand to four nearby towns translates directly into the business owning more assets, and therefore you — the business owner — owning more wealth.

This more recent Heritage Foundation take sort of blends the “tax on entrepreneurial effort” argument with family farm sentimentalism, but it’s worth unpacking:

There needs to be some context as to who really does pay the estate taxes. For example, in the agricultural context, according to the U.S. Department of Agriculture, 57 percent of the family farms that owed estates taxes were small family farms (gross cash farm income of less than $350,000). Of course, these estates do have significant wealth. But this shouldn't be confused with significant income. Much of the wealth of these farms, and most family farms, is tied up in land. This means that when heirs do have to pay estate taxes, there is often a need to sell off land (or other assets) to pay off the death tax. In trying to grow the economy and increase jobs, having a policy that compels businesses to contract is obviously counterproductive.

The full negative impact of the estate tax, though, isn't captured by who is paying the estate tax. It is fully captured by understanding how the tax impacts those who don't pay it. Imagine owning a small business and recognizing that if your assets exceed a specific level, a major tax could be triggered after you die. Your hope of passing on the fruits of your labor to your family could be severely hampered if you are too successful. Such a tax is literally a disincentive to success.

To me, the sentimental version of this doesn’t work. It is absolutely true that a person could inherit a parcel of extremely valuable land whose farm output is not lucrative enough to cover the estate tax bill. But that implies either that your farm is poorly managed or else that the land is more valuable if used for a non-farming purpose. In that case, pushing you to liquidate the farm and put the land in the hands of someone who can make better use of it is good.

But the other frame makes more sense. Suppose you own a swathe of vacant land that’s worth $20 million because it’s actually really well-located. If you build a bunch of apartments on it, then you’ll be even richer, and also a bunch of people will have a well-located place to live. But this is like Monopoly — filling your vacant parcel with houses doesn’t just increase your income, it increases your wealth. And the top marginal estate tax rate of 40% is pretty high. So you do, in fact, seem to have a disincentive to accumulate capital here, which could be bad. You don’t want lots of people sitting on useful assets that they aren’t bothering to develop.

Conservative economists are wrong

I always feel like right-wing tax thinking makes more sense if you go visit a very poor country. In Cambodia, about half the labor force is working in very low-paid, low-productivity agriculture. This exerts a huge downward drag on the wages that basically everyone can earn. But since the country is now at peace, it’s become a tourist destination. And every time a new hotel is built, that creates a bunch of non-farm job opportunities. The same is true for garment factories — even ones that offer very low pay and bleak working conditions by western standards are better than the rice paddies.

To reach the next level of economic development, Cambodia basically needs people to build a bunch more hotels and garment factories to pull people off the land and create the opportunity for a shift to higher-productivity agriculture.

At that stage of development, you really are all about attracting financial capital. You want rich Cambodians to invest their money at home in Cambodia by building those factories and hotels. You want foreign hotel companies to decide investing in Cambodia is lucrative. You want international banks to make loans into Cambodia. And you really need to sweat the competitive aspects of this, because the fact is that there are lots of poor countries trying to attract hotels and garment factories. It’s not a secret that this is the bottom rung of economic development. So if your taxes are a bit higher than someone else’s, that might be a big problem for you.

In terms of the United States, I don’t know what to say other than our situation isn’t like that at all.

Even if you want a right-wing point about the American economy, the reason we aren’t building enough housing on valuable parcels of land isn’t that taxes make it unprofitable — it’s that the zoning commission won’t let you. America is awash in financial capital. A lot of people like to laugh at dumb startups like WeWork and Theranos. But the fact that even absurd ideas can get funded in this country is a positive sign about our well-functioning capital markets.

I just don’t see any reason to think the kind of stuff that fuels right-wing tax policy ideas has any application to the contemporary United States. It’s important to understand these ideas because I do think it applies to many countries. And it’s conceivable that in the future, it will apply to the United States. So I don’t like the caricature of the conservative position nor do I dismiss it — but I think the best actual argument they have is genuinely just the Frank Luntz idea of framing estate taxation as a “death tax.”

Making death a taxable event is weird

Consider two scenarios:

Your father dies on Monday. Then on Tuesday, his father dies, leaving a $100 million estate to you.

Your grandfather dies on Monday, leaving a $100 million estate to your father. Then on Tuesday, your father dies leaving his estate to you.

These are very similar events. But the tax treatment is very different, because in the first scenario there’s only one estate, whereas in the second scenario there are two different estates that each get taxed.

This basic idea of taxing large fortunes at the exact moment that the owner of the fortune dies works fine as a wartime emergency revenue measure (which is where the estate tax comes from), but the economic logic is a little weird.

That said, what makes the estate tax compelling is that it raises revenue from very rich people who can afford it. The Republicans pushing for repeal aren’t proposing to make up the lost revenue with any new taxes, and they’re not proposing any spending cuts, either. If you did try to pay for this hyper-regressive tax cut with reductions in spending, it would immediately be politically toxic. This is the underlying dynamic whereby I think low interest rates enable right-wing populism. If the Biden administration succeeds in increasing the deficit enough — and raising the growth rate enough — that interest rates eventually come off the floor, then it becomes untenable to maintain the mishmash of working-class cultural politics and plutocratic tax policy that’s at the core of the modern GOP.

But if the whole fabric of the known political universe were to change, it seems like it should be easy enough to replace the estate tax with different ways of taxing the rich.

Consider, for example, the step-up in basis rule:

Under the current tax rules for the step-up in basis at death, much of the unrealized capital gains held by American householders will never be taxed as income. Suppose when I was young, I bought land for $1 million, which was worth $5 million at the time of my death. I bequeathed that land to my daughter, who sold the land on the day of my death. She would not recognize any capital gain because the tax basis of the land would automatically be stepped up to $5 million from $1 million upon my death.  

If you pay an estate tax, then the step-up in basis arguably makes sense. But with the current very high estate tax exclusion tons of wealth avoids the estate tax, letting people with modest fortunes in the single-digit millions pass wealth on to their heirs entirely untaxed. But conversely, if you ended the step-up in basis loophole, that would generate more than enough revenue to replace the estate tax. Under that system, it would be possible to have intergenerational untaxed wealth, but only if the heirs never sell any of their assets. Any time you try to actually put your wealth to use, it will be taxed.

You could go further than that and sign up for Ron Wyden’s idea to tax unrealized capital gains. The idea here is that if you have a ton of paper gains (like, say, Elon Musk), you should need to pay taxes year after year on your incremental gains rather than only paying if you sell. This to me seems like the most theoretically elegant approach to taxing wealth. But it does also raise a bunch of thorny practical issues, and unlike ending the step-up in basis rule, it doesn’t really generate much long-term revenue.

The bottom line

The argument that the estate tax is crippling America’s family farmers is nonsense.

But the argument that it’s a kludgy, weird, inelegant, and inefficient approach to taxing wealthy people seems perfectly reasonable to me. To the extent that that’s your objection, your obligation is to propose a more elegant and more efficient way of doing it. And that seems perfectly possible to do if you want to do it.

For now, though, that’s not what Republicans want to do — they want to create windfall gains for a genuinely tiny number of wealthy people based on an economic theory that pretends the United States has a set of economic problems that simply doesn’t exist in our current situation.