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Celebrate the Deceased, Dont Tax Them to Death

Dead people do no wrong. This is true even if the dead people happen to have been rich.

Anyone who has died with a large amount of wealth has done well by society: She has worked hard and saved well, and she has not spent all of her money on herself. A principled society should celebrate its frugal deceased. But America taxes them – and at rates exceeding 50 percent. That’s a disgrace.

Because so few Americans – about 1 percent of all decedents – actually pay any death tax, few know that it is the most onerous of American taxes. There is a large exemption slated to move to $1 million by 2006. Husband and wife, with careful planning, can combine their exemption levels to pass up to $2 million to their heirs, tax-free. This means, of course, that most Janes and Joes don’t have to worry about the tax. But over and above its exemption level, the death toll can be high indeed. Rates start in at 37 percent and quickly reach a flat 55 percent.

That’s a high toll. Worse, it falls on money that has already been taxed, sometimes twice, under the income tax. When you earn money, you pay one tax. If you save it and earn interest or dividends, that yield to savings gets taxed, too. The estate tax is merely another injury added to the insult of taxing savings in the first place.

The death tax is an awful messy tax to be carrying around exorbitant rates. All taxes have loopholes, of course. But the estate tax is riddled with them. These lead to a complicated, costly mess that keeps estate-tax lawyers, but few others, happy.

Liberals are constantly trying to plug up these holes. Given the high tax rates and the enduring interest in passing on leftover wealth to one’s heirs, this is a losing cause. Estate tax reform is like the French fixing the Maginot Line between World Wars.

Worse, no matter what liberals do, one gaping loophole will remain under any death tax: immediate consumption. The best way to avoid the death tax’s sting is to spend all of your money before you die. But what kind of incentive is that?

The ultimate irony is that we don’t need death taxes. We should tax people when they spend, not when they earn, save – or die. Dead people don’t spend. The best thing to do, in the name of fairness and common sense, is simply to scrap the flawed status quo and move to a consistent consumption tax, one that would collect its toll from the heirs when and as they spend. Then we could kill the death tax. If we aren’t going to do that, lowering the tax is a good first step. This ought not to be a partisan issue. The death tax is a bad tax under just about any light.

The tax burden

Whether there is too much taxation in America is a subject of considerable debate.

Republicans want to cut taxes, Democrats want to stay the course. But whatever one thinks of the total tax burden, there can be little doubt that there are too many taxes.

Given that, suppose I told you that I could devise a tax that would be wildly unpopular, excessively complicated, and unarguably unfair. It would collect whatever money it could from people’s estates, nine months after their death. But the tax wouldn’t net much money under the best of circumstances, and might even lose money, all things considered. It would almost certainly cost the society large amounts of capital over time. Appealing, huh?

But that’s pretty much what the current gift and estate tax is. The tax applies only to the few who die with significant assets. It isn’t, therefore, all that surprising that the wealthy who live in the shadows of the death tax go to some lengths to avoid its sting: Who wants to contemplate the specter of Uncle Sam dancing on one’s grave as one lays dying? The resulting planning techniques lead to a tax that is among the most costly and complicated in the entire panoply of federal taxes.

Yet, the death tax raises little money – about 1 percent of federal revenues, in gross. The net situation is far worse. This is partly because the tax is costly for the government to administer, and we should subtract the administrative expenses from the total. Even worse, as the economist Douglas Bernheim pointed out some years ago, the death tax encourages wealthy patrons to engage in transactions – like setting up bizarre forms of irrevocable insurance trusts – that cost the government income tax revenue. In the best of all worlds, the tax probably does little better than break even.

It can get worse, and it does. The incentives of the death tax are simple enough to state, and they fall heavily on America’s wealthiest citizens and its most productive savers: don’t work. Don’t save. Spend what you have, now, because you can’t take it with you. If you insist on caring about your own posterity, give early, often, and in trust. But these behaviors all have bad long-term consequences for the country.

The true costs

The death tax has been in place since 1916. It has never raised much money, in absolute or relative terms. But money isn’t everything. After all, the best arguments for the death tax have never been narrowly economic. Proponents rest their case on moral grounds, arguing that the death tax is fair – because it falls on the most fortunate few, increases the overall progressivity of the tax system, breaks up large concentrations of wealth, and attempts to level the playing field so that the sons and daughters of the rich won’t have undue advantages in this world.

That’s all perfectly noble. But the problem with the moral case for the death tax is that it is wrong, as both a factual and a moral matter. Inequalities have gotten worse, not better, in the face of the tax. But the death tax isn’t just ineffective. It’s also unfair. The best arguments against the death tax turn out to be moral ones, too, and the balance of the fairness arguments suggest repeal of the whole mess.

What of those arguments about breaking up large concentrations of wealth and making heirs pay something for their good fortune? It turns out that present law, despite its good intentions, makes these problems worse. Under today’s tax system, wealthy people who are well advised and plan ahead can get millions of dollars to their descendants, tax-free. The kids pay nothing on the receipt of the money. Nor do they pay any federal tax at all –no income, no social security, no nothing – when they spend away, even if they burn through the family fortune in a few years or so. That’s pretty crazy.

The people seem to have figured this out on some level. Polls consistently show that Americans do not like death taxes. Meanwhile, there is much support for the idea of a general consumption tax – a national sales tax, say, or even something that looks like the current income tax but with a better, more systematic exemption for savings.

The concerns about heirs and the concentration of wealth can and should be met without a death tax. Imagine, for example, that we had unlimited tax-free savings accounts, like IRAs under current law. No tax would be due on money earned and saved until and unless it is withdrawn and spent. A wealthy person could give all or part of her account to anyone, at any time, on life or death, without triggering a tax on the transfer itself. When and as the heir withdrew the money, he would be taxed. If the heir got greedy and tried to pull all of the money out too quickly, to spend on foolish whims, the burden of progressive rates would fall on him.

In contrast, special exemptions for medical, educational or charitable spending might encourage these uses. Wealthy patrons, who have themselves demonstrated thrift throughout their lifetimes, should like this plan for monitoring their children’s spending habits. On a social level, the plan focuses the act of taxation consistently on private consumption, not on the socially useful activities of work or savings.

Americans like “sin” taxes, as on alcohol and cigarettes. The death tax is a “virtue” tax. It is a tax on industry and thrift, on inter-generational altruism, on work and savings without consumption. It’s unfair, plain and simple, and should be killed, once and for all.

Edward J. McCaffery is Professor of Law at USC Law School and the California Institute of Technology. He is the author of “Taxing Women” (1997) and the forthcoming book, “The Next Great American Tax Revolt.” Excerpted with permission from The Seattle Times, April 9, 1999.

 

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