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The secret solution to the deficit; what the rich don't want you to know: a fair tax code would take more from the estates of the affluent.


Democrats have been congratulating themselves for out-maneuvering President Bush during this fall's budget battle with tax increases that "soak the rich." But while Rep. Dan Rostenkowski was capturing headlines with his plan to slap a tax surcharge on millionaires, he and Senator Lloyd Bentsen were quietly widening a loophole for those who earn their wealth the old-fashioned way: through inheritance. The two respected committee chairmen reopened an arcane loophole called the estate tax "freeze" that in effect allows private business owners to pass on large portions of their companies to their heirs without paying estate taxes. Total cost to the treasury: at least $775 million over five years. The Democrats taketh, the Democrats giveth away.

For whatever reason, estate taxes as a revenue raiser is an idea that now seems verboten, out of bounds, off the political agenda in Washington. This is folly. Even with the new budget accord, the federal debt, currently $3.2 trillion, will rise to at least $5 trillion by the end of the decade. It's tiresome to repeat the painfully obvious, but greater spending cuts and more taxes are going to be necessary soon. Why exempt wealthy inheritors from this burden?

Of course any kind of tax increase, if taken too far, can damage the economy, and conservatives will eagerly summon arguments against estate taxes that liberals must face squarely. Yet the $10 billion Americans pay in estate taxes annually represents only about 5 percent of the estimated $200 billion they bequeath each year, hardly a confiscatory sum. Moreover, of all revenue sources, estate taxes are among the least disruptive to the economy's productivity. In fact, higher estate taxes might even be good for economic growth, in ways that go beyond the obvious benefits of reducing the federal debt.

Trillions from heaven

This is a particularly opportune time to increase the estate tax, because inheritance in this country is entering a boom phase. Members of the World War II generation, people between the ages of 50 and 75, have done extraordinarily well for themselves. According to 1986 Federal Reserve data, Americans over 50 have a collective net worth of more than $8 trillion, not counting generous pensions and Social Security and Medicare benefits. Their great affluence provokes envy in their children and dwarfs what their parents accumulated. Thirty years ago, only the top 10 or 15 percent of older Americans had significant wealth to bequeath. Today, the upper quarter or third of older families are in that position.

Frugal habits learned during the Depression helped build this fortune, but simple good timing is the main explanation. The World War II generation entered the work force at the dawn of the famous postwar economic boom, when wages and salaries were rising. They bought homes when prices and mortgage rates were low. The affluent among them were also the main owners of stocks, private businesses, and other assets that soared in value during the eighties.

Despite this tremendous surge of wealth, the reigning wisdom on Capitol Hill is that higher estate taxes won't garner much extra revenue. The Congressional Budget Office (CBO), whose numbers Capitol Hill relies heavily on, projects at most $15 billion over five years in extra revenue from two key changes in the estate tax. That's not what Washington calls Real Money, or at least it's not seen as worth fighting for.

That $15 billion figure, however, is misleading. For complicated reasons, the real payoff from an estate tax change today won't begin flowing for 5 or 10 years. By the year 2000, say some federal economists, the treasury will have collected about $80 billion--Real Money by anyone's measure.

Angel of death

The two changes CBO analyzed have long been recommended by tax reformers. The first involves cutting the exemption the IRS grants everyone when they die. In 1981, thanks to Reagan-inspired tax changes, the amount a person can bequeath tax-free rose from $175,000, the median price of a home in the Northeast, to an impressive $600,000, the cost of two homes plus a Ferrari. The law also allows couples who utilize the "unlimited marital deduction" to shield $1.2 million of their estate from the tax man (plus more if they exploit a "gift tax exemption" before they die). The number of estates subject to tax sank from 10 percent before the 1981 law to less than 3 percent today.

Why should millionaires be allowed to escape paying a dime in estate taxes? A million dollars doesn't buy what it used to, but anyone who has it still ranks in the top one-half of 1 percent of households. For that matter, why shouldn't the wealthiest 10 percent of the country contribute at least something in estate taxes? Cutting the exemption in half, to $300,000, would do the trick. And it would allow the vast majority of Americans to leave all their wealth--their houses, cars, bass boats, and sundry bric-a-brac--to their children and grandchildren tax-free. (It's probably best to index that $300,000 to inflation, out of fairness as well as political expediency: Rebellion against "bracket creep" fueled the 1981 drive to raise the exemption in the first place.)

The second change involves President Bush's favorite subject: capital gains. Let's say one of the president's duck-hunting buddies--call him James--buys a defense industry stock for $10,000. If he sells it 10 years later for, say, $50,000, he owes Uncle Sam taxes on the $40,000 "capital gain." But if he dies and leaves that stock to his daughter, and she sells it for $50,000, she pays no tax at all. (If she sells it later, she pays capital gains tax only on the amount the stock has appreciated since she inherited it.) Thanks to the magic of the estate tax code, that $40,000 capital gain disappears.

Michael Kinsley of The New Republic calls this the Angel of Death Loophole; eliminating it would bring in $5 to $10 billion in taxes per year. This would also move the tax code towards the reformist dream of equal treatment for all forms of gain (wages, interest, capital appreciation). And it would have built-in progressivity, because on average the greater your net worth, the more likely your estate is to consist of unrealized capital appreciation.

There's one final idea worth considering: adding entitlements to the estate tax equation. The World War II generation's fortunes are being partly underwritten by Social Security and Medicare benefits far in excess of what the recipients contributed. The way the system works now, a 30-year-old grocery clerk is taxed so that a wealthy 70-year-old stockbroker can leave an even bigger estate to his already affluent kids. This inequity could be reduced if, when valuing estates for tax purposes, the government would include the lifetime entitlements a person or couple received in excess of what they contributed, plus interest. Such an accounting would generate billions in extra revenue, and most people would pay nothing, since the $300,000 exemption would still apply.

You can already hear postal workers groaning under the weight of the millions of direct-mail letters that would be generated if this idea were even hinted at on Capital Holl. Still, it could work. And proposing it could spark a debate that might lead to a simpler solution now considered too hot politically: full taxation of Social Security benefits and a sliding scale for Medicare premiums, based on ability to pay.

Opportunity knocks

Liberals have always justified estate taxes with a philosphical and essentially conservative argument. In life's race, they say, the government cannot and must not guarantee equal outcomes, but it should make the game reasonably fair by equalizing starting positions. What better way than by taxing estates, which give tremendous unearned advantages to inheritors, and by spending the money on public efforts that benefit everyone, especially the poor?

Over the years this idea has been challenged by some who argue that inherited wealth isn't that much of an advantage because it is hard to hold on to. Fortunes dissipate over generations as markets fluctuate and lazy, inept heirs take toll, Rags to rags in three generations, and so on.

The truth seems to be that fortunes do dissipate, but slowly. Paul Menchik, a Michigan State University economist who has done the most definitive study of the subject, summarizes his findings thusly: "If your father was 10 times richer than my father, you can expect to be 7.5 times richer than I." The superior educations, connections, and earnings that come to children of wealth explain part of this, but raw dough clearly plays a role: Rich kids with lots of siblings, among whom the patrimony must be divvied, don't do as well as rich children fro smaller families.

The "equal opportunity" argument, then, still makes sense. But the current budget mess offers more immediate and concreate reasons for favoring higher estate taxes. There are the obvious benefits of taming the federal debt--lower interest rates, and lower interest payments on the debt itself. Beyond that, stiffer estate taxes could bring some surprisingly positive jolts to the economy.

Taxing capital gains at death, for instance, would improve markets by eliminating what economists call the "lock-in effect." Knowing that he must pay taxes if he sells a stock before he dies, James may be tempted, as he grows into old age, to let his daughter capture the tax-free gain. So he may hold on to his defense stock, evey if it's now a dog because the Cold War has ended. Take away the loophole and he would have a greater incentive to sell and invest the after-tax proceeds in a more profitable and productive venture, such as new business. "If you're looking for a policy that improves market incentives and raises government revenues," says Henry Aaron of the Brookings Institution, "this is just what the doctor ordered."

Tougher death duties might also alter the bad habits of high-living baby boomers, the people who stand to inherit the bulk of that $8 trillion. A study by economist David Weil of Brown University found that those in 1984 who expected to receive a bequest spent more and saved less than those in the same income bracket who did not expect to inherit. Makes sense: Why save when your parents are doing it for you? Princeton economist Alan Blinder believes stiffer estate taxes would almost surely prompt younger Americans to curb their acquisitive appetites and become a bit more frugal, a positive turn for the nation's sould and its economy. Those who would feel the sting are baby boomers who grew up in affluent homes and are living the good life even before they inherit. A study of the legacies of parents who died in 1982 with $1 million to $2.5 million net worths found that their children, who inherited $238,567 on average, already enjoyed incomes of $40,581, nearly double the median family income for that year.

Soak the dead

Most of the arguments against estate taxes--the case you would have heard had there been any debate this fall--have about them the distinct odor of red herring. Conservatives, for instance, love to charge that estate duties are inherently unfair because they amount to "double taxation": The wealthy have presumbly already paid their fair share throught the income tax. The person who paid the income tax, however, is dead. He who receives the inheritance has paid nothing on it, save the estate tax. Calling this "double taxation" amounts to arguing that the IRS should tax extended families, not individual households. By that logic, every household would be in a higher income tax bracket. Yet, these same conservatives hyporitically support shifting the tax burden from income to sales taxes; there is no better example of double--and regressive--taxation than taxes on consumption. Finally, the "double taxation" argument ignore capital gains at death, on which, under the present system, nobody pays income tax.

Another favorite objection is that estate taxes undermine family farms and businesses by forcing the heirs to liquidate their enterprise just to pay the tax. Many people who make this argument will turn around and defend leveraged buyouts, which saddle firms with debt-service burdens far more onerous than estate taxes. Even assuming that privately owned firms are somehow preferable to publicly traded ones, this would be a serious objection--if it were true.

In fact, it almost never is, in part because business lobbyists have extracted so many government breaks to make sure it doesn't happen. The estate tax "freeze" loophole in this fall's budget package is one example. Another lets those who inherit family businesses take 15 years, at very favorable interest rates, to pay off their taxes (you at home, don't try this on your income taxes). Another loophole enabled the late Malcolm forbes to avert the sale of his magazines empire by purchasing insurance policies that paid off the estate tax.

Ultimately, there are only two arguments against stiffer estate taxes that should be taken seriously. The first concerns entrepreneurship. Like it or not, the sons and daughters of the well-to-do have easier access to the most important tool for starting a business: capital. Using British data, David Blanchflower and Andrew Oswald, economists at Dartmouth College, recently found that young people who receive gifts or bequests are as much as three times more likely to become self-employed than those who inherit nothing.

Does this mean that higher estate taxes could damage small business start-ups, those engines of job growth? Yes and no. The same study also found that relatively small amounts of money make all the difference. Specifically, inheritances higher than $75,000 did not make people any more likely to become entrepreneurs. The lesson seems to be that protecting small inheritances is good for the economy. A $300,000 exemption would suffice.

The order serious concern involves the now-familiar issue of incentives. "One of the motives that drives people to create wealth," contends supply-side economist Paul Craig Roberts, "is to build an estate for one's children that will leave them on a better footing." This may be true. The question is: How true?

If there is a strong "bequest motive" that affects a person's spending and savings patterns, economists have had trouble finding it. In government surveys, two out of three people say they intend to leave bequests. But a recent study by economist Michael Hurd of the State University of New York at Stony Brook found that elderly people with adult children spend their wealth just as quickly as those without children, even through the former would presumably have more incentive to save in order to bequeath. "This doesn't mean that parents don't love their childre," says Hurd, only that for most of us, the urge to leave a bequest is not very high up on the list of reasons why we go to work every morning.

A century ago, inheritance may well have been a more powerful motivator. Back then, explains John Langbein of the University of Chicago Law School, assets in the form of a farm or a firm "rescued you from a mean life of stoop labor in someone else's field, mill, or household." But in today's knowledge-based meritocracy, education and connections are the real arbiters of success, and parents generally provide these long before they die.

Conversely, where parents once depended on their children for support in their old age, today they are afraid of having to depend on their children. The primary reason older people worry about money has shifted dramatically from providing for their heirs to saving for their own retirement, a motivation which estate taxes don't affect at all.

Given that government has to collect revenues, a tax on estates, which is paid only after the asset holder dies, is far less likely to sap the nation's overall desire to work, save, and invest than higher taxes on income or consumption. Perhaps some people, particularly the wealthiest older Americans, will curb their pursuit of profitable investments somewhat. On the other hand, higher estate taxes might encourage them to work harder in order to leave the same size bequests. No one can say for sure. But it's worth nothing that there are good things to do with wealth besides creating more of it for yourself.

So thought Andrew Carnegic. The steel magnate was a great champion of capitalism and the fortunes created with it, but he was also keenly aware that the accompanying disparities of wealth were a moral and spiritual peril to the nation. A century ago in his now-famous essay "The Gospel of Wealth." Carnegie proposed a solution: All those who create fortunes, he said, should devote their money, as well as the latter part of their lives, to doing good works in the community, such as building and running libraries and hospitals in poor neighborhoods.

Carnegie was an idealist, but he was no fool. HE knew the rich needed a prod, so he advocated one: stiff estate taxes. Today, there are a dozen good reasons to raise the estate tax, none as inspiring as Carnegie's vision. "The gospel of wealth," he wrote, "but echoes Chirst's words. It calls upon the millionaire to sell all that he hath and give it in the highest, best form to the poor by administering his estate himself for the good of his fellows, before he is called to lie down and rest upon the bosom of Mother Earth."

Paul Glastris is the Midwest correspondent for U.S News & World Report and a contributing editor of The Washington Monthly.
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Author:Glastris, Paul
Publication:Washington Monthly
Date:Jan 1, 1991
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