State Estate Taxes at the Mercy of Congress

Ten years ago, it was the sweetest deal that Washington offered to state governments. States could charge estate taxes without costing their taxpayers a dime -- the money came straight out of the federal treasury. But provisions in the 2001 tax cuts changed all that, costing states billions of dollars. Now, with those tax cuts set to expire at the end of the year, state estate taxes once again are at the mercy of Congress.

When Congress first began taxing the transfer of wealth at death in 1916, states complained. States already had been charging estate taxes, but now the federal government was honing in on their revenue source. Those complaints helped create a deal in 1926. Up to a point, every dollar that someone paid in state estate taxes would be a dollar they didn't have to pay in federal estate taxes. This one-for-one tax credit gave states a convenient way to raise money. As a result, every state approved an estate tax.

That arrangement continued for 75 years. Congress, however, grew tired of giving money away. As federal lawmakers contemplated large tax cuts in the first months of George W. Bush's presidency, they sought ways to blunt the tax cuts' impact on the federal budget. One way to do that was to eliminate the credit.

The result was that the Economic Growth and Tax Relief Reconciliation Act of 2001 changed the credit to a deduction. State taxpayers could still write off some of their federal estate taxes, but it wasn't a one-to-one match. If states wanted to impose estate taxes, their taxpayers would feel the consequences.

That made imposing estate taxes a lot less appealing. Many Republicans opposed the levies as "death taxes," while lawmakers worried that wealthy seniors would flock to states that didn't have them. Some states approved new estate or inheritance taxes, but many abandoned the revenue source. Today, only 21 states and the District of Columbia assess estate or inheritance taxes. These taxes represented only .7 percent of state tax revenue in 2008, down from 1.4 percent in 2000.

Now, after a decade, the 2001 tax cuts are scheduled to expire. If Congress doesn't act, the old tax credit will return. Many states still have legislation on the books that would allow them to sponge off the federal credit, meaning states wouldn't have to do anything to receive a boon of billions of dollars.

That outcome, however, is unlikely. The more likely debate will be whether to continue further down the path that Congress started in 2001. One proposal would do away with the estate tax deduction entirely. That would put new pressure on states to eliminate their estate taxes, as state taxpayers would almost certainly feel a greater pinch. So far, the idea hasn't advanced, but defenders of states are wary. "States are hurting for revenue," says Elizabeth McNichol, a senior fellow with the Center on Budget and Policy Priorities, "so for the federal government to take away a revenue source in the midst of these problems makes no sense."

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