Death And Taxes

The demise of the federal estate tax will take with it billions in state revenue--unless states distance themselves from the feds.
March 2003
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

At a time when states are desperately seeking revenues, they're about to get clipped by the feds. The federal estate tax, which got dubbed "Death Tax" during the drive to kill it off, is slated to be interred by the end of the decade. And the Death Tax's demise will take with it billions of dollars in state revenue--unless states act to distance themselves from its burial.

As things stand now, the federal estate tax's credits provide a revenue-collecting umbrella for the 50 states--not to mention a stimulus for a high level of charitable giving. Around for more than a century, the tax has been one of the more venerable and avowedly class-conscious forms of revenue raising: It was devised to appeal to the old-fashioned notions of fair play and social obligations that stressed individual accomplishment over inherited privilege. That is, by letting individuals keep most of what they earned in their lifetime but then taxing them at death, motivation to earn money would be left in place and inter-generational concentrations of wealth would be avoided.

The estate tax was originally enacted in the early 1900s at the behest of President Theodore Roosevelt, who was rebuffed in efforts to enact an income tax. Teddy was blunt: He said that the rich were the greatest beneficiaries of society and should pay up when they died. Commentators of that time hailed the tax as a way to ensure a more level playing field and to avoid creating a self-perpetuating aristocracy, a point made in the Federalist Papers.

Today, the estate tax, given its many accommodations and amendments, is paid by very few--only about 1.3 percent of all estates have a tax liability. Those that do can face a large federal tax liability--many millions of dollars for a huge individual estate. Overall, the tax has been bringing in about $50 billion a year to federal coffers.

Most wealthy individuals have sought ways around the tax--charitable giving and intra-family gifts. But better than avoidance, opponents of the tax wanted to get it repealed and they tried to do so for years. They were ultimately successful in convincing Congress in 2000 by featuring cases where family farms or firms had to be disposed of to meet the liability. The fact that these cases were few and far between and that all manner of accommodations were built into the code to avoid forced sales were lost in the glare of klieg lights. Besides, economic times were still good and so the appeal of lopping off taxes (and relaxing enforcement) was irresistible.

President Clinton didn't see it that way, however, and vetoed the bill in 2000. But when President Bush revisited the tax front in 2001, the repeal was passed as part of the "good times are forever" tax- reduction plan.

Somehow in the debates over the tax at the federal level, the issue of what other tax should be levied or what expenditures would be cut to make up for the lost revenue was not on the table. Maybe legislators were convinced the federal surplus would continue to rise to the moon. But states with their own tax systems tied to the federal tax now find themselves uncomfortably exposed. For them, the tax on estates or inheritance is a payment taken as a credit against the federal payment. This "pick-up" provision made it politically painless for the states to tax inheritances, and about 35 states relied entirely on the pick-up credit for their tax on transfers at death. Thus, federal repeal means that unless states "decouple," their receipts will evaporate by 2004, when the credit against federal taxes that states are permitted to take is repealed. The lost revenue will be substantial. In 2000, the state revenues from the estate tax were about $6 billion, and given the awesome growth in wealth, they would have been about $9 billion in 2010.

The states are in a pickle. Without the cover of the federal tax pick-up, they not only have to decouple but also have to consider imposing a tax that will be the estate's liability. So far, about 15 states have decoupled to some extent.

As the states slump deeper into fiscal crises and expenditures are cut and taxes raised, it will be a test to see what becomes of the remnants of the state inheritance taxes, which are very progressive. While state legislatures may believe that they can ill-afford to give it up, the small but savvy constituency pushing for repeal is clearly on a roll. There is, for instance, the interstate-competition argument: The truly rich will decamp to save a million here or there. But the lessons of completely giving up a tax, especially in state tax systems, which are largely regressive, may have been learned. Without the ability to run large deficits or to wrap them in the flag of national defense, the states may just dig in on this one and reconsider the wisdom of uncoupling life's two verities: death and taxes.