Bad Idea for a Good Cause

Jane Galt suggests that one way to avoid the complications of the estate tax is to (i) have all inherited property receive a basis of $0.00, except for (ii) cash that is inherited, which would be taxed as income. Mark Kleiman thinks that this is a good idea. It's not.

I don't know whether there's been an economic analysis produced as to where the tax burden created by such a provision would fall, but I am aware that there have been analyses done with respect to proposals to do away with the estate tax, but which would also do away with the basis step-up rule. (That is, the basis of assets that are inherited are "stepped-up" to their fair market value as of the date of death.) Such a change would be less radical than the rule that Galt has proposed. The analyses that I'm aware of (I'll try to link to some this evening) show that net effect of the repeal of both the estate tax and the basis step-up rule would be to shift the burden of a tax triggered due to the death of the owner of property from families who are in the high end of familial wealth to those who are less wealthy. The reason is that only the very wealthy pay any estate tax when, as will be the case in a few years, the lifetime credit equivalency is $3M, whereas a good number of people, even people of modest means, receive some sort of inheritance. Almost all of these people would be paying additional tax if the basis step-up rule is eliminated.

My guess is that the Galt plan would, effectively, accentuate this downward shift in where the tax burden lands. For instance, in the 2 minutes since I read Galt's posting, I've already thought of a number of ways to minimize the tax bite where the asset is a family business. (I won't share my ideas with you---I consider them proprietary.) In other cases, families with significant wealth could defer the income tax for long periods of time by, for instance, borrowing against the assets. Families with less wealth who need to tap into inherited assets to buy homes, pay for college educations, etc., could not, since they will likely have to sell assets rather than merely borrow against them.

Like I said, a bad idea, unless you want to shift taxes from the wealthy to those less wealthy.

Update

In a research paper published in 2000, The Distributional Burden of Taxing Estates and Unrealized Capital Gains a the Time of Death, James M. Poterba and Scott Weisbenner conclude that:

[A]mong those with small estates ($1 million or less), taxing capital gains at death would collect more revenue than the current estate tax from roughly half of the decedents. For those with larger estates, replacing the estate tax with a tax on unrealized gains at death would result in a substantial reduction in total tax payments.

While the figures used in the report are from 1998, there is no reason to believe that the conclusion does not continue to apply today. In fact, since the unified credit amount has been dramatically increased, limiting the estate tax to taxable estates of over $4M, one would expect that the results today would be even more skewed in favor of the wealthy.

For an excellent primer on various policy questions pertaining to the estate tax, one should take a look at Estate and Gift Taxes: Economic Issues, by Jane G. Gravelle and Steven Maguire for the Congressional Research Service. They discuss a good number of the issues surrounding the estate tax, including how the tax works, whether the tax causes individuals to prematurely sell family businesses and farms (it doesn't, since "one can conclude that most farmers and business owners are unlikely to encounter estate tax liability"), and the claim that the costs of administering the tax eat up the revenue generated (they don't--the costs of administration are approximately 6-9% of the revenues generated).