Racing to the Bottom

The article, Interstate Competition and State Death Taxes: A Modern Crisis in Historical Perspective, 33 Pepp. L. Rev. 835 (2006), by Jeffrey A. Cooper, discusses the difficulties that states have in imposing various estate and inheritance taxes.

Prior to 1924, various states, lead by Florida, began to compete to attract wealthy residents by repealing various taxes that triggered upon death. In that year:

Congress amended the Internal Revenue Code to allow a taxpayer's federal estate a dollar-for-dollar credit for all or a portion of the state death taxes paid by that estate. In 1926, in response to demands from state leaders, Congress increased the maximum amount of this "state death tax credit" to eighty percent of the federal estate tax otherwise payable under the 1926 rate tables.

(All quotes have footnotes omitted.)

In due course, all of the states enacted at least a "pick-up" tax. That is, a tax equal to the maximum allowable Federal estate tax credit.

However, beginning in 2001, the Federal estate tax credit was phased out over a four year period. Cooper describes what happened next:

The state death tax uniformity of the late twentieth century is now but a memory. Interstate competition to attract wealthy residents begins anew.

* * * * *

The popular media has fanned the flames of this renewed interstate competition. One need not read past the headlines to figure out the advice being dispensed. Readers of Forbes have been encouraged to say, "Florida or Bust." Wall Street Journal subscribers have been educated on "A Reason to Relocate." In states with death taxes, local newspapers warn of a pending exodus of wealth. A front-page article in Crain's New York Business decried that retirees are simply "fleeing New York" in response to its state death tax. The Connecticut Law Tribune titled its editorial about the new Connecticut death tax "A 'Run Away' Tax," predicting state residents would run away to Florida in response.

This media pressure has both molded public opinion and helped shape the agenda for the field of estate planning. Helping taxpayers choose their state of domicile has become a fundamental element of modern estate planning practice. Domicile considerations have become so paramount that at least one author has suggested that lawyers in states with death taxes may have an ethical duty to discuss with estate planning clients the virtues of moving out of state.

Amid this backdrop, state leaders seem to be presented with a choice: lose your state death taxes or lose your wealthy residents. A past generation of state leaders faced a similar conflict and confronted a similar decision. Presented with the choice of losing state residents or abandoning state death taxes, they were prepared to choose the latter. The Congress of 1926 preempted that decision. The Congress of 2006 seems unlikely to take similar action.

As such, state leaders of 2006 may have no political choice but to finish what their predecessors started. Looking out across the new death tax landscape after EGTRRA, modern state leaders may consider it futile to compete with Florida and the other death tax havens. They may simply decide that state death tax revenues come at too high a political cost and turn elsewhere for needed tax dollars.

As I have pointed out numerous times here, while the Federal income tax is slightly progressive, state taxes tend to be regressive. (The best analysis is found in Who Pays? A Distributional Analysis of the Tax Systems In All 50 States by the Institute on Taxation and Economic Policy.) That problem has become more pronounced as the Federal tax regime has become flatter with fewer state tax-related deductions. Moreover, since some otherwise deductible taxes (e.g., state income taxes) are subject to the alternative minimum tax, wealthy taxpayers are presented with even greater incentives to leave states which rely on moderately progressive income taxes (e.g., New York, Maryland) and move to states that rely heavily on regressive sales taxes (e.g., Florida).

While directed only at the effect that decoupling has with respect to state estate and inheritance taxes, Cooper's conclusion could just as well apply to many of the recent changes in tax policy at the Federal level that have had a deleterious affect on the ability of states to levy taxes:

State leaders will abandon this traditional source of revenue in favor of others. Burdens will shift. Some taxpayers will lose while others will gain.

Let there be no question: The rich will gain. Moderate income and poor taxpayers will lose. And the public services offered by states and localities (including education) will dramatically decline.

Hat Tip: TaxProf