February 15, 2005 - Phil Hodgen

Estate tax repeal hurts more people than it helps?

Estate tax repeal is a political football. Yes, there’s money involved. Tax money. But generally the quantity of revenue raised by the estate tax is trivial in the total Federal budget. So if there’s a disagreement about estate tax, you can be sure it’s not because we’re worried about the U.S. going broke for lack of taxes.

Article from Democratic staff lawyer

The chief Democratic staff lawyer on the Joint Committee on Taxation has just published an article in Tax Notes, claiming that estate tax repeal hurts more people than it helps. For those of you with access to Lexis, go look at Tax Notes Today, citation 2005 TNT 30-17.

For those of you who don’t care to spend your children’s inheritance supporting a publishing monopoly, the article is summarized here by Bloomberg.

Why estate tax repeal can hurt more than it helps

Here’s why Mr. Buckley makes the claim that more people suffer when the estate tax is repealed. When the estate tax is repealed (says the current law), that tax will be made up by imposing capital gains tax.

A little background is in order.

To figure out capital gains tax, you look at the sales price of the asset, and subtract the purchase price from it. Multiply that number by the capital gains tax rate, and hey, presto, there’s the tax that you owe.

Example. You bought some land for $50,000. Five years later you sell the land for $150,000. The current Federal capital gains tax rate on assets held more than a year is 15%. Thus, the equation is:

($150,000 – $50,000) * 15% = $15,000.

Here’s the missing piece of the logical puzzle. When you die, a tax thing called “step up in basis” occurs. “Basis” is what you paid for the asset. “Step up” means we pretend that your purchase price for the asset was its fair market value on the date of your death.

Example. Thus, in the previous example, let’s pretend that you died while owning the land, and the land at that point was worth $150,000. Now the basis in the land is $150,000. Your heirs inherit the land and sell it for $150,000. The equation for capital gains tax paid by your heirs is:

($150,000 [sale price] – $150,000 [basis]) = $0 [capital gain] * 15% = $0 [capital gain tax].

If the estate tax is repealed, so is the step-up in basis rule

Under the current law, when the estate tax is repealed, the step up in basis rule is repealed, too.

This means that there will be no estate tax on the assets, but on the other hand, the heirs will have to pay capital gains tax when they sell the asset.

We’ve essentially replaced one tax with another.

This, then, is Mr. Buckley’s argument. He thinks MORE heirs will have to pay capital gains tax because the step-up in basis disappears than the number of estates that would have been subject to estate tax.

Is he right or not? Who knows. I don’t care at this point to look at his methodology and decide whether his economic analysis is correct. Do more people or fewer people pay tax? Are they paying more tax per capita or less tax per capita? (And more to the point, remember that from the government’s position–Mr. Buckley’s side–more tax paid is a good thing. I happen to carry the opposite view).

He’s right–there is a problem

Mr. Buckley is correct in identifying the problem, though. Losing the step-up in basis will be an enormous accounting nightmare. Imagine trying to figure out how much your grandfather paid for the farm in 1922, when it comes time for you to sell it. That’s the kind of problem that step-up in basis rules eliminated.

A known solution to the problem

The Canadian system may be the way to go. Eliminate the estate tax. Replace it with a capital gains tax — the Canadians pretend that you sold your assets on the date of your death, and you pay capital gains tax on the income tax return for the year of your death. (Well, you don’t. You’re dead. Someone else does all of this.) Appropriate exclusions from the rule exist for transfers on death to spouses.

The Canadian system means you have preserved the step-up in basis rule, the government received its revenue, and you’ve eliminated about 242 pounds of tax law, regulations, and learned tomes all about the estate tax.

The Canadian method is the way I would go, if I were King.

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