BOSTON AND WASHINGTON — More than $40 trillion in personal wealth is expected to change hands in America during the next five decades, as baby boomers and their children transfer wealth to heirs. Congress has to decide how big Uncle Sam's share will be.
Republican lawmakers hope to permanently reduce the estate tax this summer. The move could allow more of that $40 trillion to escape the tax.
Those who stand to reap the big gains are billionaires, millionaires, and their heirs. But every taxpayer has a stake in the outcome. An estate-tax overhaul could affect the nation's social structure and the tax burden on ordinary Americans for years to come.
"The revenue involved is not trivial," says Joel Slemrod, a University of Michigan economist. "What makes it more important, though, is this is by far the most progressive tax we have. [A large reduction] would certainly change in a substantial way who is bearing the tax burden."
The estate tax has stirred controversy ever since its 1916 launch, but as more Americans grow wealthier – and as the gap between rich and poor grows wider – this once-in-a-generation tax has moved to the political foreground.
Last week, the House – including all but two Republicans and 43 Democrats – voted for a major permanent cut in the tax. The Senate is now considering its own rollback legislation. To those who want to abolish the tax altogether, these moves represent an opportunity to bring their goal one step closer.
Other lawmakers see the new legislation as a welcome middle ground in a contentious debate that has simmered ever since President Bush took office in 2001. It would permanently boost the estate value exempt from taxation above the $1 million level. And a new law could remove what many see as morbid incentives in current law, which make deaths in 2010 financially advantageous.
Under Mr. Bush's 2001 tax cuts, the estate tax rate is being reduced, and the exemption amount raised every year until 2010, when the tax disappears altogether. But after that, current law allows the tax to return in full force: The first $1 million of estate value is exempt, with the rest facing as much as a 55 percent tax.
"Compromise in Congress is the answer," says attorney Sandy Kraemer of Colorado Springs, Colo., author of "60-Minute Estate Planner." "It's critically important that we provide a flow of inheritance from generation to generation. On the other hand, we do not want to see huge amounts of wealth pooled in families that can buy and sell elections."
At the extremes on this issue, he says, are socialism and feudalism. A total confiscation of estates would undercut America's traditional capitalistic incentives, hurting the economy. By contrast, absent any tax on wealth or estates, a financial aristocracy is likely to gain increasing clout. The tax also provides substantial revenue to the US government – though its $24 billion in 2004 revenues were dwarfed by the $990 billion brought in by the income tax. It also provides an incentive for charitable giving and for people to plan for the transfer of their estates, proponents of an estate tax add.
Between the extremes lie a wide range of options. The Republican-led Congress hopes to lower the tax significantly. The move would primarily affect the very wealthiest Americans. Just 62,718 estates filed taxes in 2004, the most recent year for which IRS records are available. The cumulative value of those estates was $193 billion.
A year ago, the House voted to permanently repeal the estate tax, but it fell three votes short in the Senate. The new House bill is designed to break the deadlock. Instead of eliminating the tax as of 2010, the House bill would boost the exemption to $5 million for an individual's estate or $10 million for couples. After 2010, the exemption would be adjusted yearly for inflation.
Above those amounts, estates up to $25 million in value would be taxed at a rate equal to the tax on capital gains (now 15 percent). Estates above $25 million would be taxed at twice the capital gains rate.
In effect, all wealthy estates would be big winners under the House bill – especially the vast majority of estates that would be completely sheltered by the new exemption of $5 million or $10 million.
Even with the House backing away from full repeal, not all Senate Republicans support rollback legislation. Sens. Lincoln Chafee (R) of Rhode Island and George Voinovich (R) of Ohio are concerned about the growth of the federal deficit and the burden of national debt on future generations. Where estate-tax foes dub it the "death tax," Senator Voinovich points to the "birth tax" facing newborn citizens as a result of soaring federal deficits.
"Every child born in this country has $28,000 of debt on his back," says Chris Paulitz, a spokesman for the Ohio lawmaker. "Until we're in the black and not the red, [Voinovich] thinks we should not be doing this type of tax cuts."
At the same time, some Senate Democrats campaigned on a promise to end the estate tax, and will support cuts like those passed in the House.
"It's very reasonable and gets to the heart of what I want to do, which is to provide some certainty to small business[es], which are engines of growth in our economy. These are the jobs that are going overseas," says Sen. Blanche Lincoln (D) of Arkansas. She is one of four Democrats – along with Sens. Max Baucus of Montana, Ben Nelson of Nebraska, and Bill Nelson of Florida – who voted June 8 to end a filibuster on permanent repeal of the estate tax. She says she would support the House compromise.
Aides to Senate majority leader Bill Frist say he will not bring a bill to the floor without the 60 votes needed to avoid a filibuster.
The House bill would cost the federal government $279 billion in lost estate-tax revenues between 2006 and 2016, according to Congress's Joint Committee on Taxation. Under current law, the tax is projected to bring in about $400 billion during that time.
In terms of estates that actually pay the tax, "this is only affecting a very small slice – very, very wealthy Americans," says Dr. Slemrod at the University of Michigan. Still, "There are certainly more and more people in the category of having a couple of million dollars to $4 [million] or $5 million of wealth."
Any drop in estate-tax revenues has some effect on virtually all Americans, he adds. "Either they're going to have to cough up more taxes or see a decline in what the government provides."
Calculating taxes owed on an estate is often complicated. Here's a simplified example of how the federal estate tax would apply to a $4.5 million estate taxable in 2006.
Step 1: Subtract funeral expenses, transfers to a surviving spouse, debts, charitable gifts, state taxes on the estate, and certain administrative expenses – all of which add up to, say, $1.5 million. So, $1.5 million subtracted from $4.5 million leaves an estate valuation of $3 million.
Step 2: Congress has declared $2 million of an estate's value exempt from taxation in 2006. Subtract $2 million from the remaining $3 million value of the estate.
Step. 3: The estate will be taxed on the remaining $1 million. In 2006, the highest rate an estate can be taxed is 46 percent. If this estate were taxed at that rate, it would pay a tax of $460,000 to the federal government.
Below is the schedule Congress adopted in 2001 for gradually lowering the estate tax. It increases the exemption amount or decreases the top tax rate each year until the tax phases out in 2010. But the phase-out is temporary, and the estate tax is set to return in full force in 2011 unless Congress directs otherwise.
Year Exemption Top tax rate
2002 $1 million 50%
2003 $1 million 49
2004 $1.5 million 48
2005 $1.5 million 47
2006 $2 million 46
2007 $2 million 45
2008 $2 million 45
2009 $3.5 million 45
2010 Estate tax repealed
2011 $1 million 55
Sources: Associated Press, Tax Policy Center