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DEATH without TAXATION

CEOs are in the perfect demographic group to worry about gift and estate taxes, which today are lumped together under a uniform scheme of transfer taxation. Because CEOs have usually amassed considerable wealth, and they are near or past the retirement age, they face a challenge of finding ways to pass wealth to the next …

CEOs are in the perfect demographic group to worry about gift and estate taxes, which today are lumped together under a uniform scheme of transfer taxation. Because CEOs have usually amassed considerable wealth, and they are near or past the retirement age, they face a challenge of finding ways to pass wealth to the next generation with the smallest possible tax burden. That’s no modest undertaking when today’s combined exemption for all transfers during life and at death maxes out at just $2 million, plus additional exclusions of gifts during life of up to $12,000 each year per donor per donee (meaning a married couple can give $24,000 tax-free to each child or grandchild). Worse yet, estate planning is now a game of roulette, because the current law raises that exemption to $3.5 million for 2009 only to repeal it entirely for 2010, reducing the lifetime exemption to the same puny $1 million exemption in force before inflation in 2002 and 2003.

These transfer taxes are commonly branded, albeit inaccurately, death taxes, which is a sure sign of their growing unpopularity. The reason for this widespread grumpiness is not hard to see. These taxes not only hit the billion-dollar estates, but can easily take a big chunk out of many upper middle class families’ savings, especially those in urban areas where home values alone can exceed the tax exemption. Indeed, the system is worse than it seems because of the steep rise in tax rates once the exemption is exhausted.

The current transfer tax table is a mindless holdover from the 1960s, when the basic exemption from the estate tax was a paltry $60,000. The current law has six separate brackets for the first $100,000 of wealth in the taxable estate, and these climb from 18 to 30 percent. The top transfer tax bracket of 45 percent-higher than the top income tax bracket-is reached by a relatively modest taxable estate of $3 million or more. This combination of an indefensible rate structure and the tax flip-flops in 2010 and 2011 should force Congress to revisit the subject. But do what? 

The Social Critique

Navigating the maze is the most immediate concern for most CEOs, a pricey enterprise that requires balancing intelligent family planning with the heavy burden of the transfer tax. The high marginal tax rates encourage property owners to enter into perverse schemes to minimize their taxes. One common ploy, perfectly legal, is to transfer a vacation home into joint ownership with children, which reduces its value for transfer tax purposes because of the manufactured difficulty in selling the property to third persons. This and other bizarre strategies again suggest the advisability of reconsidering the social soundness of a system that leads to a conscious destruction of wealth. However, that plea may fail to sway the many who think that death taxes are a way to equalize wealth across society by having the haves pay for social services consumed by the have-nots.

Often they object that inherited wealth creates unequal opportunities for social advancement, even though the key educational expenses are typically incurred long before death, and are treated as support payments that fall outside the transfer tax framework.

Moreover, we should reject the populist drive for high transfer taxation because envy is always a poor guide to social policy. Soak-the-rich taxation schemes are always shortsighted because the high death tax regime creates private incentives for the premature consumption or destruction of wealth-not its transfer.

But in this case, the populist argument is wholly misguided because any level of wealth transfer can be achieved more cheaply through the income taxation already in place.

In my own view, the income tax-or better yet a consumption tax that exempts savings and capital gains-should be flat. That system slashes administrative costs and eliminates any incentive to devise clever but counterproductive income-splitting schemes.

The flat tax also allows for major but not unlimited amounts of redistribution, for the revenues collected from upper income individuals are often used to fund social welfare programs from which the bulk of the population derives most of the net benefits. And if that level of redistribution does not meet societal demands, a progressive income tax is a much better instrument than the transfer tax.

Why? Single taxes work more cheaply and effectively than dual ones. In principle, the ideal function of all systems of taxation is to minimize the distortions in economic behavior while raising the revenue needed to fund government activities. Any flat tax comes out best on this score because its simple, constant rate poses few temptations to the inventive taxpayer and few obstacles for the cooperative one. Those activities that tend to maximize the individual wealth will tend to maximize the government’s share of the take. That’s why flat taxes have won the favor of market-oriented economists from Adam Smith to the present day. 

The Random Impact of Transfer Taxes

Because the progressive tax can complicate administration and increase pressures for tax avoidance, there has been steady pressure to lower marginal rates of taxation from their high of 91 percent in the late 1950s to the far more modest 35 percent or so today.

But at least these progressive taxes are assessed on an annual basis, so that people can plan for them in orderly fashion. The transfer tax is another kettle of fish altogether. The incidence of the tax depends on when people die. For CEOs and their spouses, those deaths could easily span 30 years or more.

The longer that one lives, the more wealth that can be funneled through to children and grandchildren through the annual exclusions.

These funds, moreover, appreciate in the hands of their donees free from any transfer taxation, even if the donor takes an active role in managing the assets owned outright by other people. (Be forewarned: Retained legal control by a donor is likely to result in the inclusion of the transferred property in the transferor’s taxable estate.) The taxes on the remainder of the corpus that passes years from now has to be discounted to its present value. The estate that only passes at age 90 is likely, moreover, to be depleted by consumption and nontaxable gifts.

All told, the economic impact of the supposedly neutral transfer tax may be ten- or a hundredfold greater for people who die young, even accounting for the current right to pass property free of the transfer to a surviving spouse via the marital deduction. It makes little or no sense to rely on a tax instrument that has such different impacts on people similarly situated. If anything, those who have the benefit of a longer life seem more appropriate targets for higher rates of taxation. 

Intertemporal Decisions

Finally, if I am correct in thinking that the flat consumption tax beats the flat income tax, then there is additional reason to embrace the consumption tax: It alone does not distort intertemporal decisions on consumption. The income tax imposes an additional cost on savings that tends to induce more immediate consumption (and hence less long-term investment) than would exist in a tax-free world. The transfer tax only aggravates that situation by imposing a very large and quite random burden on the transmission of wealth at the end of life.

There are all sorts of ways to use either an income or consumption tax to achieve any social revenue target and any desirable level of wealth redistribution. Transfer taxes, during life or at death, should be the unwanted guest at the tax party. Ideally, the tax should be permanently repealed before the day of reckoning in 2010. If that can’t be done at once, then by all means increase the annual exclusion, raise the lifetime exemption, and expand the size of each of those first six brackets so that each one embraces at least $1 million. The reason for these reforms is not to make life easier for CEOs (although it surely does), but that there is no room for any form of transfer tax under a responsible social regime of taxation.


Richard A. Epstein is the James Parker Hall Distinguished Service professor of law at the University of Chicago, and the Peter and Kirsten Bedford senior fellow at The Hoover Institution.

About richard a. epstein

Richard A. Epstein is the Laurence A. Tisch Professor of Law, New York University, the Peter and Kirsten Senior Fellow, The Hoover Institution, and a senior lecturer and the James Parker Hall Distinguished Service Professor of Law Emeritus at the University of Chicago. He is a recipient of the 2011 Bradley Prize. He writes extensively on topics of business and labor, property rights, health care, and liability.