The Distribution of the Estate Tax and Reform Options

97TH ANNUAL CONFERENCE ON TAXATION1THIS PAPER DESCRIBES THE DEVELOPMENT OF A microsimulation model that estimates the distributional effects of the estate tax and reforms. Consistent with several other studies, we assume the estate tax is borne by the individuals who accumulate the estate. We merge information from several sources to develop household-level data on wealth, demographics, income, and taxes, with special efforts to represent wealth patterns among high-income and high-wealth households, and households with family-owned farms and businesses. With these data, household-specific mortality probabilities, and an estate tax calculator, we estimate the revenue and distributional effects of the estate tax and alternatives.We find that the estate tax is highly progressive and significantly more progressive than the individ-ual income tax. Under 2001 law, about 98 percent of the estate tax is paid by those in the top quintile of the economic income distribution; almost two-thirds is paid by those in the top one percent. By 2009, when the exempt amount is raised to $3.5 million, almost 95 percent of the estate tax would be paid by the top one percent and more than half by the top 0.1 percent. We also examine the revenue and distributional implications of numerous reform options and show that it is possible to drastically reduce the already small number of farms and businesses that are subject to the estate tax without repealing the tax altogether. ESTATE TAX RULESThe executor of an estate must file a federal estate tax return within nine months of a personʼs death if the gross estate exceeds an exempt amount–$675,000 in 2001.1 The estate tax allows deductions for transfers to a surviving spouse, charitable gifts, debts, funeral expenses, and ad-ministrative fees. A unified credit exempted taxes on the first $675,000 of taxable transfers in 2001 (including both gifts made during life and transfers at death), a figure that was scheduled to rise to $1 million by 2006 under pre-EGTRRA law. Family-owned farms and closely held businesses benefit from a number of special provisions.2 For estates above the exempt amounts, the tax rate in 2001 began at 37 percent and rose to 55 percent on tax-able transfers above $3 million. A 5-percent surtax applied to returns with adjusted taxable estates between $10 million and $17.184 million. Estate tax rates represent combined federal and state tax rates, since the federal estate tax includes a credit for state death taxes. In 2001, the credit effectively refunded the state taxes at rates up to 16 percent of the taxable estate. Almost all states levied estate or inheritance taxes large enough to qualify for the maximum federal credit. Under pre-EGTRRA law, capital gains on appreciated assets are not subject to income tax at death and heirs must pay tax only on gains earned since they inherited the asset.EGTRRA raises the effective estate tax exemp-tion from $675,000 in 2001 to $1 million in 2002, and in stages to $3.5 million by 2009. The highest effective marginal tax rate fell from 60 percent in 2001 to 50 percent in 2002. The rate then drops gradually to 45 percent by 2007. The credit for state estate taxes is phased out between 2002 and 2005, the year when it is replaced by a deduction for state taxes. In 2004, the special deduction for family-owned businesses and farms (QFOBI) is repealed. In 2010, the estate and generation- skipping transfer taxes are repealed, and the gift tax rate is set equal to the top individual income tax rate (35 percent). The step-up in basis for inherited assets that have capital gains is repealed, subject *Leonard Burman is Senior Fellow at the Urban Institute, Co-Director of the Tax Policy Center, and Visiting Professor at Georgetown University; William Gale is Arjay and Frances Fearing Miller Chair at the Brookings Institution and Co-Director of the Tax Policy Center; Jeffrey Rohaly is Research Associate at the Urban Institute and Director of Modeling for the Tax Policy Center. This paper is a sharply abbreviated version of Burman, Gale and Rohaly (2004), which lays out the supporting detail, motivations, and results in far more extensive fashion. We are grateful to Adam Carasso, Julie-Anne Cronin, Martha Eller, Barry Johnson, David Joulfaian, Rob McClelland, Janet McCubbin, John O’Hare, Gene Steuerle, and David Weiner for helpful advice. Jim Poterba and Scott Weisbenner very generously shared the code for their estate tax model. Adeel Saleem and Deborah Kobes provided expert research assistance. The views expressed are those of the authors and do not necessarily reflect the views of any of the organizations noted above.THE DISTRIBUTION OF THE ESTATE TAX AND REFORM OPTIONSLeonard E. Burman, Urban InstituteWilliam G. Gale, Brookings InstitutionJeffrey Rohaly, Urban Institute* NATIONAL TAX ASSOCIATION PROCEEDINGS2to a very large exemption.3 The law reverts to its pre-EGTRRA form