2010's Final Tax Debate: The Future of the Estate Tax

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How should we tax multimillionaires after they die? Today, that question is the main holdup for Democrats, who are trying to wrangle an eleventh-hour compromise from Republicans as the Bush tax cut deal comes up for a vote in Congress.

If you're just joining the debate, you probably have a few questions, including: What is the estate tax, what are the arguments for and against it, and why is such a small debate holding up this $850 billion tax cut deal?

What is the estate tax? 

EstateTax_EstateTaxParamete.jpgEzra Klein has a nice primer this morning explaining estate tax. It's a tax levied on inherited wealth after a rich person dies. The estate tax has two parts: the floor (or "exemption") and the tax rate. Everything above the floor gets taxed at that rate.

In 2001, we had a $675,000 exemption and a 55 percent tax rate, Ezra writes. "So if you were inheriting an estate worth $700,000, you had to pay a 55 percent tax on that final $25,000." To be clear, in 2001, a 55 percent estate tax on a $700,000 estate would collect $13,750, not $385,000.

But as you can see in this graph, the tax shrunk throughout the Bush years until the "death tax" itself died in 2010. But it's scheduled to come back in 2011 with a vengeance, ready to hit more families at a higher rate. That's why both parties are dead set on amending it.

What's the debate?

Estate tax supporters have three main arguments. First, they say it reduces wealth inequality by compelling the richest families to leave some of their wealth to the state. Second, it encourages charitable giving, since charitable donations are tax deductible and also reduce the size of your taxable estate. Third, they say the government is starved for federal revenue. A 2000-era estate tax could raise up to $700 billion over ten years. It's ludicrous to shrink taxes below their surplus-era levels without a plan to make it up somewhere else.

Estate tax opponents counter this way. First, the estate tax doesn't reduce wealth inequality, it reduces wealth by punishing successful people who made money. Second, if you punish people who die with valuable estates, you're potentially encouraging them to find inventive ways to dilute their money in their final years, which sometimes leads to the dissolution of family-run businesses. Third, it's easy, but expensive, to orient your wealth so that only a sliver gets hit by the estate tax, so rich people wind up spending billions of dollars a year to escape the tax, which is not necessarily the best way to invest those billions of dollars.

For an interesting out-of-left-field idea, read Michael Kinsley on why we should make the estate tax universal.

What's the hold-up?

The estate tax debate is a microcosm of the fundamental difference between Republicans and Democrats on tax policy. It's just about the most progressive law you could write, because it hits only the richest families at a fairly high rate. To the GOP, which values low taxes on income and investment above almost all else, the tax is pointless and unfair. To Democrats, who value progressive tax rates on income and investment above almost all else, it is necessary and defensible.

Ideology aside, this is a debate about a group of Americans no larger than the size of Brown University. As Bloomberg reports, the president's compromise would subject 3,600 U.S. estates to the tax in 2011. The House Democrat plan would hit 6,460 multimillionaires in 2011. That's a difference of just 2,860 taxpayers. Democrats can say, Fix this tax, we're only talking about 3,000 very very rich old people. The White House will respond, Get outta the way Democrats, you're risking this bill on 3,000 very very rich old people.

Both sides have a point. I'd like to see a higher exemption and higher rate, but at the end of the day, these estates mean much more to their inheritors than to the federal coffers, the economy, or the Democratic Party. Don't expect the "death tax" to have much of a second life.

___________________________________________

This piece was a modified version of our ongoing FLASHCARD series, which decodes the concepts and terms readers encounter every day but seldom see explained.


For more Flashcard posts:

The Basel III Accords

The Bush Tax Cuts

Cap-and-Trade

Carbon Pricing

The Contagion Effect

Deficit Spending (Stimulus)

Employer Health Care Subsidy

The Mortgage Interest Deduction

The Oil Spill Liability Cap

Predator Drones

Quantitative Easing (Monetary Policy)

The Recovery Act

The Renewable Electricity Standard

Structural v. Cyclical Unemployment

Social Security Fixes

Unemployment Insurance

The Value-Added Tax

Payroll Tax Holiday

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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