The Estate Tax Is a Huge Giveaway in the Fiscal-Cliff Talks

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It will cost us $375 billion over the next decade if we keep the estate tax from going back to its Clinton-era levels. That's twice the savings from switching to chained CPI.

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(Reuters)

It's time to talk about everybody's three least favorite certainties in life: death, taxes, and cliffs. The first two are self-explanatory enough, and the last is how this Congress operates. It endlessly creates artificial crises, and then "solves" them by postponing the date of reckoning, until the government works, inasmuch as you can say it does, in a state of near calamity. The debt ceiling begat the fiscal cliff, which will undoubtedly beget the debt ceiling cliff, if the reports of a deal that extends most of the Bush tax cuts, but doesn't raise the debt ceiling, turn out to be true.

This latest cliff intersects with our two other unhappy certainties, death and taxes, when it comes to the estate tax. It's been a rather bizarre decade for what Republicans call the "death tax," but what should more properly be called the inheritance tax. Back when George W. Bush came into office, he slashed the estate tax, and gradually phased it out until 2010, when there was no estate tax. Since then, Congress has set it at a 35 percent rate, with a $5 million exemption, indexed to inflation -- but that's set to expire, along with everything else, in the new year, and revert back to its Clinton-era levels.

Those Clinton-era levels of a 55 percent rate and a $1 million exemption are much, much higher than what's being talked about as part of a fiscal cliff deal. According to Sam Stein and Ryan Grim of the Huffington Post, the latest proposal that really, really might turn into an actual deal would set the estate tax at a 40 percent rate, with a $5 million exemption, indexed to inflation. In other words, the first $5 million of any estate would not be taxed, but the rest would be at a 40 percent rate, with that $5 million exemption growing each year with inflation. And remember, these are exemption levels for singles; the exemption level for surviving spouses is double this.

It's a tax change that doesn't affect many households, but it does affect the budget in a big way. The nonpartisan Tax Policy Center looked at four scenarios for the estate tax, and what they mean for revenues and rates. Here are the four scenarios, in brief:

-- $5 million exemption, indexed to inflation, with 35 percent tax rate. This is current policy.

-- $3.5 million exemption, indexed to inflation, with 45 percent tax rate. This was the Democrats' preferred position during negotiations.

-- $3.5 million exemption, not indexed to inflation, with 45 percent tax rate. This was policy in 2009, before the estate tax was phased out entirely in 2010.

-- $1 million exemption, not indexed to inflation, with 55 percent tax rate. This was was policy under Bill Clinton, which is set to come back in 2013 in the absence of a deal.

Even more than the rates, the exemptions matter. Only 3,730 households will pay the estate tax next year if the exemption is set at $5 million, versus 47,170 if it's set at $1 million. As you can see in the chart below, there's about a $400 billion difference over the next decade between letting the estate tax go back to where it was under Clinton and keeping it where it is now. That's a $375 billion difference once you count the extra $25 billion or so that the current fiscal cliff deal -- a $5 million exemption and 40 percent tax rate -- would raise over current policy. 

EstateTaxRevenue.png


This is far from chump change. Remember, the CBO figures switching to chained CPI would reduce deficits by about $200 billion over a decade, with a little less than half coming from tax increases and the rest from Social Security and other benefit cuts. In other words, a lower estate tax costs us almost twice as much as chained CPI would save. 

Again, the exemptions matter. Most of the lost revenue from a lower estate tax comes from the not-entirely-stinking-rich -- i.e., from households that would otherwise be exempt, or mostly so. You can see that in the chart below, also from the Tax Policy Center, that shows the average tax rates for different-sized estates under the different plans. There's not much difference for estates over $20 million, but there's a big one for estates with less than that.

EstateTaxRates.png

There's a very simple lesson here. It's the same one Larry Summers recently made -- if we want to make the tax code fairer, we should focus less on tax rates, and more on tax exclusions. The super-wealthy don't benefit nearly as much from low top-end rates as they do from income that isn't even subject to tax, like a higher estate tax exemption. (Remember, capital gains aren't taxed at death, so the estate tax isn't necessarily a double tax).

But if the fiscal cliff talks are any indication, that won't change anytime soon. Maybe it's time for a fourth certainty.
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Matthew O'Brien

Matthew O'Brien is a former senior associate editor at The Atlantic.

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