Estate taxes and other tax oddities

In November of 2009, while the Congress was debating what, if any, changes to make to the law governing the Estate Tax, Ray D. Madoff, a professor at the Boston College Law School and author of Immortality and the Law: The Rising Power of the American Dead, wrote an OpEd for The New York Times in which he advocated finding a way specifically to allow for the passing of small family businesses intact from one generation to the next without giving up the government’s claim on other types of estates — while continuing to, as he put it, “…impose appropriate taxes on the wealthy heiresses — and heirs — of America” and not “…providing an unnecessary giveaway to Americans who least need it.”

I found the emphasis on ensuring that “…children be able, if they so desire, to carry on the work of their parents” a bit odd as either a moral principle or a practical need.  It seemed like his point was simply that ensuring family businesses could be passed from generation to generation would relieve opponents of the estate tax of their most potent argument against it, thereby saving it on behalf of its grand social purpose.

I actually think the Estate Tax has a beneficial consequence in preventing the establishment of multi-generational economic dynasties.  Apart from the potential detrimental effects of such dynasties on society and the economy, they do spiritual damage to those who inherit them: handing someone “success” without any need for effort or sacrifice is almost always a recipe for intellectual, psychological, and moral dissipation.

My objections to the estate tax — and to other tax policies — are based more on basic ideas of economic fairness and on the cultural ideals of “family”.  I wrote this to the Times to explain those ideas and ideals.  It was not published.  Then again, in hindsight, it is somewhat rambling and disjointed — and entirely too long for a letter to the editor or even for an OpEd.  Alas….

21 November 2009

Ref: your NY Times commentary, “Protect the Farm, Tax the Manor”, 21 Nov 2009.

It seems to me that a fundamental problem with the estate tax is the same as it is with a host of other government tax policies, like the Alternative Minimum Tax (AMT) and taxes on capital gains and others: the congress, in setting tax policy, often refuses to take inflation into account.

You mentioned that, going forward, the exemption for the estate tax should be indexed for inflation.  That it never has been so before — and that trip points for things like the AMT have not been — is a disgrace.  I’m old enough to remember when “bracket creep” was a common term of discussion until an intense public backlash forced the congress to fix it.  They did that, but they continue to ignore other equally pernicious policies.

My particular peeve is taxes on “capital gains”.

If I put $10,000 in a savings account and collect 3% annual interest on it (in my dreams…), then, after 10 years, it will be worth $13,440 and I will owe the government taxes on $3,440, which they call a “capital gain”.

But if, at the same time, inflation has been running at an annual rate of 3%, then the value of that investment hasn’t actually grown at all.  I’ve gained nothing: that $13,440 I have today will buy exactly as much stuff as the original $10,000 would have when I put it into savings.

After paying the taxes, then, I can actually buy less after having invested for ten years than I would have been able to do if I’d spent the money immediately.  So, in reality, that “capital gains” tax, if it doesn’t take inflation into account (and it doesn’t), is a “capital bleed” tax, slowly eroding the value of what I already had in hand.

I would argue that all tax policies should be indexed for inflation, not merely the estate tax.

 

As for the estate tax, itself: aside from the “family business” issue, there are three main arguments (that I’ve heard) used against it by those who have to pay it:

  1. I already paid income taxes on the money when I first earned it.  Why should my heirs have to pay taxes on it again just because I died and left it to them?
  2. When I earned the money during my lifetime, the government took a cut and decreed that the rest was mine to use for what I deemed important.  That is, they decreed what their “fair share” was and took it, leaving the rest as my “fair share”.  Why should my death change the split between their “fair share” and mine — why should they suddenly be entitled to more?  Even if you reasonably conclude that my heirs should count anything they get from me as income, why is the same true of charities and other non-profits that I might decide could use my legacy better than the government could?  The issue is, “Who gets to control to what use my resources — meaning the ones the government has already relinquished its claim on — are put?”
  3. Although the government does its accounting on an individual basis, we all know that people consider “family” to be a fundamental social structure deserving of respect and protection.  What the government views as my resources I view as family resources.  When I pass my inheritance on to my children I am merely passing control of the family resources on to the next generation of the family; what the government views as a discontinuity — a change of ownership — I view as merely a transition in the continuous flow of the generations.  In that view there has really been no “event” for the government to tax because what belonged to the family before still belongs to the family afterward.

The last item is the generalized version of what your commentary was about — passing on the family farm or small business.  The question is, why should a “business” have favored status over an “estate”?  What’s so special about the fact that it is being operated as a commercial enterprise, rather than merely as a communal resource pool, that should change the way the tax system treats it?

The second item is really about the underlying discomfort with government that we have inherited from the founding of the country.  It’s about control:  “I earned these resources; the government has already relinquished its claim on them and they are mine to dispose of as I wish, so why should control over them revert back to the government just because I’ve died?”  I think the option of designating charities as heirs that are exempt from the inheritance tax — that is, allowing you to determine what social causes your resources will go to support rather than having control wrested from you and put into the hands of a government you distrust — would subvert that objection.

The first item is similar to the problem I raised earlier with the capital gains tax, in that it feels like a “slow bleed” of what you have.  It just seems unfair that income which has already been taxed should be taxed again.  That sense of unfairness rests, of course, on the same emotional/intellectual pedestal as the third item — the notion that passing money to your heirs doesn’t count as “income” to them because it already, in a sense, belonged to them in the first place — because it belonged to the “family”.  I think you could reach a reasonable compromise on this if you allowed people to figure in a “cost basis” on an estate in the same way you do so for calculating capital gains.  That is, you get to differentiate between the part of the estate that has been built up from income already taxed and the part of the estate that has been built up from unrealized investment gains; you pay estate taxes on the investment gains but not on the cost basis; and, of course, as with capital gains, you allow indexing of the cost basis for inflation.

And, by the way, if you allowed things to be accounted that way, you could make a reasonable and defensible argument that we don’t need an “estate tax” at all — that, rather, such unrealized gains should simply be taxed as they would if you had earned them as an individual — as capital gains or as regular income.  That is, the death of the owner of such assets and the passing of them to heirs would appear, for tax purposes, as a “sale” of those assets that forced gains to be realized and taxed at that time rather than carried forward in perpetuity.

The counter-argument, of course, is that you don’t actually need to tax them at that time — that, for an heir to make use of those resources, he would eventually need to sell them and you can tax them at the time of the actual sale, instead.  In other words, go ahead and grant the premise of “family continuity” because it doesn’t cost you anything.  At some point, assets will be sold in order to make use of them (at the very least to re-direct the investment into something else) and you will collect a tax on them when that happens.

In fact, it may well be that all the emotional and political angst over the estate tax is wasted, that what we are really arguing about is the timing of when taxes will be collected not the fact of them being collected.  If I inherit assets and also inherit the cost basis of those assets — if we treat the transfer of assets from deceased to heir as merely a continuation of possession — then those assets will be taxed as capital gains when the gains are realized, when I sell them either to spend them or to re-invest them into something else.  In the long view, the only way I could avoid paying taxes on those assets would be to never enjoy the benefits of them, not only in this generation but in all succeeding ones.  Hence, the estate tax, viewed over a long term and in the context of a continuous process of taxation, may be entirely superfluous.

I fact, I would guess that all the estimates of how much money the estate tax might bring in may be overstated.  To the extent that paying the estate tax upon inheritance also resets the cost basis of the underlying assets to their present value, it must, of necessity, decrease the amount of tax liability incurred later when those assets are sold by the heir.  If you offset the gains from the estate tax now with the losses on capital gains taxes later, I would bet the apparent benefit from the estate tax would look pretty small.

© Copyright 2009, Augustus P. Lowell

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