Life and Death Questions About the Estate and Gift Tax · 2019-04-11 · Life and Death Questions...

Life and Death Questions About the Estate and Gift Tax

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National Tax JournalVol. LIII, No. 4, Part 1

INTRODUCTION

The political debate over the U.S. estate tax has becomewhite hot in recent months, filled with moral indigna-

tion over compounding a family’s grief over the loss of a lovedone with a tax, of all things, and with the charge, made andlater retracted by then Deputy Treasury Secretary LawrenceSummers, that those who oppose it are motivated solely byselfishness. Underneath this public ruckus, however, lie somefascinating and important economic issues. Our goal in thispaper is to steer clear of the political debate and examine theestate tax by standard public finance criteria.

In the first section, we provide an overview of the estate andgift taxes. Noting that the taxes place burdens on transfers ofwealth, in the second section we explore what is known aboutwhat motivates people to give gifts and bequests. The thirdsection examines equity and incidence issues. The fourth sec-tion examines the efficiency of transfer taxes. The fifth sectiondiscusses administrative aspects of the tax. The sixth sectiondiscusses two key behavioral effects: the impact on saving andlabor supply. The seventh section is a short conclusion.1

AN OVERVIEW OF TRANSFER TAXES2

Although taxes on the transfer of wealth were levied inEgypt as far back as the 7th century B.C., the first U.S. Fed-

Life and Death Questions Aboutthe Estate and Gift Tax

William G. GaleThe BrookingsInstitution,Washington, D.C.20036-2188

Joel B. SlemrodOffice of Tax PolicyResearch, University ofMichigan BusinessSchool, Ann Arbor,Michigan 48109-1234

1 We do not discuss the history of economic thought relating to estate taxes,but pertinent analyses date back to at least Adam Smith in the 18th century.Smith argued that taxes at death were more administrable than taxes ongifts between living persons, because the former are harder to conceal. Healso thought that estate taxes should be lighter or non–existent when thechildren of a decedent still live in the same house as the father, since thedeath would likely be associated with a “diminution of material well–be-ing, and so a tax would be cruel and oppressive.” (See Smith, 1976, p. 859.)Any estate left to children that are out of the parental house with childrenof their own, however, might be liable to some tax “without more inconve-niency than what attends all duties of this kind.” Smith argued that the taxwas consistent with three of his maxims for taxation—certainty, convenienceof payment, and economy in collection. It clearly violated his fourthmaxim—equality. Smith also believed the tax reduced saving. David Ricardo(who was very rich) agreed, but John Stuart Mill and J.B. McCulloch didnot. The debate largely focused on whether a tax liability due so far in thefuture, and attached to an event many people prefer not to think about,could really be a disincentive to activities undertaken in the prime of life.

2 See Joint Committee on Taxation (1998) for a summary of current law andlegislative history of transfer taxes.

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eral tax on wealth transfers dates to 1797when, faced with the expenses of dealingwith French attacks on American ship-ping, the Congress imposed a stamp dutyon receipts for legacies and probates forwills. The tax was eliminated in 1802. Aninheritance tax was instituted in 1862,during the Civil War, and was repealed in1870. In 1894, Congress passed and thePresident signed into law an income taxthat included all gifts and inheritancesreceived as taxable income. The SupremeCourt, however, declared the taxunconstitional. In 1898, to help finance theSpanish–American War, the federal gov-ernment imposed its first estate tax, whichwas repealed in 1902.

The modern estate tax also originatedin a time of war preparation, if not waritself, in 1916, but its survival after WorldWar I is not surprising. Its introduction co-incided with the movement of the late 19th

century and early 20th century to replacefederal customs and excise taxes, whichwere viewed by many as regressive, withmore progressive taxes.

Since 1976 federal law has imposed alinked set of taxes on estates, gifts, andgeneration–skipping transfers.3 By law,the executor of an estate must file a fed-eral estate tax return within nine monthsof the death of a U.S. citizen or resident ifthe gross estate exceeds a threshold thatis currently set at $675,000.4 Generally, thegross estate includes all of the decedents’assets, life insurance proceeds from poli-cies owned by the decedent, and giftsmade by the decedent in excess of an an-

nual exemption that is currently set at$10,000 per donee per year.5

Total gross estate on estate tax returnsfiled in 1997 exceeded $162 billion. Tax-able returns—i.e., returns that paid posi-tive taxes—accounted for 48 percent ofall returns and about 60 percent of totalgross estate. Among taxable estates, per-sonal residence and other real estate ac-counts for about 15 percent of gross es-tate, stocks (other than closely held),bonds and cash account for 66 percent,and small businesses (closely held stock,limited partnerships, and other non–cor-porate business assets) account for 10percent. Farm assets account for 0.3 per-cent.

The composition of taxable estates var-ies significantly by estate size. Amongtaxable estates with gross assets below$1.0 million, small business assets ac-count for only about 2 percent of grossestate, cash accounts for 23 percent, andstocks for 23 percent. Among taxable es-tates with gross assets above $20 million,small business assets account for 23 per-cent, stocks account for 45 percent, andcash accounts for just 3.2 percent of grossestate.

The estate tax provides unlimited de-ductions for transfers to a survivingspouse and contributions to charitable or-ganizations. Deductions are also allowedfor debts owed by the estate, funeral ex-penses, and administrative and legal feesassociated with the estate. In addition,closely–held family businesses are al-lowed an extra deduction of up to

3 The laws that govern how and to whom property may pass are the exclusive domain of the states. Most statesprovide a surviving spouse and minor children with some protection against disinheritance. In cases ofintestacy, state laws provide a structure to guide succession. In contrast, federal law governs the taxation ofsuch transfers, although states may also impose estate, inheritance, or gift taxes.

4 This threshold is scheduled to rise, along with the “effective exemption” described below, to $1 million by2006.

5 Typically, assets are set at fair market value. Closely–held businesses, however, are allowed to value assets attheir “use value” rather than their highest alternative market–oriented value. This can provide a reduction invalue of up to $750,000. In addition, it is often possible to discount the valuation of assets by placing them ina mediated ownership form, such as a family limited partnership, rather than holding them on own account(see Schmalbeck, forthcoming). The estate is usually valued as of the date of death, but alternatively may bevalued at a date up to six months after the death, if the asset values decline during this period.


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$625,000 for the value of the business be-ing transferred.6

Among all returns filed in 1997, deduc-tions accounted for about 45 percent ofgross estate, but this ratio rises dramati-cally with estate size, from 26 percent forestates with gross assets below $1 millionto 70 percent for estates above $20 million.Bequests to surviving spouses are sub-stantial across all estate sizes. In contrast,charitable contributions total only 11 per-cent of deductions for estates below $1million, but rise to 40 percent of deduc-tions for estates above $20 million. The 182taxable estates with gross estate over $20million that made charitable contributionscontributed an average of $41 million.

After determining net estate—gross es-tate less deductions—the statutory tax rateis applied. Statutory marginal tax rates aregiven in Table 1. Formally, the statutorytax schedule applies an 18 percent rate tothe first $10,000 of lifetime transfers, withthe rate rising to 37 percent on transfersabove $675,000, and rising in several

stages to 55 percent on taxable transfersabove $3 million. However, effective taxrates differ from the statutory schedule forseveral reasons. First, although the low-est formal tax rate is 18 percent, the low-est rate that any taxable return faces is 37percent due to the federal unified estateand gift tax credit. This credit is currentlyset at $220,550, which provides an effec-tive exemption of the first $675,000 oftransfers given during life and at death,above and beyond the $10,000 per personper year gift exemption and the other ex-clusions noted above. The unified creditis scheduled to rise in stages to $345,800by 2006, raising the effective exemptionto $1 million per person.

Second, an additional credit is allowedfor gift taxes previously paid, and for es-tate tax previously paid on inheritedwealth. The latter is phased out over tenyears, in two year intervals, from the datethe wealth was inherited. The credit forestate taxes previously paid on inheritedwealth is intended to reduce the extent of(double) taxation of recently inheritedwealth. Third, another tax credit is givenfor state inheritance and estate taxes (butnot for state gift taxes). The credit rate isbased on the “adjusted taxable estate,”which is the federal taxable estate less$60,000, and the allowable credit rangesfrom zero to 16 percent of the base. Thus,the credit for state taxes can reduce themaximum effective federal statutory taxrate to 39 percent for the largest estates.Most states now levy so–called “soak–up”taxes that fall within the credit limit, sothat they transfer revenue from the fed-eral to the state treasuries without add-ing to the total tax burden on the estate.Finally, a 5 percentage point surtax isadded on transfers between $10 millionand about $17,180,000.7 This surcharge

6 The value of this deduction, plus the effective exemption created by the unified credit and discussed below,cannot exceed $1.3 million.

7 Before 1998, the surtax clawed back the benefit of the graduated rates and the effective exemption and thusapplied to estates with values as large as $21,040,000. A drafting error in 1997 removed the clawback of theeffective exemption.

Statutory MarginalTax Rate(percent)

$0–10,000$10,000–20,000$20,000–40,000$40,000–60,000$60,000–80,000$80,000–100,000$100,000–150,000$150,000–250,000$250,000–500,000$500,000–750,000$750,000–1,000,000$1,000,000–1,250,000$1,250,000–1,500,000$1,500,000–2,000,000$2,000,000–2,500,000$2,500,000–3,000,000Over $3,000,000

1820222426283032343739414345495355

TABLE 1FEDERAL UNIFIED ESTATE AND GIFT TAX

RATES, 2000

Taxable Estate and Gifts($ thousands)

Source: IRS (1999)


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raises the effective marginal estate tax rateto 60 percent and claws back the benefitof the graduated rate structure.8

Although the federal estate and gifttaxes are unified in many respects, an im-portant distinction is that estates aretaxed on a tax–inclusive basis, whereasgifts are taxed on a tax–exclusive basis.9

In addition to estate and gift taxes, fed-eral law imposes a separate tax on gen-eration–skipping transfers (e.g., fromgrandparents to grandchildren) that ex-ceed $1 million per donor. This tax,which raises little revenue itself, is de-signed mainly to shut down what wouldotherwise be a straightforward way toavoid transfer taxes (see Schmalbeck,forthcoming).

MOTIVES FOR INTERGENERATIONALTRANSFERS

The impact of transfer taxes on effi-ciency, equity, and economic behaviordepends crucially on why people givebequests (see Kaplow, forthcoming; andGale and Perozek, forthcoming). Previ-ous research has considered severalclasses of models of intergenerationaltransfers, but has had difficulty reachinga consensus about the relative impor-tance of each.

In the accidental bequest model, peopleface uncertain life spans and accumulateassets to save for retirement. They do notplan or desire to give bequests, but theydo not annuitize their wealth either, aswould occur in a simple life–cycle model,because of imperfect or missing annuity

markets or because they are also savingfor precautionary reasons against, say,uncertain future health expenses. Underthese assumptions, people will generallyhave positive asset holdings when theydie, even though they do not have a be-quest motive.

Accidental bequests can account for alarge fraction of aggregate wealth (Abel,1985) and can help to explain puzzlingwealth accumulation patterns of the eld-erly (Davies, 1981; Hurd, 1987). Substan-tial evidence from patterns of inter vivosgiving, life insurance, and annuitychoices, however, indicates that some por-tion of transfers are intended (Bernheim,1991; Gale and Scholz, 1994; Kotlikoff,1989; Laitner and Juster, 1996; McGarry,1997; Page, 1997). The existence of estateplanning and tax avoidance techniquesfurther suggests that not all bequests areaccidental.

In the pure altruism model (Barro, 1974;Becker, 1974), parents care about their ownconsumption and the utility of their chil-dren. Parents make transfers and leavebequests until the marginal cost in termsof their own foregone consumption isequal to the marginal benefit to the par-ents of the increase in their children’s con-sumption. Bequests are given differen-tially across children to compensate fordifferences in endowments or outcomes.Variations of altruism with and without amechanism that allows a parent to com-mit to a given transfer level are examinedin Bruce and Waldman (1990, 1991),Lindbeck and Weibull (1988), and Perozek(1996).

8 By law, payment is due within nine months of the decedent’s death, although a six month extension may beobtained. However, the actual timing of the tax payment is flexible. In the presence of a well–functioningmarket for life insurance, a one–time estate tax liability at an uncertain future date can be transformed into aseries of annual premium payments. In addition, the tax law itself provides for ex post spreading out of taxpayments over 14 years for closely–held family businesses.

9 For example, suppose the applicable estate and gift tax rate is 50 percent and consider the implications ofgiving a gift or a bequest that costs the donor $15,000 including taxes. If the funds are given as an inter vivostransfer, the recipient would receive $10,000 and the donor would pay gift tax of $5,000 (50 percent of $10,000).If the funds are given as a bequest, the recipient would receive only $7,500, and the estate would owe $7,500in taxes (50 percent of $15,000).


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Tomes (1981, 1988) and Becker andTomes (1979, 1986) provide support for thealtruistic model. Other research, however,has rejected three sharp empirical impli-cations of altruism. First, Altonji, Hayashiand Kotlikoff (1992) show that the divi-sion of consumption within the family isnot independent of the division of income,contrary to the predictions of an altruismmodel with operative transfers. Second,several studies find that, among familieswhere parents make transfers to children,a one–dollar increase in parents’ resourcescoupled with a one–dollar reduction inchildren’s resources does not raise trans-fers by a dollar, although it should underaltruism (Altonji, Hayashi, and Kotlikoff,1992; Cox, 1987; and McGarry andSchoeni, 1995).10 Third, under altruism,siblings with lower incomes should re-ceive larger inheritances than siblingswith higher incomes, but empirically theytypically do not (Joulfaian, 1994; Menchik,1980, 1988; and Wilhelm, 1996). The lastrejection is striking because equal divisionof estates among children appears to bethe norm. Bernheim and Severinov (1998)offer an explanation of this norm by show-ing how it can arise in a model with pa-rental altruism combined with the as-sumption that a child derives utility fromhis perception of parental affection to-wards him relative to other siblings.

A variety of “exchange” models positthat bequests or transfers are the paymentfor some good or service provided by chil-dren. In the strategic bequest model(Bernheim, Shleifer, and Summers, 1985),parents care about their own consump-tion, their children’s utility, and services

obtained from children. These servicesmay represent standard market goods orservices (lawn mowing, for example) ormore personal items, such as visits, atten-tion, or children’s choices regarding mar-riage, childbearing, education, career, andlocation of residence. Parents pay for ser-vices with bequests, rather than inter vi-vos transfers. By delaying payment, par-ents can control children’s actions for alonger period, and extract the entire con-sumer surplus out of the exchange rela-tionship. In Cox (1987), parents buy ser-vices from their children via inter vivosgifts, and the exchange may be mutuallybeneficial. Empirical tests of exchangemodels have generated mixed results(Bernheim, Shleifer, and Summers 1985;Cox, 1987; and Perozek, 1998).11

Other specifications simply assume thathouseholds acquire utility directly fromwealth or from the after–tax bequest theyleave. This specification is sometimes of-fered as a structural model. Aaron andMunnell (1992), Bakshi and Chen (1996),and Carroll (2000), for example, argue that(pre–estate–tax) wealth may enter the util-ity function as a separate argument, aboveand beyond the conventional consump-tion goods it can finance, because wealthmay also provide social status, power,social connections, etc. A related case oc-curs if households care directly about thesize of the after–tax bequest they provide(Blinder, 1976; Carroll, 2000). Alterna-tively, the specifications using pre– orpost–tax wealth may be thought of as re-duced forms consistent with differentstructural motivations for transfers.Carroll (2000) presents casual evidence

10 Although, see McGarry (2000), who considers a dynamic model of altruism and concludes that this test ismis–specified.

11 The equal division puzzle is a problem for the strategic bequest motive, although Bernheim, Shleifer, andSummers (1985) offer a possible reconciliation. Kotlikoff and Spivak (1981) offer an alternative exchange model,where parents face uncertain lifetimes and imperfect annuity markets. To insure against outliving their re-sources, parents essentially buy annuities from their children and pay for the annuities with bequests. Themodel suffers from the empirical problem that large, ongoing flows of wealth from children to living parentsare rarely observed (Gale and Scholz, 1994), but that may be due to the sizable annuities that the governmentalready provides in the form of Medicare and Social Security.


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consistent with the utility–of–wealthmodel, but no formal tests of either modelexist.

Each motive above is plausible anddraws support from at least some re-search, but each motive that has beentested has also been rejected. This suggeststhat households may be influenced byseveral motives, or that the importance ofeach may vary across households. Differ-ences in empirical outcomes may also bedue in part to data limitations and the dif-ficulty of distinguishing rejection of theunderlying behavioral model from rejec-tion of the maintained assumptionsneeded to generate testable hypotheses.

It is worth emphasizing that analysis ofthe estate tax requires evidence on themotives of the very wealthiest house-holds. However, there is even less knownabout the very wealthy than about themoderately wealthy or middle–classhouseholds that are the mainstay of mostempirical work on transfers, and the rich-est households may well have differentmotives for, and patterns of, wealth accu-mulation. Recent work has only begun toexamine the behavior of the very wealthyin detail. See, for example, the papers inSlemrod (2000).

EQUITY ISSUES

This section explores issues relating tothe vertical and horizontal equity of theestate tax. The first and second sectionsexamine the partial equilibrium incidenceof the tax. The third section discusses gen-eral equilibrium incidence issues. Thesesections generally conclude that the tax is

progressive. The fourth section examinesother issues relating to progressivity,while the fifth section discusses horizon-tal equity.

Assigning the Burden to Donors

The economic incidence of the tax de-pends on the base, the rate structure, theenforcement regime, and households’ re-sponses to the tax. These responses, inturn, will depend on the motivation fortransfers, as discussed above. We exam-ine incidence first by assuming the bur-den is borne by donors, and then by as-suming it is borne by recipients. In a par-tial equilibrium setting, the tax will beborne only by donors if variations in es-tate tax rules cause donors to adjust theirgross estate (and hence their consumptionor labor supply) in a way that keeps con-stant the net–of–tax inheritance received.12

The tax will be borne by recipients if varia-tions in the tax cause donors to keep thegross (pre–tax) bequest constant.13

Examining the incidence of a tax re-quires addressing the prior question ofhow to classify people or families in or-der to construct a “distributional table.”For the estate tax, a natural ordering unitis estate size. Other taxes, however, aretypically distributed—by CongressionalBudget Office (CBO), Treasury, Joint Com-mittee on Taxation (JCT), and others—byannual income. We pursue both ap-proaches below, though neither approachis without problems.14

Table 2 provides information on the dis-tribution of returns, gross estates, and taxpayments by estate size in 1997. Estate tax

12 Note that this implies that increases in the estate tax would raise donors’ saving, unless all of the revenue isrecycled to the donor.

13 Of course, if the donors are altruistic, the reduced (after–tax) bequest will also reduce the utility of the donors.14 Ideally, data would match estate tax returns to lifetime income measures. No such income measure currently

exists, although Joulfaian (forthcoming) uses a data set that matches decedents’ estate tax returns with theprevious 10 years’ worth of income tax returns. Joulfaian (1994) uses data from a Treasury collation study thatlinks estate tax returns to the income tax return in the last full year the decedent was alive. Income in the lastyear, however, when people are typically elderly and retired, and often are ill, is probably not be a verymeaningful indication of affluence.


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liability is extraordinarily concentratedamong high–wealth decedents. In 1997,estates with gross values over $5 millionaccounted for over 43 percent of gross es-tate and over half of all transfer tax rev-enues, but only 5.5 percent of all taxableestates (and about 1 out of every 1,000deaths, not shown). In contrast, the 85percent of taxable estates with assets be-low $2.5 million account for only about42 percent of gross estate and just 30 per-cent of transfer tax revenues.

Table 3 provides information on taxburdens by estate size. The average tax-able return has gross estate worth over$2.2 million and pays federal estate taxesof about $388,000 and pays total transfertaxes, including gift taxes and state taxes,of about $506,000. This corresponds to anaverage estate tax rate of 17 percent and

an average overall rate of 22 percent.These rates generally rise with estate size.For taxable returns with gross estates be-low $1 million, the average transfer taxrate is just 8 percent. This figure rises toabove 30 percent for taxable estates withgross assets between $2.5 million and $20million, and then falls to 21 percent fortaxable estates with gross assets above $20million. The decline in the average over-all transfer tax rate among estates above$20 million is due to a sharp increase indeductions for this group relative to oth-ers.

The Office of Tax Analysis (OTA) of theDepartment of the Treasury has under-taken distributional analysis based onannual income and assuming that estateand gift taxes are borne by decedents.Expected estate tax payments for each

TABLE 3AVERAGE ESTATE SIZE, TAX PAYMENTS AND TAX RATES BY ESTATE SIZE CATEGORY, 1997

Size of Gross Estate

All 0.6–1.0 1–2.5 2.5–5.0 5–10.0 10–20.0 Over 20

All ReturnsAverage Estate Size*Average Estate Tax Paid*Average Total Transfer

Taxes Paid*Average Estate Tax RateAverage Transfer Tax Rate

Taxable ReturnsAverage Estate Size*Average Estate Tax Paid*Average Total Transfer

Taxes Paid*Average Estate Tax RateAverage Transfer Tax Rate

1,803 768 1,470 3,408 6,907 13,697 70,243185 18 133 510 1,225 2,445 8,309

243 28 163 622 1,544 3,249 12,2490.10 0.02 0.09 0.15 0.18 0.18 0.120.13 0.04 0.11 0.18 0.22 0.24 0.17

2,276 806 1,481 3,431 7,040 13,678 74,922388 44 244 862 1,887 3,321 10,531

506 66 298 1,049 2,368 4,403 15,4730.17 0.05 0.16 0.25 0.27 0.24 0.140.22 0.08 0.20 0.31 0.34 0.32 0.21

* in thousands of dollarsSource: Johnson and Mikow (1999)

All Taxable Estate ReturnsTotal Gross Estate Among

Taxable ReturnsTotal Estate Taxes PaidTotal Transfer Taxes PaidSource: Johnson and Mikow (1999).1Dollar figures in thousands.

42,901

97,650,46316,637,37921,776,270

TABLE 2ALLOCATION OF RETURNS, GROSS ESTATE, AND TAX PAYMENTS BY ESTATE SIZE

AMONG TAXABLE RETURNS, 1997

Size of Gross Estate ($ millions)

44.3

15.75.05.8

41.0 9.2 3.3 1.4 0.8

26.7 13.9 10.2 8.3 25.225.8 20.5 16.0 11.8 20.824.1 19.1 15.5 12.0 23.5

Total1 0.6–1.0 1–2.5 2.5–5 5–10 10–20 Over 20


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family are calculated by (a) imputing fam-ily wealth, (b) calculating estate tax liabili-ties as a function of wealth and maritalstatus, and (c) applying a mortality prob-ability based on age.15 The resulting dis-tribution of estate taxes is shown in Table4, along with Treasury estimates of indi-vidual income tax burdens. The tableshows that, when the burden is assignedto the donor, estate tax burdens are highlyskewed toward high–income individuals.More than 99 percent of the burden fallson the top quintile, 96 percent on the topdecile, 91 percent on the top 5 percent and64 percent on the top 1 percent of the in-come distribution. The estate tax is clearlymore progressive than the income tax,under the OTA assumptions. For the mostaffluent 1 percent of families its burden ismore than 6 percent of the burden of theindividual income tax. To the extent thatincome in the last year of life understatestrue lifetime income, the Treasury meth-odology will understate the trueprogressivity of estate taxes.16

Feenberg, Mitrusi, and Poterba (FMP,1997) provide an alternative estimate,based on public–use income tax returnfiles supplemented by CPS data on non–filers. They allocate the burden of estateand gift taxes to units with someone overthe age of 65 in proportion to each unit’sshare of capital income in excess of$30,000.17 Thus, they assume that the taxis borne by decedents and provide no spe-cial adjustments for a surviving spouse.Table 5 shows the resulting distributionof imputed estate and income tax liabilityby income class for 1991. Because taxpay-ers with annual income over $200,000comprise about 1 percent of the totalpopulation, it is straightforward to com-pare their results with OTA’s. FMP calcu-late that the estate tax burden on thisgroup totals $6.4 billion or 58 percent oftotal estate taxes, just slightly below the64 percent estimate provided by OTA.According to FMP, for this group the $6.4billion estate tax burden is 5.1 percent ofthe burden imposed by the personal in-

Lowest quintile 0.0 –2.4 0.0 –0.6Second quintile 0.0 0.8 0.0 0.5Third quintile 0.0 5.6 0.0 6.9Fourth quintile 0.0 7.8 0.8 16.3Highest quintile 0.5 13.7 99.2 76.6 Top 10% 0.7 15.4 96.2 61.3 Top 5% 0.9 16.9 91.0 49.1 Top 1% 1.3 20.2 64.2 25.5Total 0.3 10.1 100.0 100.0

As a Percent of Income As a Percent of Total Tax Burden

Income Quintileor Percentile

Estate andGift Taxes

IndividualIncome Tax



TABLE 4ESTIMATED DISTRIBUTION OF INCOME AND ESTATE TAXES, 1999

Source: Cronin (1999).

15 To impute wealth, OTA grosses up (using a 7 percent rate of return) a measure of capital income. Capitalincome includes interest, imputed accrued capital gains, real earnings on IRAs, Keoghs, pensions and lifeinsurance, rental income including imputed rental income from owner–occupied housing, and the capitalcomponent of sole proprietor, partnership, and subchapter S corporation income. To calculate estate tax liabil-ity, OTA assumes that when the first spouse in a couple dies, no estate tax is incurred. OTA also assignsaverage charitable deductions by estate size.

16 Although the JCT does not currently estimate estate and gift tax burdens, JCT (1993) describes a methodologyused in the past, in which the burden of (changes in) the estate tax was assigned to the decedent based uponthe decedent’s income in the year preceding the year of death. The gift tax was not distributed. JCT does notreport a distribution of the current existing estate tax that is comparable to Table 4.

17 Capital income is defined as the sum of dividends, taxable and tax–exempt interest, (realized) capital gains,trust income from trusts, partnerships, Subchapter S corporations, rents, and royalties.


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come tax, which is also somewhat lessthan the 6.4 percent of the Treasury analy-sis.

B. Assigning the Burden to Recipients

While assigning the burden to recipi-ents of inheritances (or those who wouldhave been recipients if taxes had beenlower) may seem to be a polar alterna-tive to the assumption that donors bearthe burden, in practice the implicationsfor progressivity do not appear to be dis-similar, because the recipients of estatestend to have very high income andwealth themselves. Joulfaian (1998) re-ports that, among children receiving in-heritances from taxable estates in 1982,average adjusted gross income (AGI)was $47,433. For decedents with estatesover $10 million, average children’s AGIwas $271,000. For decedents with estatesbetween $2.5 million and $10 million, av-erage children’s AGI was $123,000. Theseresults suggest that recipients are quitewell off. By comparison, median familyincome was $23,433 in 1982, and aver-age money income in the top 5 percentof the distribution was $82,684. Thus,while there may be significant contro-versy over whether donors or recipientsbear the burden of estate taxes, for pur-poses of understanding the progressivity

of the tax with respect to current income(and, we conjecture, lifetime income), thecontroversy does not matter very much.Both donors and recipients are quite welloff.

General Equilibrium Considerations

None of the estimates discussed aboveallow for general equilibrium effects.These will in turn depend on how peoplewho give and receive bequests adjust theirlabor supply and saving, a topic ad-dressed in more detail in the sixth section.Nevertheless, it is worth noting that if thetax reduces personal saving and that re-duces (domestic) capital accumulation,the resulting long–term reduction inwages will offset to some degree the ex-treme progressivity of its statutory bur-den distribution. Along these lines,Stiglitz (1978) shows that, if the estate taxreduces saving, it can have perverse ef-fects on the distribution of income. Spe-cifically, the reduction in saving reducesthe capital stock, which raises the returnon capital and reduces wages. In the longrun, an increase in the estate tax couldraise the share of income accruing to capi-tal. Laitner (forthcoming) develops anintergenerational simulation model andshows that removing the estate tax in hisframework would raise saving, as Stiglitz

As a Percent of Income As a Percent of Total Tax Burden

Income Level($ thousands)





TABLE 5ESTIMATED DISTRIBUTION OF ESTATE AND GIFT, AND INCOME TAXES, 1991

0–10 0.0 –1.2 0.0 –0.310–20 0.0 2.4 0.0 2.020–30 0.0 5.9 0.0 6.030–40 0.0 7.9 0.9 8.140–50 0.0 8.7 0.9 8.950–75 0.1 9.9 7.3 19.675–100 0.2 12.1 8.2 12.6100–200 0.5 15.1 21.8 16.5200+ 1.2 22.2 — 26.6

200–500 — — 19.1 —500–1000 — — 10.0 —1000+ — — 29.1 —Source: Feenberg, Mitrusi, and Poterba (1997), tables 8 and 10, and authors’ calculations.


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assumes. Laitner also finds that removingthe estate tax would significantly increasethe concentration of wealth.

Progressivity: Further Discussion

Progressivity has long been a principaljustification for the estate tax (see Graetz,1983, for example). The large increase inthe concentration of before–tax incomeand wealth over the last two decades ar-guably makes the case for progressivityeven more compelling (see Slemrod andBakija, 1999). Our analysis above suggeststhat transfer taxes in the U.S. are progres-sive, but raises some additional issues.

First, one might reasonably ask why thedesired degree of progressivity couldn’tbe achieved solely through the income tax.The answer usually given is that the ca-pacity of the income tax to impose pro-gressive burdens is limited by several fac-tors, notably the preferential treatment ofcapital gains. Capital gains are taxed at alower rate than other capital income; theyare taxed only when the underlying as-sets are sold as opposed to when the gainsaccrue. Most important, gains are excusedfrom income taxation at death. Unrealizedgains are very heavily concentrated in thelargest estates. For example, Poterba andWeisbrenner (forthcoming) estimate thatin 1998 more than half of all estates withassets above $10 million had over half oftheir wealth in the form of unrealizedgains. For all estates above $250,000, lessthan one–third of the wealth consisted ofunrealized capital gains. Thus, the role ofthe estate tax as a “backstop” to the in-come tax is closely related to theprogressivity of the estate tax.

Second, it is often claimed by both sup-porters and opponents of the tax that theestate tax has failed to reduce the concen-tration of wealth, which seems at firstglance to contradict the claim that the taxis progressive. It is true that the concen-tration of wealth is not obviously lowerin the era of high estate taxes than it was

before. But the real question is whetherthe concentration of wealth is less than itwould be in the absence of the tax. In ad-dition, it is probably unrealistic to expectthat a tax that in a typical year raises rev-enue equal to just 0.3 percent of gross do-mestic product (GDP) and just 0.1 percentof household net worth would make a se-rious dent in overall wealth inequality.Thus, even if the estate tax has not had ahuge impact on the measured concentra-tion of wealth, it can still be highly pro-gressive.

A related argument is that policy shouldbe concerned not with the concentrationof wealth as much as with the concentra-tion of consumption or well–being. If theestate tax encourages people to spendtheir money while they are alive, it exac-erbates inequality in living standards(McCaffery, 1994).

Horizontal Equity

While progressivity issues focus on thetreatment of those with higher income orwealth relative to those with less, horizon-tal equity focuses on how “equals”—dif-ferent households with the same incomeor wealth—are treated relative to eachother. The estate tax raises many difficultissues along these lines.

For example, opponents claim that theestate tax inequitably burdens familiesthat are altruistic relative to those who areselfish, and punishes those who are un-willing or unable to engage in sophisti-cated tax planning to avoid the tax. To besure, the estate tax is a tax on one way todispose of one’s wealth, passing it alongin financial form to one’s chosen heirs.Comparing two families of the same (con-siderable) means, this tax will not burdenthe one that chooses to spend every pennyon themselves, or even the family thatgives it away to charity, but burdens onlythose families that pass their good fortunealong to their own. Edward McCaffery(1994) stresses this “horizontal” inequity


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of the estate tax. Clearly, from the perspec-tive of the decedent, it does seem to vio-late principles of equity to single out fami-lies that are generous to their own chil-dren.

The perspective, however, is crucial tothis argument. From the perspective of thenext generation, inheritance provides anadvantage to some rather than others.Supporters of the tax claim that advan-tages so derived are unearned and unfair.They claim that inheritances provide largebenefits to people who may not have dem-onstrated any other “skill” than that ofchoosing affluent parents. They argue thatthis seriously distorts notions of equalityof opportunity, and is detrimental towidely shared notions of fair play. In re-sponse, opponents of the tax would arguethat these notions of fairness need not beuniversally shared, and in any case, dif-ferences in inheritance contribute only asmall amount to overall differences inwealth inequality.

A second line of debate concerns paren-tal versus societal rights regarding the in-stitution of inheritance. Opponents of thetax argue that parents should have unlim-ited rights to pass along wealth to theirchildren. They note that other forms oftransfers—investing in human capital,providing social contacts and networks,bringing kids into a family business, giv-ing gifts of up to $10,000 per year, etc.—are tax–free and question why transfersat death should be treated differently. Sup-porters of the estate tax agree that largetransfers can already be made tax–free andconclude that the ability to provide ad-equately—indeed, generously—for one’soffspring is not hampered by transfertaxes. But they see a need to level the play-ing field—or at least to limit the tilt—among the recipients of inheritances, for

reasons of equity. Stelzer (1997) also notesthat putting limits on the use of personalproperty is a natural, continuing, and ap-propriate role for society to play. Othershave argued that inheritance is a civicright, not a natural right, so governmenthas not only the discretion but the dutyto regulate such activity.

A third set of horizontal equity issuesrelates to the treatment of married versussingle taxpayers. Bequests to survivingspouses are not only deductible from tax-able estate, they also enjoy the benefits of“basis step–up” for assets with capitalgains. This provides an added benefit toa married couple with a given amount ofwealth relative to two single people withthe same amount of wealth as the mar-ried couple. This marriage bonus has toour knowledge never been measured, butcould potentially run in the millions ofdollars for some wealthy families.

These fairness issues hinge to a signifi-cant extent on value judgments, fairnessbeing always and everywhere “in the eyeof the beholder.” As a result, it is quitedifficult to resolve these issues analyti-cally, and even more difficult to do so in apolitical arena.

EFFICIENCY ISSUES

A tax has an efficiency cost to the ex-tent that it causes people and firms tomake choices different than what theywould have made in the absence of taxes,income effects and externalities aside.From this perspective a uniform tax on (orat) death is a highly efficient lump–sumtax, given the inevitability of death.18 Theestate and gift tax, however, is not a taxon death per se, but on wealth transferred(other than to spouses or charities) dur-ing life and at death, so the relevant be-

18 The timing of death may be somewhat sensitive to financial considerations. Kopczuk and Slemrod (2000b)investigate the timing of deaths around major changes in the estate tax and find some evidence that the date of(reported) death is prolonged into the period after a tax reduction. They also report data suggesting that thetiming of death may be sensitive to major personal or societal events.


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havioral responses concern the accumu-lation of wealth, to whom that wealth istransferred, and what avoidance mea-sures are taken to reduce the tax burden.

Pure Efficiency Considerations

Does an estate tax create greater orlesser distortions per dollar of revenueraised than other taxes?19 Optimal taxtheory indicates that, on pure efficiencygrounds, taxes should distinguish amongthe different uses of labor income only tothe extent that the uses are more or lesscomplementary to leisure, which is un-taxed. Taxing complements of leisure at ahigher rate than other goods reduces theinefficiency created by the inability to taxleisure. The income tax distorts the life-time leisure–consumption choice,whereas the estate tax distorts the lifetimeconsumption–inheritance choice. Kaplow(forthcoming) argues that in the absenceof any evidence about the relativecomplementarity of lifetime consumptionversus inheritances with respect to leisure,there is no place for an estate tax in anoptimal tax structure that is based solelyon efficiency considerations. This simple,but powerful, conclusion, however, maybe affected by at least three considerations:the trade–off between equity and effi-ciency, the motivation for transfers, andavoidance technology for estate taxes. Weconsider the first two in this section, andthe third in the following section.

Trade–offs Between Equity and Efficiency

Optimal tax analysis may incorporateconsiderations of equity as well as effi-ciency, and the trade–off between the two.As discussed above, the burden of the es-tate tax appears to be extraordinarily pro-gressive. Thus, a model of optimal taxa-

tion that trades off the net benefits of dif-ferent taxes on both efficiency and equitygrounds would show that the estate taxcan be part of an optimal tax system evenif its marginal efficiency cost exceeds thatof other, less progressive, taxes.20 In itssimplest form, the marginal efficiency costis the ratio of the marginal revenue col-lected in the absence of behavioral re-sponses to the marginal revenue collectedin the presence of whatever behavioralresponses occur. Note, though, that theefficiency cost of the estate tax should cer-tainly not be ignored. For example, if theestate tax distorted behavior but raised norevenue (as alleged by Bernheim (1987)and Feldstein (2000)), the marginal effi-ciency cost would be infinite and the es-tate tax would certainly not be part of anoptimal tax system.

The Role of Transfer Motives

In assessing the efficiency costs of tax-ing, for example, gasoline, we would in-quire into how the tax affected demandfor gasoline and other goods, includingleisure. We would not ordinarily need todwell on why anyone buys gasoline, ex-cept to the extent that doing so providedinsights into the relevant elasticities of de-mand. Why people leave bequests,though, affects the efficiency costs of theestate tax, because it affects the behavioralresponse to the tax (see Gale and Perozek,forthcoming) and the presence of exter-nalities in giving (Kaplow, forthcoming).

The simplest “motive” for transfers isnone at all. Consider the special case ofno bequest motive coupled with an im-perfect market for annuities. In this case,there are “unintended” bequests. An es-tate tax would have no substitution effecton the donor ’s behavior (because itchanges the relative price of something the

19 See Slemrod (forthcoming) for a formal model.20 Slemrod and Yitzhaki (1999) show formally the relationship between the progressivity of a tax’s burden and

the maximum efficiency cost it can have to be part of an optimal tax system.


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individual places no value on). Nor doesit have any income effect, for the samereason. Thus, the donor’s consumptionand wealth at any time are unaffected. Theabsence of substitution effects implies thatthe tax revenue is collected without pro-ducing any excess burden, as would betrue under a lump–sum tax. But, unlike alump–sum tax, the estate tax in this casealso does not make the donor worse off.This makes such a tax look “super–effi-cient,” as it produces revenue for the gov-ernment without hurting the donor. Ofcourse the potential inheritors will beworse off because of the tax take, as dis-cussed below.

Although some bequests are undoubt-edly “unintentional,” others are undoubt-edly motived by altruism, whereby thedonor places a value on the inheritors’well–being. Kaplow (forthcoming) arguesthat altruism creates a positive external-ity for gifts and bequests, because thetransfers have value to both the donor—which the donor considers in determin-ing the size of the bequest—and to therecipient. As with any positive external-ity, ceteris paribus gifts and bequests willbe underprovided, leading to an argu-ment for a subsidy, rather than a tax.

This model, however, has a surprisingimplication. It implies that in some cir-cumstances a social planner would favora policy that reduces the consumption ofall generations, if more of the consump-tion is financed by inheritances! The posi-tive externality of the transfer process off-sets the fact that everyone in the extendedfamily actually has less resources to spendon the things they value (other than giv-ing to others). This result is due to the joyof giving model. In a pure altruism model,the result would not arise because ances-tors care about the utility of their descen-dants but not about giving per se.

A related model combines parental al-truism and opportunistic behavior on thepart of children. This gives rise to a“Samaritan’s Dilemma:” if the parent isaltruistic toward the child, and the childknows that, the child has incentives tobehave in ways that are counter to theparent’s overall interest. For example, thechild would have incentives to overcon-sume when young in order to elicit alarger bequest from the parent. In thiscase, it is possible that the estate tax hassome welfare–improving properties. Bymaking it more difficult for the parent totransfer resources to the child, the taxhelps offset the distortion created by theSamaritan’s Dilemma in the first place (seeGale and Perozek, forthcoming).

Finally, bequests may be payment forservices provided by potential inheritors,and these inheritors may be strategicallyplayed off against each other by the do-nor. In this case, bequests are simply pay-ment for goods and services purchasedfrom the child, and the estate tax is simi-lar in nature to the gasoline tax mentionedabove. A relevant consideration is the elas-ticity of parents’ demand for such services.If the elasticity of demand is very low—which could occur if there are not goodsubstitutes for a child’s love and atten-tion—then the optimal estate tax ratewould be higher than otherwise. But thefull efficiency implications in this contexthave not been worked out.

Thus, the efficiency implications of es-tate taxes are unclear and will depend onmotives for transfers, which likely varyacross givers and types of gifts.21 Onepotential way out of these problems, sug-gested by Kaplow (forthcoming) is towork toward identifying particular typesof gifts (for example, to children, to char-ity, to unrelated individuals) that appearlikely to be motivated by a particular con-

21 There are other interesting and unexplored efficiency issues. For example, compared to an equal present valueincome tax, the estate tax serves as an annuity. In the presence of imperfect private markets for annuities, thismight improve welfare.


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sideration (for example, altruism, joy ofgiving, exchange) and then apply the ef-ficient tax, given the transfer motive.

Administrative Issues

Simplicity, avoidance, and evasion arecentral features of the analysis of estatetaxes. On the one hand, death is very likelyto provide a convenient “tax handle.” Thepublic nature of the probate process re-veals information about assets that maybe difficult to obtain in the course of theenforcement of other taxes, but that nev-ertheless may be relevant for societal no-tions of the appropriate level ofprogressivity. This administrative aspectof taxation of death likely explains whyinheritance and estate taxes date back forcenturies.

On the other hand, critics argue that oneof the tax’s main effects is to spawn a hostof avoidance schemes that are sociallywasteful and erode the potential revenueyield. In that vein, Cooper (1979) labeledthe estate tax a “voluntary” tax. Bernheim(1987) argued that the revenue yield, netof the avoidance schemes it induced, wasapproximately zero. Although many ofthe avoidance schemes that Cooper andBernheim discussed have been closed offor otherwise mitigated by subsequent leg-islation, others (bordering, frankly, on theabusive) remain (see Schmalbeck, forth-coming). In this section, we examine thecosts of complying with and administer-ing the tax, and the extent and implica-tions of transfer tax avoidance and eva-sion.

Compliance and Administrative Costs

The cost of collecting the estate tax hastwo components. Compliance costs areborne directly by taxpayers as time ormoney spent on tax advice and implemen-tation of tax planning devices, and byclaimants to the estate in complying with

the estate tax itself. Administrative costs areborne directly by the Internal RevenueService (IRS), in operating, monitoring,and enforcing the system.

Estimates of the compliance cost of theestate tax vary enormously, partly becausethe methodologies used range from back–of–the–envelope estimates to method-ologically suspect surveys to more or lessinformed speculation. Munnell (1988) iswidely cited as the source of the claim that“the costs of complying with the estate taxlaws are roughly the same magnitude asthe revenue raised” (Joint Economic Com-mittee, 1998). What Munnell actuallywrote was that the compliance costs “maywell approach the revenue yield.” Hermethodology consists of noting that (in1988 or thereabouts) there were 12,000subscriptions to the practitioner publica-tion Trusts and Estates, noting that a largefraction of trusts are apparently estab-lished solely to avoid taxes, and makingthe following calculation. The AmericanBar Association at the time reported that16,000 lawyers cited trust, probate, andestate law as their area of concentration.Valuing their time at $150,000 per year onaverage and assuming that they spendhalf of their time on estate tax avoidanceyields $1.2 billion, compared to revenuesof $7.7 billion in 1987. To get from $1.2billion to close to $7.7 billion, Munnell re-fers to “accountants eager to gain an in-creasing share of the estate planning mar-ket,” financial planners and insuranceagents who devote a considerable amountof their energies to minimizing estatetaxes, and the efforts of the individualsthemselves. Munnell concludes that theavoidance costs “must amount to billionsof dollars annually,” but the $1.2 billioncomponent is based on some not unrea-sonable but highly arbitrary assumptions,and the rest of the overall compliance costestimate is a hunch and no more. It is alsoworth noting that the estimate is 13 yearsout of date, and during that period estate


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tax revenues have risen dramatically.Thus, even if compliance costs at thatpoint were almost equal to revenues, thereis no guarantee that they have increasedat the same rate that revenues have.

Davenport and Soled (1999) adopt adifferent but related approach. Based onconsultations with tax professionals aboutaverage charges for typical estate tax plan-ning, they come up with an estimated feeper estate for six different estate sizeclasses, and then apply these estimates tothe number of estate tax returns by cat-egory in 1996. This procedure producesan estimated compliance cost for planningof $290 million, or only about 2 percent ofthe $14.5 billion collected in 1996. After aseries of fairly ad hoc adjustments for suchfactors as the number of nontaxable dece-dents that do tax planning and that taxplanning may have to be repeated as thetax law changes, they come up with a fig-ure of $1.047 billion for planning costs in1999. To this they add $628 million for es-tate administration costs, based on takingone–half of the total lawyers’ fees andother costs reported on estate tax returns,and reducing that number by 45 percentto reflect the tax deductibility of the costs.(Note that the last reduction is inappro-priate if one is measuring the social, ratherthan private, costs of the activity.) The sumof their estimates for planning and estateadministration come to $1.675 billion in1999, or about 6.4 percent of expected re-ceipts. They allocate another 0.6 percentof revenues for the administrative costsof running the activities of the IRS relat-ing to estate taxes, for a total cost of col-lection estimate equal to 7.0 percent of rev-enues.

The Davenport–Soled (DS) estimate ismore recent and more detailed thanMunnell’s estimate. Although both esti-mates require a set of somewhat arbitraryassumptions, it is difficult to see how thebasic DS methodology could be re–donewith an alternative set of reasonable as-

sumptions and yield anything close toMunnell’s figure.

The estimates above—based on suppli-ers of estate tax avoidance techniques—produce a huge range of collection costs.Another approach would be to survey thedemanders of the service, the wealth own-ers. This approach has been employedwith some success for the U.S. individualincome tax (Slemrod and Sorum, 1984;and Blumenthal and Slemrod, 1992), andfor the U.S. corporation income tax(Blumenthal and Slemrod, 1996). As apoint of comparison, based on such stud-ies, Slemrod (1996) concludes that the col-lection cost of the U.S. individual and cor-porate income tax comes to about 10 per-cent of the revenue collected.

Unfortunately, no reliable and compre-hensive survey research has been carriedout for the estate tax. What does exist ap-plies only to businesses and may be con-sidered suspect. Astrachan and Aronoff(1995) surveyed businesses in the distri-bution, sale, and service of construction,mining, and forestry equipment industry,and separately surveyed businessesowned by African–Americans. Each ofthese are very special and smallsubsamples of the estate tax population,and the methodology employed, is wor-risome on a number of dimensions. Forexample, the authors include as a cost ofavoidance the amount spent on insurancepremiums to provide liquidity for payingthe estate tax. This expense is properlythought of as pre–paying the tax liability,and to consider it as a cost in addition tothe tax liability itself is surely inappropri-ate double counting.

Based on a survey of 983 of all types offamily businesses, but still restricted tofamily businesses, Astrachan andTutterow (1996) conclude that family busi-ness owners have average expendituresof over $33,000 on accountants, attorneys,and financial planners working on estateplanning issues; family members aver-


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aged about 167 hours spent on estate plan-ning issues over the previous six years (thetime frame for the dollar expenditures isnot made clear). However, this survey in-cludes as a compliance cost the prepay-ment of estate tax liabilities via life insur-ance, which is problematic for reasonsnoted above. In addition, an unknownfraction of the remaining costs is due toestate planning, inter alia aboutintergenerational succession of the busi-ness, that is unrelated to taxation. Repetti(2000), while corroborating in surveys ofestate tax attorneys the broad magnitudeof the Astrachan and Tutterow results,argues that in fact part or much of thesecosts would likely be incurred regardlessof whether there was an estate tax.

Thus, there is some evidence on thecosts of estate planning for small busi-nesses, but the estimates are marked byconceptual problems and disagreementabout what fraction of costs due to theestate and gift tax as opposed to non–taxfactors or other taxes. For the broaderpopulation, there is no informative evi-dence from surveys of wealth owners.

Extent of Avoidance and Evasion

Estimating the extent of (legal) avoid-ance and (illegal) evasion is difficult.Wolff (1994) and Poterba (2000) attemptto do so by comparing tax revenues andthe distribution of estates reported on taxforms and similar statistics calculatedfrom a procedure that estimates theseitems using data on individuals’ mortal-ity probability and wealth measured inthe Survey of Consumer Finances. Be-cause of a number of methodological dif-ferences, they reach vastly different con-clusions, with Wolff finding that the es-tate tax catches only about 25 percent ofthe potential tax base, and Poterba con-cluding that it catches nearly all of it.Eller, Erard, and Ho (2000) point out thatany such exercise is highly sensitive to a

few essentially arbitrary assumptionsabout the allocation of deductions andcredits, the differential mortality of mar-ried and unmarried individuals, and thetreatment of the first spouse in a coupleto die.

For obvious reasons, coming up with adirect estimate of the extent of evasion isproblematic, to say the least—surveys areunlikely to work in this situation! Note,though, that audit coverage of estate taxreturns is relatively high. According toEller and Johnson (1999), in 1992 19 per-cent of estate tax returns filed (not all ofwhich were taxable) were audited. Theaudit rate rose with the size of the grossestate, with 11 percent of estates below $1million being audited, rising to over 48percent for estates over $5 million. Be-cause of the concentration of audits on thelargest estates, the audits covered returnswith 63 percent of the reported tax liabil-ity.

Eller, Erard, and Ho (forthcoming)show that 60 percent of audited estates in1992 resulted in an additional positive as-sessment, 20 percent resulted in no changein tax liability, and 20 percent resulted ina reduced tax bill. Extrapolating from theresults of a sample of those estate tax re-turns that were audited, Erard (1998) es-timated overall evasion to be 13 percentof the potential tax base, which is slightlylower than the estimated tax gap for theincome tax.

Implications of Avoidance and Evasion

What are the implications of avoidanceand evasion for the equity and efficiencyof the estate tax? As to equity, certain op-ponents of the estate tax have asserted thatthe nature of the avoidance and evasionis such that it renders the tax burden re-gressive, at least within the highly wealthycategory of those subject to the tax. Forexample, consider the following passagefrom JEC (1998, p. 31):


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“One way to measure vertical equity is tocompare the average tax rates for differ-ent income or asset levels. Based on thiscriterion, the estate tax does not exhibitvertical equity. According to IRS data, theaverage estate tax rate for the largest es-tates (gross estate over $20 million) is ac-tually lower than the average tax rate forestates in the $2.5 million to $5 millionrange.” (Italics in original)

It is true that for estate tax returns filedin 1997, the ratio of net estate tax to grossestate was lower for the over $20 millionestate tax class (11.8 percent) than for the$2.5 to $5 million class (15.0 percent).22 Butthis apparent anomaly in the face ofgraduated tax rates occurs for two reasonsthat are certainly not related to evasion orto any sophisticated tax planningschemes. First, charitable deductions arelarger as a fraction of gross estate for thehigher wealth group, 28.4 percent versus5.7 percent (see Table 3). Second, the creditfor gift taxes already paid and for statedeath taxes paid are larger for the higherestates, 5.6 percent versus 3.3 percent.

What are the implications of avoidanceand evasion for efficiency? First, adminis-trative costs and compliance costs are partof the resource cost of collecting the tax,to be added to the costs of distorting be-havior referred to earlier. A more intrigu-ing but more difficult question is to whatextent the avoidance and evasion oppor-tunities mitigate the disincentive effectsthe tax would otherwise cause. Opponentsclaim that the tax is both easy to avoid anda serious deterrent to wealth accumula-tion. At first glance, these argumentssound inconsistent: if it is so easy to avoid,why does the tax hurt wealth accumula-tion? As Slemrod (forthcoming) shows,however, these two claims need not belogically inconsistent. Whether they aredepends on the nature of the avoidance

technology. If greater wealth lowers thecost of a given dollar amount of avoidance,then the availability of avoidance does re-duce the effective disincentive to accumu-late wealth that the estate tax would oth-erwise cause. If, alternatively, the cost of agiven dollar amount of reduction in thetaxable estate is independent of wealth,then the disincentive is unaffected by theavoidance opportunities. To answer thisquestion, one would need to examine thepricing structure of various estate plan-ning devices, as Schmalbeck (forthcoming)begins. His discussion suggests that theavoidance technology often features afixed fee for an avoidance device that re-duces the effective tax rate on an unlim-ited amount of wealth that is passedthrough the device. This reduces the ef-fective marginal tax rate on wealth accu-mulation above the level that makes thefixed cost of using this device worthwhile,and therefore reduces the effectiveprogressivity of the estate tax system.

Just as there is heterogeneity in bequestmotives, there is certainly heterogeneity inthe vigor with which people pursue taxavoidance opportunities. There are un-doubtedly people who maximize the af-ter–tax bequest, while at the same timethere are many others who do not pursueeven the most basic tax planning strategies.Poterba (1998) has documented that mostwealthy people do not take advantage ofthe annual $10,000 per donor, per recipi-ent exemption for inter vivos gifts. Thereare several plausible explanations for atleast part of the lack of giving, includingprecautionary motives among donors. Butthe low level of giving may also be due topeople finding it uncomfortable to contem-plate their own demise. In this case, thelimited response of inter vivos gifts may bean indication that the revenue leak, andtherefore the efficiency costs, are not aslarge as they might otherwise be.

22 These figures refer to all returns filed, and not just those that were taxable.


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EFFECTS ON SAVING AND LABORSUPPLY

Combined with the income tax, themarginal tax disincentive to work andsave created by the estate tax for the af-fluent can be exceptionally high. The topfederal income tax rate of 39.6 percent,combined with the top estate tax rate of55 percent, implies a tax penalty per dol-lar earned with the intent to bequeath ofup to 73 percent. Nevertheless, the impactof the tax on saving and labor supply iscomplex. Indeed, several prominenteconomists (including John Stuart Mill,A.C. Pigou, Richard Musgrave, and Jo-seph Pechman) have argued that taxespayable at death have smaller disincen-tive effects for lifetime saving and laborsupply than do equal–revenue taxes im-posed during life.

Saving

There are few formal models of estatetaxes and saving. Kotlikoff and Summers(1981) estimate that a one dollar declinein gross transfers reduces the capital stockby about 70 cents, but they do not esti-mate how transfer taxes affect gross trans-fer levels. Caballe (1995) develops an al-truistic model with endogenous growth,human capital, and bequests and findsthat estate taxes reduce the capital stock.A feature of his model, however, is thatestate taxes and capital income taxes haveidentical effects, which appears to besomewhat of a special case. Laitner (forth-coming) provides the most sophisticatedmodel of estate taxes to date, embeddingthem in an overlapping generations simu-lation model. He finds that removing es-tate taxes would have a small positive ef-fect on the long–term ratio of capital tolabor.

Gale and Perozek (forthcoming) de-velop a theoretical model of a parent andchild interacting under a variety of alter-

native transfer motives. They show thatthe qualitative effects of estate taxes onsaving depend on why donors give be-quests or accumulate wealth, on whetherthe effect on the donor is considered, andon how the government disposes of therevenue. In this framework, estate taxescan raise the combined saving by the do-nor and recipient under several differenttransfer motives.

Indirect evidence on the impact of es-tate taxes on saving from analyses of theeffects of income taxes on saving is relevantand the bulk of the evidence suggests thatthe effect is small. Estate taxes are leviedat higher rates, which might suggest alarger effect. But they are also levied atmore distant points in the future, suggest-ing smaller effects. In any case, direct evi-dence of the effects of estate taxes issparse.

Kopczuk and Slemrod (forthcoming),using estate tax return data from 1916 to1996, explore links between changes in theestate tax rate structure and reported es-tates, which reflect the impact of the taxon both wealth accumulation and avoid-ance behavior. They find that an aggre-gate measure of reported estates is gener-ally negatively associated with summarymeasures of the level of estate taxation,holding constant other influences. Inpooled cross–sectional analyses that makeuse of individual decedent information,the relationship between the concurrenttax rate and the reported estate is, how-ever, fragile and sensitive to the set of vari-ables used to capture exogenous tax ratevariation. However, the negative effect oftaxes appears to be stronger for those whodie at a more advanced age and with awill, both of which are consistent with thetheory of how estate taxes affect altruisticindividuals. Perhaps of most interest, thetax rate that prevailed at age 45, or tenyears before death, is more clearly (nega-tively) associated with reported estatesthan the tax rate prevailing in the year of


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death. This suggests that future researchshould concentrate on developing lifetimemeasures of the effective tax rates.

All of the above discussion focuses onsaving by the donor. Weil (1994) showsthat the past or anticipated receipt of aninheritance raises a household’s consump-tion by between 4 and 10 percent, aftercontrolling for income, age, education,and other factors. Given the magnitudeof typical household saving rates, Weil’sresults suggest that reduced inheritancesdue to estate taxes would substantiallyraise the donee’s saving out of earned in-come. However, Holtz–Eakin, Joulfaian,and Rosen (1994a, 1994b) show that re-ceipt of a large inheritance raises the like-lihood that a household starts a businessand raises the probability of the businesssurviving and expanding. Thus, to theextent that inheritances relieve liquidityconstraints associated with investment,reduced inheritances due to estate taxescould reduce saving among recipients.However, only a small minority of inheri-tors inherit or start businesses.

Labor Supply

As discussed earlier, the estate tax iseffectively a tax on one use of labor in-come, and so reduces the real wage. Thenumerous studies of how taxes affect la-bor supply, which generally find that theaggregate substitution effect is rathersmall, are therefore relevant. However,with one exception no one has attemptedto directly measure the impact of estatetaxes on the labor supply of potential do-nors. Holtz-Eakin (1999), using a surveyof business owners in New York State,finds that those facing higher estate taxrates work less. This could be a reflectionof the estate reducing labor supply, or—in our view more likely—may simply re-flect the fact that leisure is a normal good

and households that face higher estate taxrates have higher wealth.

There has been more fruitful work onthe impact of inheritances, and by impli-cation the effect of any change in inherit-ances caused by the estate tax, on aspectsof labor supply. Holtz–Eakin, Joulfaian,and Rosen (1993) show that receipt of aninheritance of $350,000 reduces labor forceparticipation rates by 12 percentage pointsfor singles and reduces the likelihood ofmarried couples having two workers by14 percentage points. Holtz–Eakin,Joulfaian, and Rosen (1993) and Joulfaianand Wilhelm (1994) find small reductionsin the labor supply of inheritors who re-main in the labor force.

CONCLUSION

The political process that brought us themodern estate tax in 1916, changed itnumerous times since then, and is nowflirting with abolishing it could hardly bedescribed as delivering an optimal taxsystem, in the sense economists use theterm—maximizing a well–defined objec-tive function subject to revenue require-ments and taxpayer responses. But the rig-orous analysis that this frameworkprovides is a major contribution of theeconomics of public finance of the lastthree decades. The framework clarifiesthe tradeoffs that are inherent in taxpolicy decisions, illuminates what valuejudgments—about which economicshas no say—are involved, and identifiesthe crucial conceptual and empirical is-sues.

Alas, the political process is not goingto wait for an academic consensus to arise,but that is not an excuse to avoid pursu-ing these issues. So we close with a pleafor more rigorous investigation of thisquestion23 and a sketch of the role of es-tate taxes in such a system.

23 For a good start, see Kaplow (forthcoming).


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The current U.S. estate and gift tax isthe most progressive weapon in the arse-nal of federal taxes. It is also levied on abase closely related to a family’s wealthaccumulation, arguably the most essentialseed of economic growth. It is about lifeand death matters, and the tradeoff be-tween equity and efficiency that infusesall of tax policy. But the estate tax is notthe only progressive tax instrument—thegraduated income tax has been aroundjust as long as the estate tax, and nowraises significantly times as much rev-enue. Nor is it the only possible transfertax; many countries and U.S. states haveinheritance taxes instead of estate taxes.

At least three issues are relevant for theoptimal role and form of transfer taxes.First, the income tax is imperfect—e.g.,much income in the form of capital gainsis never taxed—and transfer taxes canfunction as a backup in deliveringprogressivity. Second, the public nature ofthe probate process reveals informationabout the lifetime well being of familiesthat is useful in achieving the desired de-gree of progressivity in the least costlyway. Third, transfer taxes could be im-posed on estates or inheritances, whichmight have differing effects. Theseissues can be formalized in a model ofoptimal tax systems described in Slemrod(1990) and laid out in Mayshar (1991), andmust be quantified using empirical infor-mation on such things as the response ofsaving to estate tax levies. Although thepolitical process regarding the estate taxis now moving quickly, a long–term chal-lenge for the academic community is toclarify our understanding of the role oftransfer taxes in the public finances of thiscountry.

Acknowledgments

We thank Ben Harris and Pete Kimballfor research assistance. We gratefully ac-knowledge helpful comments from a largenumber of colleagues.

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