The estate tax has been a fixture of the federal tax system for more than ninety years, enhancing the progressivity of the U.S. tax system and promoting opportunity. Demands to change the estate tax and to restructure it to be applied more equitably have risen in recent years, with the upcoming 2010 hiatus a unique opportunity to examine anew the estate tax.
An inheritance tax, rather than an estate tax, would equalize the treatment of gifts made during life and of bequests made at the time of death by taxing cumulative lifetime inheritances in excess of $2.3 million at an heir’s income tax rate plus 15 percentage points. This approach would make the tax system better attuned to an heir’s ability to pay and would encourage broad sharing of wealth, because donors could lower the overall tax burden on their estates by giving more broadly and to those more in need.
The repeal of the estate tax for one year only in 2010 creates vast uncertainty but also provides an opportunity to reconsider the taxation of gifts and bequests. This paper proposes replacing the estate tax with an inheritance tax. Heirs receiving lifetime inheritances greater than $2.3 million would include in income and pay a 15 percentage point surtax on the excess. The proposal would also replace stepped-up basis with carryover basis for bequests. As under the estate tax, the fraction of heirs affected would be miniscule, falling from three to two in 1,000.
The proposal has a number of advantages relative to the estate tax. It would reward donors who give more broadly. It would enhance efficiency and reduce compliance costs by curbing tax planning and the rules needed to contain it. Cross-national experience also suggests it would be administrable. Most importantly, the proposal would lower taxes on heirs receiving smaller inheritances and those with moderate incomes, making the tax system better attuned to unearned advantage and ability to pay. At an individual level, the distribution of tax burdens would change considerably: only 5 percent of the estate tax rate for an heir is accounted for by her inheritance tax rate, and vice versa, and each tax would raise 14 percent of revenue from heirs facing no tax burden under the other. The proposal is revenue-neutral relative to 2009 law. A lower exemption would raise more revenue and bring the tax rate on inherited income closer to the income tax rate on noninherited income, which is about three times higher.