It is the Estate Tax Rate That Matters

Everybody pays for reduced entrepreneurial activity

MarketWatch
By Harvey S. Rosen, ACCF Scholar
June 8, 2006

(PDF)

This week, the U.S. Senate is expected to turn its attention to the Federal estate tax.

Under current law, the estate tax is being phased out, with repeal set for 2010. But then in 2011 the old law is scheduled to be restored, with marginal tax rates that can exceed 50%. The old law was capricious, complex, and inefficient -- bringing it back to life in 2011 would be bad policy.

Arguments that high estate tax rates make the U.S. tax code more progressive are problematic.

While the first-best policy response would be to make repeal permanent, this option appears to be politically infeasible. An interesting alternative proposed by Senator Jon Kyl, R-Ariz., would make the estate tax rate permanent at 15%, increase the exemption level to $5 million, and include step-up in basis.

As the debate on Senator Kyl's and other options moves forward, it is important to focus on keeping the rate of the tax low because of the negative consequences that a high rate has on the economy.

First, a high estate tax rate has a detrimental effect on the behavior of individuals in their roles as entrepreneurs. People with large estates are disproportionately owners of small businesses -- Douglas Holtz-Eakin, former director of the Congressional Budget Office and Donald Marples (GAO) estimate that entrepreneurs are three times more likely to be subject to the estate tax than portfolio investors. The estate tax in effect reduces the returns to entrepreneurs' investments. Thus, the estate tax increases the "user cost of capital" -- the rate of return that an investment must make in order to be profitable. The higher the user cost of capital, the lower the number of profitable investments available to the entrepreneur.

According to the U.S. Treasury's Office of Tax Analysis, the estate tax leads to an increase in the tax rate of between 4.5 to 9%. Research on entrepreneurial decision making that I published with several colleagues suggests that a 5 percentage point increase in marginal tax rates leads to a 9.9% decline in investment by entrepreneurs. So, if we take the 4.5% tax increase at the low end of the Treasury's range, the implied decrease in entrepreneurial investment is 8.9%. Using the 9% tax rate at the top of the Treasury's range, the decrease in capital accumulation by entrepreneurs is 17.8%.

In short, changes in the user cost of capital induced by the estate tax have a substantial impact on entrepreneurs' investment spending. Given that entrepreneurial enterprises are an important source of growth and innovation in our economy, this is a very sobering result.

Second, an increase in the estate tax rate would have a negative effect on individual saving rates and wealth accumulation. Research by academic economists suggests that an increase in the estate tax rate of 10% leads to a roughly 14% decrease in net worth. Other serious studies conclude that there would be a substantial increase in saving if the estate tax were eliminated altogether.

Put this together with an observation taught in every introductory course in economics: a smaller capital stock reduces productivity and labor income throughout the economy. The clear implication is that the estate tax reduces incomes for everyone. Because of its negative effect on capital accumulation, the burden of the estate tax is shifted, at least in part, to all workers. In particular, future generations are worse off by virtue of having a smaller capital stock with which to work.

Third, arguments that high estate tax rates make the U.S. tax code more progressive are problematic. The basic assumption is that the burden of the estate tax falls entirely on the decedent -- the rich dead guy takes the entire tax hit. This assumption is natural because, by law, the decedent's estate is responsible for paying the tax. However, it reflects an approach that the economics profession has rejected for at least a century. Who bears the burden of a tax depends on the underlying economic fundamentals, not on who writes the check to the IRS. When the government levied a special tax on yachts, for example, the burden fell not only on the owners of yachts, but also on the individuals who produced and serviced them. Applying the same kind of logic in this case, the most likely scenario is that the decedent will not bear the burden of the tax. Rather, he or she will simply leave a smaller bequest, because the estate tax makes wealth accumulation (saving) less attractive.

Thus, the argument made by estate tax proponents that increasing the exemption will enhance progressivity is flawed. Whatever the size of the exemption, some entrepreneurs will be hit by the tax and scale back their investments. Other individuals will simply save less. In both cases, the result is the same: workers are worse off. Any estate tax that is big enough to collect substantial revenue is also big enough to have a substantial negative effect on saving and the economy.

In conclusion, although increasing the exemption for the estate tax while retaining a high rate might appear to enhance the progressivity of the tax system, this is not likely correct. True, the typical worker has little reason to know that her weekly paycheck is smaller because of the estate tax. She may never realize that part of the burden of the tax falls on her. But conventional economic analysis suggests that these subtle, indirect effects are real, and critical to understanding the ultimate burden of the tax. As the debate on increasing the estate tax exemption moves forward, policymakers should understand that the putative progressivity of such a step is likely illusory and that reducing the rate would benefit the economy.

Harvey S. Rosen is the John L. Weinberg Professor of Economics and Business Policy at Princeton University and former Chairman of President Bush's Council of Economic Advisers.