“The only things certain in life are death and taxes.” There are few guarantees in life, but these are two of them; you will die at some point (hopefully, not soon), and you will have to pay taxes. Of course, with such inevitability, it was only a matter of time before someone decided to tax death. (Or rather, the money left behind after someone dies; after all, as another old saying goes, “You can’t take it with you when you die.”)
The ‘Death Tax’ Explained
There are actually two different types of taxes that are commonly called ‘Death Taxes’: inheritance taxes and estate taxes. To understand the difference, let’s consider a hypothetical example. Your great, great uncle Jedidiah dies, leaving a large fortune (let’s call it $10 million dollars) in his estate, a goodly amount of which is going to you (let’s say that old Jedidiah left you one tenth of his final estate). Of course, such a fortune is high enough to be taxed; the taxes could be taken in one of two ways:
Estate Taxes: Jedidiah’s entire $10 million estate could be subject to taxes, taking a substantial portion of the money in the estate before the money is disbursed to you or any other beneficiaries. Essentially it’s a ‘tax’ on the whole ‘estate’ (witty, no?) Since Jedidiah is gone, it falls to whomever is administering the estate, and there is usually a single rate applied to the entire estate after any exceptions or allowances are applied.
Inheritance Taxes: In this case, Jedidiah’s fortune isn’t taxed, but the amount that you receive IS taxed. If the entire $10 million dollar estate is disbursed, your share ends up being $1 million, on which the tax ends up being levied. Inheritance taxes also can differ according to whom is being taxed, with direct lineal relatives being taxed the least and non-relatives facing the greatest tax rates.
There are numerous similarities between the two taxes; both types usually exempt transfers to a surviving spouse as well as charitable contributions, for example. (The federal government only levies an estate tax, although some states tax inheritances.)
Also, it’s probably worth noting gift taxes, taxes designed to limit the amount of money transferred from one person to another while they are both still alive. A major reason that such taxes exist is so that Jedidiah (or other persons of means) can’t give away all their money before they die in order to avoid estate or inheritance taxes, which is one reason why they are frequently grouped together in legislation.
This year is a bit odd; for 2010 (and only 2010, barring any Congressional changes to the current policy) the federal estate tax has been repealed. It’s scheduled to make a come back in 2011, meaning that this year is likely to have some debate over whether it’s better to allow the tax to reinstate or eliminate it permanently.
The Cons and Pros of Estate and Inheritance Taxes
If you’re a long time reader of The Amateur Financier (or any personal finance publication), you probably realize that there’s going to be some argument of whether these taxes are good or bad. For a change of pace, let’s start with the cons first:
-Inheritance or estate taxes may reduce the incentive to save. If Jedidiah knows that up to half of his fortune will go to the government rather to his heirs, he might not make as much effort to gain more money. Essentially, it’s the same argument against excessively high income taxes; if the tax rate is too high, the amount of income (or bequest) needed to get a net increase isn’t worth the time and effort.
-These taxes are also a form of double taxation; every dollar that gets passed onto your beneficiaries must have been earned and taxed already, so the estate and inheritance taxes are at least the second round of taxes to which the estate is subject.
-The tax adds to the complexity of the tax code. As with any type of additional tax, there’s added paperwork and red tape to go through. Add in the numerous ways people try to avoid the tax (by giving away their fortunes, for example) and the counter measures the government adapts (like the aforementioned gift tax), and soon the tax code gains another few volumes.
-Lastly, the argument is made that death is not the appropriate time to be collecting taxes. The term ‘death tax’ that’s frequently attached to these types of taxes is used by many opponents to emphasize the improper timing of such taxes (and arguably, the wrongness of the tax in general).
That’s quite a list of arguments opposing inheritance and estate taxes. Of course, if those were the only arguments, these taxes would already have been repealed. Let’s see what’s the proponents of keeping such taxes have to say:
-Since the taxes typically fall only on the wealthiest estates (those in excess of the 1 million dollars as of 2011 assuming that the tax is reinstated), the tax is progressive, only affecting the wealthiest individuals in the country. Many proponents argue that’s it’s a reasonable way to ensure that the overall tax system is progressive as well, preventing the wealthiest individuals in the country from dodging taxes altogether.
-Estate taxes can increase the motivation to accumulate wealth. Though this seems like a direct contradiction of the first ‘con’ above (and it is), the fact is that different people have different motivations and will be affected differently by the existence of an inheritance tax. One wealthy person might be demotivated near the end of their life, not wanting much of their estate to go to the government, while another might look at the tax as an obstacle to be overcome on the way to giving the amount they want to their beneficiaries.
-There’s also an argument made that the estate tax is ‘fairer’ than many other types of taxes. Since it’s levied after the person who originally earned the money is deceased, taking money from heirs who didn’t materially contribute to earning it seems more justified. (Opponents of the tax would argue that the government has no more (and probably less) claim on the money than do the heirs.)
-A final justification for the estate tax is pretty simple; it brings in money to the federal government. The Center on Budget and Policy Priorities puts the ten year cost of eliminating the tax beyond 2010 at $1.3 trillion, money that will have to come from other tax revenue or be eliminated from spending (or, given how our government tends to handle such situations, just added to the deficit).
With so many different aspects to the estate tax, both in favor and opposed, it’s hard to make a blanket statement about whether it’s better to keep it repealed or reinstate it. Not that will stop any number of commentators (myself included). Personally, I’m inclined to think that the good outweighs the bad, although I’m betting I’m missing part of the story.