A strong estate tax will ensure equal treatment of wealth and wages

Inequality has increased tremendously over the past few decades as the wealthiest households continue to accumulate gains while stagnant wages for middle- and working-class Americans see an ever-diminishing slice of a growing pie.

A significant portion of this situation can be attributed to the steady erosion of our tax code over the past few decades. Of the trillions of dollars in tax cuts enacted over the last 18 years, an estimated 65 percent have gone to the top 20 percent of households, and nearly a quarter has gone to the top 1 percent.

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Of the more egregious cuts, significantly weakening the estate tax — a levy on very wealthy estates — stands out as a blatant giveaway to the wealthiest Americans. 

Before the Tax Cuts and Jobs Act was passed in December 2017, the estate tax affected fewer than 0.2 percent of the wealthiest estates — about 5,000 estates per year owed any tax out of over 2.5 million deaths.

The 2017 tax plan further weakened this provision by doubling the exemption so that estates worth up to $11 million ($22 million for couples) are exempt from the tax. Now a mere 0.06 percent — roughly 1,800 estates — will face any estate tax liability.

This provision exclusively benefits the very wealthy and is one of many ways that the TCJA tilted the tax code further in favor of those at the top.

There is a fundamental imbalance in how we tax wages and wealth today, and the estate tax is an important tool that could help combat that. An inheritance tax could work as well. Here’s why. 

Without the estate tax, a large portion of assets owned by wealthy Americans would never be taxed at all, even under the income tax. That’s because gains in the value of assets are subject to income tax only when realized, that is, when the assets are sold or transferred.

Wealthy people have an incentive to hold onto assets. They can borrow against those assets, if needed for cash flow, without incurring tax. Later, when heirs inherit those assets, a special rule relieves them from paying up the income tax on the gain that occurred before they took ownership.

The estate tax is supposed to provide a backstop by limiting the amount of wealth that can pass to the next generation tax free. But, because the estate tax has been so watered down, it is no longer effective.

Wealthy family dynasties can pass along large amounts of valuable assets tax free, while working- and middle-class Americans continue to pay both income and payroll taxes on their wages and salaries each year.

One option to prevent a further rise in wealth inequality is to significantly expand and strengthen the estate tax. Currently, the top rate of the tax is 40 percent, but because it only applies to the value of an estate that exceeds the current exemption amounts, the effective tax rate is lower and varies depending upon how large the estate is.

In 2018, it is estimated that estates worth more than $20 million will pay an average estate tax rate of just 17.7 percent. Estates between $10 and 20 million will only pay an average rate of 8 percent, and those under 10 million won’t be on the hook for any tax at all.

Thus, despite talking points from opponents of the tax, small businesses and farms will remain unaffected. In fact, a special provision of the code provides further protection from estate tax for qualified businesses and farms if the property continues to be used for that purpose.

The Tax Policy Center (TPC) estimated that just 80 small business or farms paid any estate tax at all in 2017 before the TCJA took effect.

A stronger estate tax, with a much lower exemption amount and a higher rate on estates exceeding the exemption, would help rebalance the tax code, especially if paired with a rule requiring income tax to be paid up on any untaxed gain before property is transferred to heirs.

A lower exemption would still leave the majority of Americans unaffected. In 2009 when the exemption level was $3.5 million, only 0.23 percent of estates paid any tax at all.

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These changes in the estate tax would generate significant revenue that could be invested in education and infrastructure improvements, which would help make the economy stronger over the long term. 

Another approach would be to simply tax inheritances and gifts in the hands of the recipient, instead of to the decedent’s estate. A person who wins the lottery is taxed on their winnings; so too should someone who is lucky enough to receive an inheritance — especially if that inheritance is very large.

An inheritance tax would treat the inheritance as if the heir had worked to earn it and been taxed accordingly, thus balancing the tax treatment of wages and wealth. As with the current estate tax, an inheritance tax could be unified with the gift tax, with each person receiving a lifetime exemption, for example, of $2 million. 

Most important, an inheritance tax would encourage the uber-wealthy to spread their wealth around in order to minimize taxes on those who inherit from them. This could help to reduce the growing concentration of wealth. 

Alexandra Thornton is senior director for tax policy at the Center for American Progress. Galen Hendricks is a research assistant for economic policy at the Center for American Progress.