The Obama administration’s proposal for the estate tax has all of the ingredients of a damaging tax – large exemptions and loopholes, confiscatory marginal tax rates and little revenue potential. The best reason for having such a tax, if there is one, is to tap into any punish-the-rich sentiment that may be in the electorate.
The Obama administration has proposed an estate tax for 2011 and later years that is much like the one that was in place before to 2010. Writing in favor of the proposal, Prof. Richard Thaler of the University of Chicago acknowledged that the marginal estate tax rate “sounds high, almost confiscatory.” He then notes the $7 million exemption available last year, says that with it in place only 3 estates in 1,000 would have to pay an estate tax and adds that those with big-enough estates could afford a good lawyer to help them further increase the effective size of their exemption.
But the huge potential for avoidance behavior is exactly why the proposal is so damaging from an economic point of view.
Taxes affect behavior, because taxpayers take steps to pay less tax. As a result, every tax dollar brought into the public treasuries harms the private sector more than a dollar, and the amount of extra harm depends on the marginal tax rate. (That’s not to say that taxation ought to be zero — the private sector could benefit much more than one dollar from a dollar of government spending.)
Telephone-service taxes offer an example of a basic principle that applies to taxes on estates and just about everything else: the higher the rate of taxation, the more households and businesses that take steps to reduce their tax liability.
Consider a business with, say, 1,000 telephone calls a day and no telephone tax. If the government began to assess a penny tax on each call the business pays for — outgoing, incoming 800 and collect calls — and the business did nothing in response, the business would owe $10 a day in telephone tax.
But the business would probably consider alternative means of communicating with customers and suppliers and might soon no longer have 1,000 calls a day. It might, for example, switch some or all of its calling to an Internet-based system. Or it might give customers additional incentives to place orders or make inquiries on its Web site, rather than call using its toll-free number.
These actions might reduce taxed calling to, say, 800 a day, from 1,000, and thereby reduce the telephone tax bill by $2 a day (see the middle column of the table below). But those actions would be costly to other parts of the business; some customers might be lost because they were not called, or revenue might be reduced through the incentives given to get customers to use the Web. Those additional costs would be roughly $1 a day.
Ultimately this telephone tax brings $8 a day to the public treasury, but it costs the company $9: $8 sent to the treasury and $1 in tax-avoidance behavior. The taxpayer is harmed more than the amount received by the public treasury, because the taxpayer took costly actions to make sure that the tax liability was not even higher.
Economists agree that taxes have an excess burden beyond the revenue surrendered to the treasury by taxpayers, even if they do not agree about the exact amounts. Examples of excess burdens include health insurance plans that are excessively expensive in part because of their special personal income tax treatment, and corporate debt burdens that are excessive in part because of the special treatment of interest payments by the corporate tax.
All together, the excess burden of taxes in the United States is more than a trillion dollars a year. Of course, government spending may have great benefits, and that spending would be worthwhile if it exceeded all of the costs to the taxpayer (namely, the taxes they pay and the excess burden they bear).
With the telephone tax, the amount by which calling is reduced by a tax, and thereby the excess burden of that tax, depends on the rate of taxation on those last 200 calls: a penny a call in my example.
This business propensity to avoid the tax by seeking other communication means would be the same if the tax law provided a tax exemption for the first, say, 400 calls a day, because reducing calls from 1,000 to 800 would still result in a tax saving of $2 per day. The only difference is that public treasury would get less revenue with the tax exemption in place: $4 per day rather than $8. And the tax exemption means that each $8 brought the treasury costs the taxpayer $10 rather than $9 (with the exemption it takes two days to get $8 in revenue, rather than one day).
So tax exemptions and other loopholes reduce revenue collected without necessarily affecting the marginal tax rate. In this way, tax exemptions and loopholes raise the excess burden per dollar of revenue and thereby the ultimate cost to taxpayers of bringing any given amount of revenue into the Treasury.
Economists’ opinions on tax exemptions and loopholes generally derive from the arithmetic of excess burdens. Exemptions and loopholes raise the marginal tax rates – the creators of excess burden – required to maintain treasury revenue. So if you want the government to get its revenue with a minimum of economic harm, smaller exemptions, loopholes and marginal tax rates are the way to go.
The federal estate tax — sometimes called the “death tax” by its critics — is remarkably extreme in terms of the size of its exemptions and marginal tax rates. The estate tax brings in only about $20 billion a year (with no revenue this year) despite marginal tax rates that have varied from 45 to 55 percent, because of its large exemptions and many loopholes. And some of its excess burdens are evident: an entire estate-planning industry would be largely unnecessary if marginal estate-tax rates weren’t so high. Planning is part of the reason that many estates do not pay tax, and planning is part of the excess burden.
Alternatives to President Obama’s plan include elimination of the estate tax, sharply reducing its rates or integrating it with the capital-gains part of the personal income tax. If necessary, the small revenue loss could be recovered with a tiny increase in the rates of a broader-based tax, like the taxes on payroll or personal income.
Professor Thaler explained how that eliminating the estate tax would “make sure heiresses like Paris Hilton have the proper attire for trips to St.-Tropez.” I agree that the estate tax’s best attributes do not derive from economic efficiency, but rather its contribution to the sport of envying some of the love-to-hate members of America’s rich.