$3.5 Million or $5 Million?

In the midst of a severe economic crisis that is, among other things, depressing federal tax revenues and adding to the national debt, the debate over the estate tax has flared up again. The basic question is whether the exemption will be raised from $1 million – where it was in 2002-03 and where it is scheduled to return after the Bush tax cuts expire – to $3.5 million (Obama) or $5 million (Lincoln-Kyl) per person; there is also disagreement over whether the marginal rate should be 35% or 45%. (Note that even with Obama’s proposed 45% tax rate, the average effective tax rate on estate would be 19%, because of the $3.5 million exemption.)There is plenty of debate over this already, so I will confine myself to three points.

1. It’s not a question of whether the estate tax is good or bad; it’s a question of whether it’s better than the alternative. If you take away $100 billion of tax revenue (that’s the Times’s figure – not sure how many years that is over), you have to add it to the debt or raise it some other way. Compared to raising marginal tax rates on income, the estate tax almost certainly has less impact on incentives to work, for a few reasons: (a) most people with that much wealth make most of their money from investments, not working; (b) most people – even high earners who pay the top marginal income tax rates – are unlikely to ever pay the estate tax, and even if they do, it will be decades after the current period; and (c) to the extent that that people plan to consume or donate their marginal income (like Bill Gates), the estate tax doesn’t affect incentives to work at all. The estate tax has more impact on what people do with their money once they’ve made it: it encourages contributions to charity, but arguably it encourages consumption instead of saving.

2. The estate tax has the unusual property that even though it only affects the super-rich (and thereby benefits everyone else), many people who are completely unaffected by it are against it. Part of this is undoubtedly due to the fact that far more Americans believe they will someday become rich than actually will become rich. (There was a famous poll cited in The Economist a long time ago according to which some large proportion of Americans believed that they were already or would someday be in the top 1% of the population by wealth.) If this economic crisis has any salutary effects, perhaps one of them will be to convince many people that they are not rich enough to pay the estate tax and that, even in this land of opportunity, they are statistically unlikely ever to be rich enough to pay the estate tax – and therefore they should start voting in their own interests and not the interests of celebrities. (And even if you think you will be rich someday, shouldn’t you hedge against that not happening, rather than the opposite?) Put another way, the movement to repeal the estate tax should have crested along with the stock market.

3. Like most Silicon Valley entrepreneurs, when I started my company, one of the motivations was the small chance of someday making a lot of money. Back in 2001, none of us looked around the table and said, “You know, I would work really hard at this startup, but since I’m going to have to pay the estate tax if we’re successful, I’m just going to phone it in.”

Originally published at the Baseline Scenario and reproduced here with the author’s permission.