Why the Estate Tax is Still a Legislative Priority

Capital Letter No. 13

November 25, 2008

By Ronald D. Aucutt

There Is Surprisingly Strong Evidence That the New President and Congress Have Reasons to Give Effective Attention to the Estate Tax in 2009.

Dear Readers Who Follow Washington Developments:

We have witnessed an historic election. We look forward to an historic Administration. And the economy is in the midst of historic turmoil. Meanwhile, the decade that culminates in one year of estate tax repeal has lasted a lot longer without resolution than many of us ever expected. Could it be that the Democratically-led Congress will enact, and President Obama will sign, legislation that stabilizes the estate tax?

Although the estate tax, of course, was not explicitly a prominent issue in the campaign, Senator Obama’s campaign website stated his preference for simply freezing the estate tax at its 2009 level (a not-very-radical idea that Senator Clinton expressed in the October 2007 primary debate in Philadelphia). Compared to 2008, that represents the greatest percentage increase in the exemption equivalent since the increase from $60,000 to $120,667 in 1977. Compared to what the exemption equivalent is now scheduled to be in 2011, it is a 250% increase. Could it be that such an increase in the exemption will be tolerated in an environment of staggering budget deficits?

This Capital Letter will examine the reasons why both questions should be answered yes.

The Residual Impatience with the Estate Tax

When Republicans controlled Congress, making the 2010 repeal of the estate tax “permanent” was a perennial agenda item. While two 2006 cloture votes in the Senate fell short of the 60 votes needed to take up a repeal bill for consideration, even for the purpose of substituting a compromise, the House was always willing. The last House vote for permanent repeal was a more or less bipartisan vote of 272-162 on April 13, 2005. Of those 272 who voted for repeal, 216 (almost a majority) returned to the current Democratically-controlled Congress, and 179 (a sizeable minority) will be back in next year’s Congress. While these repeal supporters are mostly Republicans (142 out of 179) who no longer control the House calendar, that is still a sizable residue of repeal sentiment, and the inclusion of 37 Democrats is not insignificant.

On March 23, 2007, while finalizing the fiscal 2008 budget resolution (S. Con. Res. 21), the Senate rejected by a vote of 48-51 an amendment proposed by Senator Kyl (R-AZ) to direct the tax-writing committees to report a bill setting the estate tax exemption at $5 million and the top rate at 35%. This came immediately after the Senate rejected by a vote of 25-74 a Democratic alternative with similar numbers, except that it was only permissive, not mandatory, and therefore would not have been implemented unless the Ways and Means and Finance Committees in their discretion found a way to “pay for” it with other tax increases or with spending cuts. Eliminating the four Senators who voted for both amendments, 70 Senators that day gave some level of endorsement to the $5 million exemption and 35% rate.

Likewise, on March 12, 2008, the Senate rejected by a vote of 50-50 the same Kyl amendment to the fiscal 2009 budget resolution (S. Con. Res. 70), after rejecting the same Democratic alternative, offered by Senator Salazar (D-CO), by a vote of 38-62. (Vice President Cheney had been in the presiding officer’s chair to recognize Senators Salazar and Kyl, but did not stay to break the tie on Senator Kyl’s amendment.) All told, 84 Senators voted this year for the $5 million exemption and the 35% rate.

Those who predicted that 60 votes were at hand to totally repeal the estate tax after the Republican gains in the 2004 election learned the lesson that “free votes” like these, on procedural measures that do not become law, are a shaky basis on which to predict future votes that really count. Nevertheless, 70 Senators and 84 Senators are large majorities, and the increase from 70 to 84 – both in the same Democratic Congress – is striking. Nine of the 50 Senators who voted for the Kyl amendment will not be back in the new Congress next year, although in one case (Mike Johanns replacing Chuck Hagel of Nebraska) that should not change the vote. Four of the 38 Senators who voted for the Democratic alternative will not be back in Congress next year; they happen to be Senators Obama, Biden, Clinton, and Salazar. But even after those subtractions, 71 Senators will be back next year who, like Senators Obama and Biden, voted for some form of a $5 million exemption and 35% rate.

The point is that even this year’s and next year’s Democratic Congresses reflect a significant amount of lingering uneasiness with the “death tax,” no doubt mirroring the resentment of the tax that often is seen among voters. A substantial increase in the exemption – compared to the projected 2011 law – would remove still more families from the reach of the estate tax, would have a measure of populist appeal, and might be attractive to many of those 179 Representatives and 71 Senators.

The Residual Impatience with the Estate Tax

Meanwhile, key members of the Democratic Congress, particularly in the Senate, have already shown a remarkable eagerness to embrace a $3.5 million estate tax exemption as exactly the kind of “middle class” tax relief that was prominent in the 2008 campaign. In the debate on the same budget resolution in which 84 Senators affirmed in some fashion a $5 million exemption and 35% rate, Finance Committee Chairman Max Baucus (D-MT) (who was reelected in a landslide this month) offered an amendment to permit the budget surpluses projected for the later years in the five-year budget window under consideration to justify corresponding deficits in the earlier years to fund tax relief he described as follows:

This amendment would take the surplus in the budget resolution and give it back to the hard-working American families who earned it. It would make permanent the 10-percent tax bracket. It would make permanent the child tax credit. It would make permanent the marriage penalty relief. And it would make permanent the changes to the dependent care credit. Further, it would make changes to the tax law to honor the sacrifices our men and women in uniform make for us every day. We lower the estate tax to 2009 levels. And it would allow middle-income taxpayers who do not itemize their deductions to nonetheless take a deduction for property taxes. [154 CONG. REC. S1840 (daily ed. March 11, 2008) (emphasis added)]

An odd list of middle class relief provisions into which to tuck the estate tax.

When Senator Baucus offered a similar amendment last year, Senator Kent Conrad (D-ND), the Chairman of the Budget Committee (and a former state tax commissioner), responded, in part:

The Senator has also provided for small business because we have a number of provisions that are critically important to small business and, of course, to prevent the estate tax from having this bizarre outcome, which is now in the law, where the exemption would go down to $1 million from $3.5 million just two years before. That makes no sense. So the Senator provides for room in this amendment to deal with estate tax reform. [153 CONG. REC. S3469 (daily ed. March 21, 2007)]

There are several insights into congressional attitudes in Senator Conrad’s response. First, it acknowledges the effect of the 2011 sunset as a “bizarre outcome” that “makes no sense” (not exactly breaking news). Second, as if by sublimation, it simply ignores the intervening step of one year of repeal, finding the revival of pre-2001 law in 2011 to be “bizarre” enough. Third, it labels the freezing of 2009 law as “estate tax reform.” Fourth, it ties this reform to “small business,” amplifying the middle class target of “hard-working American families” articulated by Senator Baucus.

More insights are gained from the estate tax hearings the Senate Finance Committee has held under Democratic leadership in this Congress. After wide-ranging hearings on November 14, 2007, and March 12, 2008, the agenda became more focused (as frequently happens in a series of hearings) on April 3, 2008. As Capital Letter No. 9 reported, the witness list included ACTEC President-Elect Dennis Belcher, addressing the rules for deferral of estate taxes under section 6166, and Transfer Tax Study Committee Chair Shirley Kovar, addressing the “portability” of the unified credit from predeceased spouses to surviving spouses, an idea that had been incorporated into the compromise measures (PETRA and ETETRA) passed by the House and offered to the Senate in 2006. Other witnesses addressed the reunification of the gift and estate tax unified credits and the effect of the estate tax on charities.

Because public witnesses in congressional hearings typically do not choose their topics, but address the topics staff members ask them to address when inviting them to testify, these topics reveal what is on the mind of committee staffs and presumably what is important to the Senators for whom they work. Both section 6166 and portability, which are targeted respectively to family-owned businesses and married couples at the lowest end of the range of the estate tax, echo the middle class theme of the Senate budget debates. Even those who might argue that no one in the small percentage of wealthiest Americans subject to the estate tax is in the “middle class” must acknowledge that that theme is apparently being indulged in the Senate. And it certainly recapitulates themes that were prominent in the 2008 presidential campaign, even if the estate tax as such was not.

Having somehow acquired a “middle class” mantle, estate tax reform might not be guaranteed, but it arguably has found a place in the rather unfamiliar company of Democratic priorities.

The Possible Ascendancy of Policy Considerations over Partisan Gridlock

Lively partisan debate will continue to mark this city and generate Capital Letter material. But there is reason to be encouraged that the debates of the immediate future will not imitate the extreme bitterness of the immediate past.

Besides the celebration of the election’s statement about our diverse culture that has tempered the disappointment of many McCain supporters, there is the obvious relief that we are writing about a President-Elect in November and not litigating the outcome of a close election. It is hard to resist the feeling that what was done and attempted to be done in the aftermath of the 2000 election sorely affected the political climate of the last eight years, producing smoldering vitriol on the one hand and cynical defensiveness on the other, and fueling the harsh repudiation of President Bush that his supporters find so unfair and his detractors find so self-evident. (As proof, most readers of this Capital Letter will find the preceding sentence to be unsettlingly half-wrong.) That we have been spared a reprise of that ordeal is almost certain to permit a sharper focus on issues and policy in the days ahead. Any sort of reform around which significant consensus has already begun to congeal is bound to benefit. Surprisingly, that now appears to include the estate tax.

In the current Congress some Democrats might have been tempted to ignore the estate tax and let it run its “bizarre” course in 2010 and 2011. This result, after all, was created by the 2001 Republican Congress – it’s not a Democratic problem. Ways and Means Committee Chairman Charlie Rangel (D-NY) has been reported, perhaps apocryphally, to be so inclined. But with greater Democratic congressional majorities and President Obama in the White House next year, this Republican problem will very quickly become a Democratic problem if it is not fixed in 2009. There is no reason to expect the Democratic leadership to want that. The election was about getting things done, and the very fact that the Republicans never got around to fixing the estate tax will only increase the pressure on the Democrats to do so.

The Challenges of the Revenue Impact

Just as the disappointment of many McCain supporters has been tempered by celebration of national identity, so has the exuberance of many Obama supporters been tempered by dread of national crisis. Prospects of a ten-trillion-dollar national debt – that’s $10,000,000,000,000 – and a trillion-dollar annual deficit are staggering. This parallel universe of fiscal challenge and response, unlike anything most of us have ever seen, begs the question of whether any conventional markers for prediction are of any use anymore. The redefined challenge of deficit management might be so huge that every action must be altered to address it. Or the challenge might be so huge that it can’t be solved no matter what we do, so for the time being all convention and discipline is simply suspended. Who can tell? But on the assumption that traditional notions of estimating revenue impacts still play a role, the following observations are offered.

Freezing the federal estate tax at its 2009 level will increase federal revenues for fiscal 2011 – the 12 months that begin October 1, 2010 – because that is when the tax will be collected with respect to decedents dying in 2010, the current repeal year. After 2010, “reducing” the federal estate tax to its 2009 level will reduce federal revenues. But because of the revival of the credit for state death taxes, the net federal rate on the largest estates will not increase very much. At the level of a taxable estate of $3.5 million (the 2009 exemption), the net federal marginal rate will be 45.4%, as it was before 2002. At a taxable estate of $3.6 million, it drops to 44.6%, and never again is above 45%, the current federal rate in states with no deductible state death tax. At a taxable estate just under $10 million, the net federal marginal rate is 39.8%. Because of the 5% surtax under old section 2001(c)(2), the net marginal rate becomes 44.8% at $10 million and then 44% over $10.1 million. At a little over $17 million, the net marginal rate falls to 39%, the net rate on all taxable estates above that level. These rates compare to the 2009 net federal marginal rate on the largest estates of 45% in “coupled” states, 38.8% in ordinary “decoupled” states, and 37.8% in “decoupled” states where the state tax itself is not allowed as a deduction in computing the state tax.

The upshot of all this is that a return to pre-2001 law in 2011 would, compared to 2009 law, collect significantly more federal revenue, but mostly from estates at the lowest end of the range of taxable estates. The very largest estates would actually get a federal tax cut in many states. It is an oversimplification to ignore state taxes and other factors, but the prima facie effect of raising substantial revenue from the smallest taxable estates and reducing net federal taxes on the estates of the richest decedents will not fit well with President-Elect Obama’s priorities.

Other “middle class” relief related to the estate tax might be harder. Take portability of the unified credit. It would lose revenue. Never mind that the revenue it would lose represents ill-gotten gain almost entirely from taxpayers who with careful planning with credit shelter trusts or inter vivos QTIP trusts could save that tax anyway. By the methods used to make revenue estimates, it still would lose a significant amount of revenue. But it remains an extremely compelling way for a new Congress and new Administration to leverage the tax relief at the lowest end of taxable estates.

Or take section 6166. It is a mess. Everyone agrees. But it is next to impossible to fix. That is because the revenue estimates associated with any tax legislation are calculated on a very strict cash basis. Any tax that is merely deferred beyond the applicable five-year or ten-year budget window is treated as lost. Receivables do not count and charging interest helps only a tiny bit. Thus, it would require enormous statesmanship even to do what everyone agrees would be right. That makes comprehensive section 6166 reform a pretty low percentage bet.

Then there are the possible “base broadeners” that historically accompany tax reform and might in today’s climate serve as “revenue offsets.” This includes a possible revisit of the reforms Congress had in mind when it first enacted section 2036(c) in 1987 and then replaced it with the “more accurate” valuation rules of chapter 14 in 1990. As reported in the reflections on the 2006 election in Capital Letter No. 2 (Nov. 20, 2006), statutory regulation of entity-based valuation discounts (translated “family limited partnerships”) must be very tempting, if proposed regulations under section 2704(b)(4) don’t beat the legislative branch to the punch. In contrast, reforms of section 2702– for example, by eliminating “zeroed out GRATs” – seem to be receiving little congressional attention, although reports of even a little attention have been repeated with enough frequency to have produced a firestorm of speculation. There has never been a good way to predict such congressional actions, especially from long range, but if a client of any Fellow has been putting off the implementation of such techniques, today’s climate of depressed values might be a good excuse for moving such things to the front burner.

Ronald D. Aucutt