2010: A Good Year to Die?

Next month, for one year only, the federal estate tax is set to go away. Don't break out the cyanide capsules just yet though, because Congress is likely to reinstate the tax retroactively sometime during 2010, as part of a permanent estate tax reform. When doing so, Congress should make sure to get the reform right - this means setting a high exemption so few taxpayers have to comply with the tax, and indexing the tax to inflation so it does not impact smaller estates over time.

A temporary repeal is coming because of the structure of the 2001 Bush tax cuts. The Bush tax reforms gradually cut the estate tax rate and raised the share of an estate exempt from tax, leading to the 2009 exemption of $3.5 million and top rate of 45%. Then, for 2010, the tax is repealed entirely.

By default, tax rates for 2011 revert to prior law, including a 55% top estate tax rate and a $1 million exemption. The idea was that Congress would act later to extend the Bush tax cuts or make them permanent, but instead a Democratic majority took hold and such an extension is unlikely.

Fortunately, there is a cross-party consensus that estate tax law set for 2011 is too onerous. In the 2008 presidential campaign, both John McCain and Barack Obama proposed permanent estate tax reforms that set a higher cap and a lower rate. Obama proposed to maintain 2009 law indefinitely. McCain sought greater relief with a 15% rate with a $5 million exemption.

A high exemption is important because it greatly reduces the share of taxpayers who face a compliance burden while paying little tax. In 1992, economists Henry Aaron and Alicia Munnell wrote that estate tax compliance costs approach collections and are among the highest of all taxes. Since then, the rise in the exemption has drastically reduced the number of filers and therefore compliance costs, while reducing collections more modestly. This is because compliance costs are a smaller share of taxes paid as an estate gets larger.

The Brookings-Urban Tax Policy Center estimates that, if 2009 estate tax rules were maintained into 2011 (as Obama proposes), 16,200 estates will be obligated to file tax returns, with 6,400 owing tax. But if the exemption falls to $1 million as scheduled, required filings would instead be 108,200 (a 568% increase) with taxable returns rising to 44,200 (591%).

Meanwhile, tax due would rise only by 90%, because the newly taxable estates would be relatively small. (Not all of this revenue increase is even attributable to the expansion of the estate tax base - a large portion is due to the scheduled rise in the top estate tax rate to 55%.) Burdening nearly seven times as many families with the need to comply with estate taxes for a modest rise in revenue is not a good value proposition. Congress should set a high exemption to keep the share of Americans burdened with estate tax compliance small.

It is also important to index the estate tax exemption to inflation. Indexation promotes tax stability and helps taxpayers predict how much their estate tax burden is likely to be. As seen with the Alternative Minimum Tax, taxes not indexed to inflation can "creep" over time to ensnare people closer and closer to the middle class.

The estate tax exemption has never been indexed to inflation, though Congress has acted periodically to raise it. The exemption stayed flat at $60,000 from 1942 to 1976, but fell by more than 2/3 in real terms over that period. By 1976, 8% of estates were taxable, compared with less than 0.5% under 2009 law.

While a wide variety of bills have been introduced in both houses of Congress, political sentiment is settling toward President Obama's campaign proposal: maintaining 2009 law for years 2010 and onward. Earlier this month, the House passed a bill that makes the $3.5 million exemption and 45% rate permanent, but does not index the tax to inflation. Fortunately, leading Senate Democrats, including Max Baucus and Kent Conrad, say indexation is needed as part of a reform package.

There are strong arguments for repealing the estate tax altogether, with which many readers will be familiar. But Republicans couldn't even pass a permanent repeal when they held Congress and the White House. With Democrats running Washington, a permanent repeal is politically unavailable.

Republicans who want full repeal might be tempted to block Democratic proposals for estate tax reform, particularly because they would undo the one-year repeal in 2010. Indeed, every Republican in the House voted against the reform package this month. I hope they were merely holding out for indexation; trying to block a compromise reform altogether would be unwise, for two reasons.

First, a one-year estate tax repeal is not tax relief worth defending. Unlike a permanent repeal of the estate tax, a one-year tax holiday cannot encourage savings and investment because people do not know in what year they will die. A stable tax environment is important for fostering investment, so investors can accurately predict their future tax rates; yo-yoing estate tax rates do not further this goal.

Second, while a permanent repeal is currently off the table politically, an outcome worse than the Obama compromise is available: no legislative action, resulting in a return of the $1 million exemption and 55% rate in 2011. If Democrats can blame "obstructionist Republicans" for the failure to raise the exemption and cut the rate, they may be glad to let matters play out as scheduled.

Next year may not turn out to be the perfect year to die from a tax perspective. But there is a political opportunity in 2010 for Congress to make the estate tax more predictable and less burdensome forever. Let's hope they seize the day.