The Death Tax That Won`t Die
Jude Wanniski
August 4, 1999


Memo To: Senate Majority Leader Trent Lott
From: Jude Wanniski
Re: A Haunting Story by Bruce Bartlett

I've been wondering for a few weeks now why The New York Times seems so ready to make the adjustments in the estate tax that are being worked out in Congress. Now our old Reaganaut friend Bruce Bartlett, who you may recall was Jack Kemp's chief economist back in the late 1970s and a deputy assistant Treasury secretary for tax policy in the Bush years, tells us why. I append here the op-ed column he wrote yesterday for the Los Angeles Times, which he was good enough to e-mail me last night. He finds in the tax legislation's fine print an end to the carryover basis, through which large estates could pass on to their heirs without passing through a capital gains tax gate. What you guys seem to have done in cutting the 55% rate to 20% is tear up the provision that has enabled a good part of the nation's wealth from being confiscated by the federal government. You should have a word with Senator Roth and House Ways&Means Chairman Bill Archer. You may not want this achievement carved into your gravestone.

Tuesday, August 3, 1999
The Haunting: Estate Tax Won't Die
Congress: Carryover basis, a fiasco of yesteryear, would take over and raise just as much, with more confusion.

One of the most remarkable features of the House-passed tax bill is repeal of the estate tax in 2009. The National Federation of Independent Business, a strong supporter of repeal, hailed this as the "crown jewel" of the legislation. It and other estate tax foes might not have been so quick to praise if they had read the fine print. Although the estate tax would indeed be repealed, it would be replaced by something that they may find worse: carryover basis. An important feature of the tax law as it relates to estates has to do with capital gains. Ordinarily, realizations of appreciated assets are taxed. Gains on assets held less than a year are taxed like ordinary income and those held longer are taxed at a maximum of 20%. However, gains on assets that pass through estates are not taxed at all. When heirs sell an inherited asset, they pay capital gains taxes only on any gain since they received it. All gains during the life of the person who originally acquired the asset are forgiven and never taxed.

This provision of the law is called step-up basis, because the value of an asset for tax purposes is stepped up at death. It has been a target of tax reformers for decades. Not only is it unfair, they charge, but step-up also has important economic consequences. It produces a powerful lock-in effect for wealthy people late in life. Even if the capital gains tax rate is lowered to 15%, as the House bill also proposes, many such people will never sell their assets if they can, in effect, get a zero percent rate on assets that pass through their estates. This creates inefficiency by preventing capital from flowing from investments with low-profit potential to those with higher potential.

In 1976, Congress sought to fix this problem by instituting carryover basis. Under this, heirs would pay taxes on gains from the original date of purchase, not just on gains from the date of death. Under step-up basis, a share of stock purchased for $10 that was worth $100 at death would be free of capital gains tax. An heir later selling the stock for $105 would pay tax only on the $5 gain since receipt. But under carryover basis, the heir would be required to pay tax also on the $90 gain during the life of the original purchaser. Carryover basis never took effect, however, because of massive administrative problems. It was extremely difficult for executors and heirs to determine what the original price of assets were since the person who knew was now dead. Also, carryover basis represented a new layer of taxation on estates, since the estate tax was not abolished.

So, in 1978, Congress delayed implementation of carryover basis and, in 1980, repealed it retroactively. Legal scholar Lawrence Zelenak calls the short unhappy life of carryover basis "one of the greatest legislative fiascoes in the history of the income tax." Now the House plans to reinstitute carryover basis. Even though the estate tax is being eliminated, the same administrative problems are going to arise that killed carryover basis 20 years ago.

Moreover, those favoring estate tax repeal may soon find carryover basis to be worse, because abolition of the estate tax will also eliminate all the tax avoidance provisions that are now part of the law. Aggressive use of these techniques can completely eliminate the estate tax even for large estates. It will be much harder to avoid paying capital gains taxes if carryover basis is reinstituted.

In effect, what the House has done is something like the flat tax for estates. All the exemptions, exclusions and credits that currently apply to the estate tax are being eliminated and the rate is being lowered from 55%, the top estate tax rate, to 20%, the top rate on long-term capital gains. In fact, this new tax system will raise exactly as much revenue as the estate tax raises now.

According to the Treasury Department, step-up basis now reduces revenues by $25.8 billion while the estate tax raises $25.9 billion. Thus for all the talk about abolishing the estate tax, what the House has really done is just replace one tax with another raising the same revenue. It may make sense for the same reasons a flat tax makes sense, but it is not the same thing as abolishing the estate tax altogether. Those who favor estate tax repeal need to look carefully at carryover basis. They may like it even less than the estate tax.

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Bruce Bartlett Is a Senior Fellow With the National Center for Policy Analysis. He was Deputy Assistant Secretary of the Treasury during the Bush Administration.