Progressives Getting Played: A Case Study In Really Bad Federal Tax Policy

This post may run through tax geekdom a bit, but it hopefully shows the relationship between federal and state tax policy, and how badly the battle has been waged by progressives over the years.

Over the past twelve years, significant changes have been made to the Federal estate tax code. Most of us know about the increase in the amount that can be passed free of federal estate tax, from One Million Dollars per person in 2001 to more than Five Million Dollars per person today. But there were other changes, among the most significant of which were (1) the elimination of the federal estate tax credit for state inheritance tax in favor of a deduction for state inheritance tax and (2) the reduction of the maximum federal estate tax rate from 50% to 40%.

It is those two changes, taken together, that present a case study in really bad federal tax policy and a shining example of progressives getting creamed at the negotiating table. And, based on the dearth of writing on this subject, it’s not clear progressives even understood they were getting creamed.

The remarkable thing about these two changes in the federal estate tax code, and why they are so instructive, is that by themselves they have almost zero net effect. Under the old scheme, back in 2000, the credit for state taxes was based on a progressive schedule, which topped out at 16% for large estates. Almost all the states imposed state level inheritance tax based on that schedule, because doing so meant they were not adding to the estate tax burden of their residents. They were just soaking up the available federal estate tax credit. Hence, these state level estate taxes were referred to as “soak-up” taxes.

So, under the old structure, in the vast majority of states, those at the top were paying a total combined fedreal and state tax of 50%, with 34% going to the IRS and 16% going to the treasuries of their home states. Remember those three percentages, 50%, 34% and 16%.

Computing the total top rate under the new structure and the manner it is shared between their state treasuries and the IRS is a bit trickier, but still fairly straightforward. If an estate is charged state level estate tax at 16% and that tax is deductible for federal estate tax purposes, the deduction tops out at 40% of 16%, or 6.4%. Thus, the total top combined federal and state estate tax rate is now 40% + 16% – 6.4%, or 49.6%. Of that total, 16% goes to the state treasury and 33.6% (i.e., 40% – 6.4%) goes to the IRS.

Now, compare the total top federal and state tax rates, and the manner in which the tax revenue is shared between the IRS and state treasuries, under the old structure and the current structure. The net change is absolutely trivial – four tenths of a percentage point.

So why bother changing the federal estate tax structure? If you’re a conservative, it’s because these two changes radically change the incentive for state legislators to eliminate their state level estate tax. About half the states already have done so. Under the old rules, it would have been stupid for a state to eliminate or even reduce its estate tax, because doing so wouldn’t save state residents a dime; it would just push tax revenue from the state to the IRS. That was why all states used to have a “soak up tax.” Under the new rules, however, if a state eliminates its estate tax, it reduces the tax burden on the wealthy person’s heirs. Under the new rules, if a state reduces its top estate tax rate from 16% to zero, only 6.4 percentage points of the reduction go to the IRS. The remaining 9.6 percentage points of the reduction go to the children of that state’s wealthy residents.

I’ve recently written about the mischeif ALEC is making at the state level, with it’s report Rich States, Poor States. Well, chapter 3 of that report is entitled “Death Taxes: Economic Growth Killers.” Engaging in rank intellectual dishonesty, the chapter compares Tennessee, which sitll imposes an estate tax, but not an income tax, unfavorably to the eight other no income tax states, all of which have repealed their estate taxes. Twelve years ago, that entire chapter of ALEC’s “Rich States, Poor States” study would have been ludicrous. Today, it is being used to encourage state lawmakers to try and use lower (or zero) estate taxes to lure wealthy residents from higher tax states. Half the states already have bought in, and more are considering doing so.

So here’s what’s happened. At the federal level, changes were made to the estate tax code that on the surface were trivial. But those changes created all the space ALEC needed to push for elimination of inheritance tax at the state level. It’s clear that progressives got played. It’s not clear whether they didn’t see this coming or they saw it coming but got steamrolled. Either way, it’s pathetic.