(Un)intended consequences of death tax repeal

Now that April 15 has passed, you may have hoped not to think about taxes for another year.  However, on April 16 the House of Representatives passed H.R. 1105, the “Death Tax Repeal Act of 2015,” which would repeal the federal estate tax, no matter how large the estate, while preserving existing law’s favorable exclusion from tax of any gain on inherited property.  Coupling the repeal with the exclusion results in both decedents and recipients winning at the cost of federal revenue in a time of deficit spending and federal debt.  But more importantly, it is a quiet step that likely leads to the repeal of the capital gains tax, a result we should debate rather than stumble to.

There are equitable consequences of H.R. 1105 that trouble me, but they are not why I am writing this editorial.  I do not write because of the estimated $269 billion in tax revenue the bill would cost or that the bill will only help individuals with wealth of more than $5.4 million and couples with wealth of more than $10.9 million, a small fraction of the top 1 percent.  No, I write because I fear that the bill’s authors have a hidden agenda—the repeal of the capital gains tax—and I believe we should debate this repeal before small, stealthy steps like H.R. 1105 make it inevitable.

{mosads}Taxpayers generally earn income by providing services or when they sell assets that have increased in value.  The government generally taxes all wages, but it does not tax the full value of assets sold because some amount was invested in them, in tax we call this the assets’ basis.  Capital gains are taxed on the difference between sales proceeds and invested basis.  Under already favorable law, recipients of inherited wealth enjoy a fair market value basis, which means that any appreciation a decedent has not paid income tax on is never taxed.  Some have argued this is mitigated for the very wealthy by the estate tax.  One study found that 55 percent of the value of estates worth more than $100 million is unrealized capital gains that have never been taxed.  Death currently creates tax savings by not taxing this wealth, and repealing the estate tax only enlarges it.

More troubling is what H.R. 1105 does to the decision-making of living owners of wealth.  The bill likely increases the “lock in effect” that is often cited to justify preferential capital gains tax rates.  The concern regarding lock in is that taxpayers do not sell appreciated capital assets but wait until they die to avoid the income tax.  As a result, investors and businesspeople do not make the socially and economically best decisions but the least taxed ones.  H.R. 1105 increases this incentive.  Despite the existing favorable capital gains rate, no economically rational person would sell appreciated assets because any tax is higher than the 0 percent rate at death, especially as this favorable rate would be achieved without tax planning.

It is possible this result is intended to force the repeal of the capital gains tax.  After this heightened “lock in” is criticized, the public would have a choice.  The public would direct Congress either to repeal the Death Tax Repeal (politically harder than allowing the 2001 death tax repeal to lapse) or to eliminate capital gains taxation entirely and, with it, the lock in problem.  It is for this second option that the advocates of H.R. 1105 are likely working.

It should not be surprising that politicians may be attempting something in steps that failed when the repeal of capital gains taxation was presented to the public.  But we should not be fooled when the latter choice is presented as an unintended consequence of H.R. 1105.  

Let us not forget at least one result of the removal of capital gains taxation:  the shift of the tax burden from capital owners to workers.  In turn, this shifts taxes from wealthier to less wealthy taxpayers at a time when the president’s tax rate is lower than his secretary’s and $1,000,000 income taxpayers earn well over 50 percent of taxable capital gains.  We could debate the extent to which wealthy capital owners must avoid tax to create jobs.  Regardless of whether eliminating capital gains taxation will or will not produce a fresh boom in jobs, those with jobs will see an increase in their share of the tax burden.

These issues need to be debated before we start down a path that reduces taxes on capital.  Even if H.R. 1105 fails in the Senate or to be signed, the reiteration of the idea of estate tax repeal (now with a favorable basis rule) makes it more palatable for the future.  So let us be honest about we are doing so that the consequences of tax legislation can be intended.

McMahon is a professor at the University of Cincinnati College of Law.