Estate Tax Repeal and Lifetime Gifts (or, Is Donald Trump the Grinch Who Stole Christmas?)
Donald Trump says he wants to repeal the estate tax but retain stepped-up basis for the first $10 million of gains. The tax plan on his campaign website says nothing about the gift tax, however, and it will be very hard for Trump to repeal the gift tax in the next two years. The problem is that if tax reform happens through the filibuster-proof budget reconciliation process, then it will be subject to the Byrd Rule. That means the reconciliation bill can’t cause a long-term increase in the federal deficit (although, as David Herzig and I explain, the Senate Budget Committee chair might have a few tricks up his sleeve that he can play). Reconciliation can be used to repeal the estate tax temporarily (as it was in 2001), but it will be harder to get rid of the gift tax via reconciliation. Let’s say that the Republicans pass a reconciliation resolution covering 2017 to 2026 and then turn off the estate tax for the entire period, with rates returning to current levels in 2027. Estate tax revenues for 2027 won’t decrease relative to current law (unless high net worth individuals strategically die in 2026 rather than 2027). But if Republicans temporarily repeal the gift tax for any year between now and 2026, then estate tax revenues for 2027 and beyond certainly will decline. The Donalds of America will make large transfers to the Ivankas during the gift tax holiday, and so the federal government will raise less in estate tax revenue when the Donalds die. And this means that gift tax repeal — even temporary repeal — will likely flunk the Byrd Rule.
If the estate tax is temporarily repealed and the gift tax remains in place, then we can probably expect to see a decline in lifetime transfers. Why would Donald give an asset to Ivanka now and pay gift tax, when he could instead hold the asset until death and pay no tax? A harder question is: Should we be concerned about the fact that the estate tax will probably go into hibernation while the gift tax will remain in full force? (This is separate from the question of whether we should care about estate tax repeal. My short answer to that question is: I think we should, and we should think that repeal — temporary or permanent — is a bad thing. Under current law, the estate tax will raise $275 billion over the next decade, and while that might seem like a small amount in comparison to the $42 trillion that the federal government will take in from all sources over the next decade, $275 billion is not peanuts either. Estate tax repeal will either add to the debt or will result in less funding for federal programs, a lot of which do a lot of good. And the argument that the taxation of estates is “unfair” strikes me as specious, for reasons I’ll discuss in a future post.)
There are at least three reasons why society might want to encourage high net worth individuals to transfer assets inter vivos (i.e., during their lifetime) rather than at death. The first reason (and I think the weakest) is that those assets might do more good in the hands of a younger generation. This could be because (a) the Ivankas of the world are not quite as wealthy as the Donalds and so have a higher marginal utility of wealth, or (b) the Ivankas of the world are more likely to invest in exciting and value-generating enterprises than the Donalds (though one could just as easily argue that the parent who amassed a great fortune is probably a better investor than the child who has accomplished little independently). [Note: None of this should be read to say anything about the actual investment skills of Donald or Ivanka Trump. I’m using them as stand-ins for “older generation” and “younger generation.” If you’d prefer, read “Bill Gates” and “Jennifer Gates” in their place.]
A second reason is that lifetime transfers avoid some of the transaction costs that come with bequests (i.e., gifts by will). With a lifetime transfer, there is no probate process, and there are no will contests. If Donald transfers Blackacre to Ivanka inter vivos, then there will be no claim by Barron that he was really his father’s intended beneficiary. Donald is still alive, and so we can just ask him. Lifetime gifts are a way to avoid the deadweight loss associated with death-time transfers.
A third, and more complicated, argument — initially made by Louis Kaplow — is that gift-giving increases social welfare even if the donor and donee have the same marginal utility of wealth. Let’s say that Donald is close to indifferent between keeping $100 himself and giving $100 to Ivanka. We’ll posit that he derives 100 utils from $100 in his own pocket, and derives 99 utils from the warm glow of giving $100 to Ivanka. Let’s also say that Ivanka derives 100 utils from $100 in her own pocket. If Donald keeps the $100 himself, then total utils are 100 (all Donald’s). If Donald gives the $100 to Ivanka, then total utils rise from 100 to 199 (Donald’s 99 plus Ivanka’s 100). Gift-giving makes the world a happier place.
Now, it might be that Donald derives the same warm glow from bequests that he does from gifts, in which case there would be no reason why lifetime transfers would increase overall happiness more than death-time transfers. Presumably the warm glow effect on the donor ends at death, but maybe the donor feels some anticipatory warm glow from knowing that his heirs will receive his assets when he dies. But if the warm glow argument seems more plausible in the context of lifetime transfers than death-time ones, then that might be a reason why public policy should favor lifetime giving. It might even be, as Kaplow suggests, a reason why the government should subsidize inter vivos gifts. It more clearly seems like a reason why the tax code should not penalize inter vivos gifts relative to death-time transfers.
Current law creates complicated incentives with regard to inter vivos gifts. For individuals with less than $5.45 million (couples with less than $10.9 million), there is a strong incentive to hold on to assets until death because your estate will pay no tax and your heirs will get stepped-up basis. Above the exemption amount, the incentive is generally in the other direction. The top estate and gift tax rates are both 40%, but the estate tax base is tax inclusive while the gift tax base is tax exclusive. So if you leave $100 above the exemption amount to your children, then your estate pays a tax of $40 and your children get the remaining $60. If, on the other hand, you’re above the exemption and you want to transfer $100 to your children inter vivos, what you should do is gift $71.43 to your children; your gift tax is 40% x $71.43 = $28.57; your gift plus your gift tax sums to $100; and so your effective transfer tax rate is 28.57% even though the gift tax rate is nominally 40%.
With a gift tax but no estate tax, this built-in incentive for lifetime giving goes away, and there is a strong incentive to hold onto one’s assets until death. If we think that the government should encourage high net worth individuals to transfer their wealth inter vivos rather than death, then that’s a problem. Is it a huuuge problem? Probably not. The deadweight loss of the probate process is not insignificant, but it’s not even a rounding error relative to GDP. The warm glow loss is harder to calculate, but also too abstract a concern to keep one up at night. What we can say is that for the tiny fraction of families personally affected by estate and gift taxes, the younger generation’s Christmas stockings might be stuffed a bit less full this year. Shed no tears though: These are the individuals with the most to gain from estate tax repeal over the long haul.