During the 2020 presidential campaign, Democratic candidates made many proposals for changes to the Tax Code, ranging from changes to the tax rates to the imposition of a new 5 percent excise tax and a national sales tax. As the Democratic nominee for president, Joe Biden has a tax plan that includes the following proposals:
- Eliminate the step-up of the cost-basis for inherited property;
- Increase estate and gift tax rates by an unspecified amount (it is now 40 percent); and
- Decrease the estate tax exemption from $11.58 million to $3.5 million, and the gift tax exemption from $11.58 million to $1 million.
The proposal for changes to the estate and gift taxes reverses the longstanding policy on reforms to the Tax Code made ever since the estate tax was enacted to pay for the costs of World War I. Both Republicans and Democrats have supported raising the exemption amount, cutting the tax rates and closing loopholes as the means of reform. Biden’s proposal reverses this with a dramatic decrease in the exemption, an elimination of the step-up in cost basis and an implied, but unspecified, increase of the gift and estate tax rates.
What effects these changes will have on you depends on why you transfer assets in the first place. The transfer might be an “accident,” in the sense that you have accumulated assets for retirement or long-term care costs, but you die before you use up those assets. The transfer may be motivated by your altruism toward your children or other people you care for. The transfer may be motivated by the sheer joy you get from giving to a charity or other cause. The transfer may represent a sort of payment by you, as a parent, to your children for their health or education, or later in exchange for the children’s help and attention.
Some of these transfers are taxable and some are not. When the transfers are taxable, the estate and gift tax is a progressive tax. This is because inheritors of significant wealth have significant incomes as well. It is also an unequal tax — how much you pay depends on how you transfer assets, not on the wealth or income of your inheritors. It is not an efficient means of reducing economic inequality from accumulated wealth, and taxing someone at their death is a ghoulish concept. It is more efficient to avoid excessive accumulation of wealth in the first place.
Higher gift and estate taxes are bad because they foster tax avoidance. Since income tax laws are different from estate and gift tax laws, there are many techniques that legally reduce your estate and gift tax. Higher taxes are also bad because they foster anxiety among owners of family assets like a family business or a family farm, which has large emotional resonance far greater than the actual impact on society. Only about 3 percent of estates have more than 50 percent of their worth tied up in a family farm or business but even Bernie Sanders seeks to carve out an exemption for family farms and business.
If rates are raised, the exemptions lowered, and the step-up in basis is eliminated, the effect will be the same as similar tax changes in the past — a reduction in savings (to avoid the effect of an accidental transfer), more charitable donations that reduce taxes, and less investment in long-term capital gains assets. It will not generate very much in taxes, and it will not have the economic and social effect that some progressives seek.
So, if you are a progressive, and want to efficiently raise more taxes and level out the inequality of inherited wealth, you should press for elimination of the gift and estate tax and have inherited or gifted wealth treated as ordinary income, subject to a progressive income tax. This already happens when you inherited an IRA. The IRA assets do not receive a stepped-up basis and are considered ordinary income to you when you withdraw the funds. Elimination of the estate and gift tax and inclusion of inheritances as ordinary income is equitable, fair, and efficient and addresses past economic inequalities, which the current Biden proposal fails to do.
