Reform Options for the Estate Tax System : Targeting Unearned Income, Testimony Before the U.S. Senate Committee on Finance

This testimony makes three main points. First, inheritances tend to exacerbate existing economic disparities and may be the most important barrier to intergenerational economic mobility. These tendencies are most pronounced at the top of the income distribution. While inherited income is distributed fairly evenly across most of the population, it rises sharply at the very top. Second, the estate tax system is the most important mechanism by which the current fiscal system mitigates the effect of inheritances on economic disparities and intergenerational mobility. The burden of the estate and gift taxes falls largely on heirs, not donors. Moreover, on average, it rises rapidly with the amount the heir inherits and his economic income. Nevertheless, the relationship between the heir’s financial circumstances and his or her estate tax burden is relatively imprecise. Third, upcoming legislative changes create an opportunity to better focus the estate tax system on the unearned income that inheritances represent. We should use that opportunity to reform, not repeal, the estate tax system so that it continues to tax inherited income but in a more equitable manner. Two reform options are discussed. The first would replace the estate tax system with a comprehensive inheritance tax, under which heirs would pay tax on extraordinary amounts of inherited income at roughly the same rate that presently applies to earned income under the income and payroll taxes. The second would retain the estate tax but better focus it on the amount transferred as a proxy for the amount received. It would do so through a package of simplification reforms that would limit the extent to which the tax burdens on heirs depend on their access to sophisticated tax advice