CRS Examines Indexing Estate Tax for Inflation

The estate tax exemption has not previously been indexed for inflation. Rather, Congress has acted from time to time to raise the statutory amount exempt from tax. Even with the increases legislated by the Taxpayer Relief Act of 1997, the estate tax exemption remained below what it would have been if the exemption of $600,000 in 1987 had simply been indexed for inflation over the 1988-2006 period. In contrast, the increases made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) overshot the inflation-adjusted level by increasingly large margins once the exemption rose above $1 million in 2002 and 2003 -- to $1.5 million in 2004 and 2005, $2 million in 2006-2008, and $3.5 million in 2009. The effect is reflected by a substantial decline in the projected number of taxable estate tax returns measured as a percentage of adult deaths over the years 2004-2009, well below the common historical range of 1% to 2%.

H.R. 5638, approved by the House on June 22, 2006, would extend the estate tax with an exemption of $5 million in 2010. According to projections by the Urban-Brookings Tax Policy Center, an exemption of $5 million would cause the number of taxable estates to be 4,200 or 0.16% of adult deaths in 2011. If instead 2009 law were extended with an exemption of $3.5 million, the number of taxable returns is projected at 8,200 or 0.31% of adult deaths. Both percentages are far below any of the levels experienced over the entire period from 1934 through 2002.

H.R. 5638 would tax taxable estate values up to $25 million at the long-term capital gains tax rate. It would tax amounts of $25 million or over at twice the capital gains rate. The long-term capital gains rate is currently 15% through 2010 but is scheduled to return to 20% in 2011.

H.R. 5638 would index the applicable exclusion (exemption) amount of $5 million per decedent for inflation after 2010, rounded each year to the nearest $100,000. But the bill would not index the $25 million amount that marks the beginning of the second rate bracket. That means that, over time, the range of values subject to tax at the capital gains rate would shrink as the lower bound, marked in effect by the applicable exclusion amount, rose to reflect inflation while the upper bound of $25 million remained unchanged. For example, if the $5 million exemption increased by 2.2% per year after 2010, the exemption would reach $6 million by 2018. Oppositely, as inflation and economic growth increased asset values, a greater amount of very large estates would be taxed at twice the capital gains rate than if the $25 million rate threshold was also indexed for inflation.

Indexation of the annual gift tax exclusion was enacted in 1997. H.R. 5638 would not change the method of indexing the annual gift tax exclusion. The bill would, however, undo some changes made by EGTRRA and reunify the estate and gift taxes. The same total exclusion of $5 million (indexed) per decedent would apply whether the assets were transferred by bequest at death or as lifetime gifts.

This report will be updated if there is further legislative activity on the estate tax.

 Contents

The number of taxable estate tax returns expressed as a percentage of adult deaths is a commonly used measure of the incidence of the estate tax on the population over time. When taxable returns as a percentage of deaths rises substantially, it suggests that the level of the estate tax exemption has not kept pace with the growth of assets held by wealthy individuals. Oppositely, if that percentage falls substantially, especially when the exemption is increased, it suggests that the growth of the exemption has outpaced the growth of assets. It may also reflect a purposeful decision by Congress to reduce the fraction of the population liable for the estate tax.

H.R. 5638, the Permanent Estate Tax Relief Act of 2006, was passed by the House of Representatives on June 22, 2006. Among the changes it would make are raising the level of the exemption under the unified estate and gift taxes to $5 million per decedent in 2010 and indexing that amount for inflation in the years thereafter. The inflation-adjusted amount of the exemption for a year would be rounded to the nearest multiple of $100,000.³

The most recent previous changes to the estate tax were made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16). This report considers in historical perspective the changes made to the estate tax exemption by EGTRRA in 2001 and the changes that would be made by H.R. 5638.

The Economic Recovery Tax Act of 1981 (P.L. 97-34) raised the exemption equivalent from $175,625 in 1981 to $600,000 in 1987, where it was to remain until further changes were enacted. The Taxpayer Relief Act of 1997 (TRA, P.L. 105-34) scheduled relatively gradual increases in the estate tax exemption from the level of $600,000 that had prevailed from 1987 through 1997. Under TRA, the exemption was scheduled to rise, initially in $25,000 increments, to $625,000 in 1998, $650,000 in 1999, $675,000 in 2000 and 2001, and $700,000 in 2002 and 2003, then $850,000 in 2004, $950,000 in 2005, and finally $1 million in 2006, where it would remain. Before even half of that scheduled phase-in had occurred, the provisions of TRA were superseded by EGTRRA in 2001. The exemption amount was immediately increased to $1 million effective in 2002 and 2003. The exemption was scheduled to rise in large increments to $1.5 million in 2004 and 2005, $2 million in 2006 through 2008, and $3.5 million in 2009. The estate tax was scheduled to be repealed in 2010, after which the estate tax provisions of EGTRRA would sunset. The exemption would return to $1 million under TRA's provision of a $1 million exemption for the years 2006 and beyond.⁴

 Table 1. Taxable Estate Tax Returns, as a Percentage of Adult

Comparing these two sets of bars shows that, according to the laws in effect prior to EGTRRA, the estate tax exemption remained below what the inflation adjusted level would have been over the period from 1988 through 2006. This would be expected for the years 1988-1997 when the exemption remained unchanged at $600,000. But even the increases scheduled by the Taxpayer Relief Act of 1997 would not have approached the inflation-adjusted level until 2006. At that time the exemption was due to reach $1 million and the inflation-adjusted level would have been $1.06 million. If the statutory exemption had remained at $1 million beyond 2006, it would have again continued to fall behind an inflation-adjusted level.

The effects of EGTRRA of 2001 are shown by the back row of gray bars with a stair step pattern at the right side of Figure 1. EGTRRA of 2001 increased the exemption to $1 million effective immediately in 2002 and 2003. This change alone caught up with the inflation since 1987. (The inflation-adjusted levels would have been only slightly lower, at $967,000 and $982,000, for those two years.) When EGTRRA then raised the exemption in large increments to $1.5 million for 2004 and 2005, $2 million for 2006-2008, and $3.5 million for 2009, the statutory exemption overshot the inflation-adjusted level by increasingly large margins. Under EGTRRA the estate tax is repealed in 2010. If EGTRRA sunsets in 2011 and the exemption returns to $1 million, it would be 16% below the estimated inflation-adjusted level ($1,192,058).

 

Figure 1. Statutory Estate Tax Exemption Compared with an

 

Inflation-Adjusted Level, 1987-2011

 

 

 

The increase in the exemption to $5 million in 2010 that would be introduced by H.R. 5638 would be far above the recent historical levels illustrated in Figure 1. Furthermore, if the $5 million exemption increased by 2.2% per year⁵ starting in 2011, the exemption would reach $6 million by 2018.

One measure of the reach of the estate tax that has been calculated over time is the number of taxable estate tax returns expressed as a percentage of adult deaths. The middle column of Table 1 above presents the percentages for most years from 1934-2002, as calculated by the Internal Revenue Service. These numbers suggest that there may have been a target, albeit unstated, of keeping that percentage in the range of 1% to 2%. The percentage rose above 2% over the years 1956 through 1976 when the exemption remained at $60,000, where it had been since 1942. The percentage also rose above 2% from 1997 through 2001. As previously explained, this was the period when the Tax Reform Act of 1997 was increasing the exemption level, but not enough to keep pace with inflation or the growth in assets.

Projected under EGTRRA, 2002-2009

The Urban-Brookings Tax Policy Center (TPC) has developed a microsimulation model which enables it to project the effects of alternative estate tax reform proposals. This includes the number of taxable returns in future years.

Table 2 shows that under the changes in the exemption level legislated by EGTRRA, the number of taxable estate tax returns as a percentage of adult deaths was projected to fall below 1%, to 0.71% and 0.79%, when the exemption amount rose to $1.5 million for 2004 and 2005. The percentage was projected to fall to 0.51%, 0.55%, and 0.62% when the exemption rose to $2 million for 2006, 2007, and 2008. The percentage was forecast to fall again by half, to 0.28% or only 7,200 taxable returns, when the exemption rose to $3.5 million in 2009.

       Table 2. Projected Taxable Estate Tax Returns as a

Table 3 presents the TPC estimates of taxable returns in 2011 under three alternative estate tax reform proposals mentioned in June 2006 as well as current law. If the exemption returned to $1 million under current law, taxable returns were forecast to be 50,500, or 1.92% of adult deaths, still within the common historical range of 1% to 2%. If 2009 law were extended, with an exemption of $3.5 million, the number of taxable returns was forecast to be 8,200, or 0.31% of adult deaths. If H.R. 5638 were enacted with an exemption of $5 million, the number of taxable returns was forecast to fall by nearly half, to 4,200, or 0.16% of adult deaths. Finally, under a proposal attributed to Senator Olympia Snowe, with an exemption of $7 million, the number of taxable returns was forecast to fall again by half, to 2,100, or 0.08% of adult deaths.⁶ Thus any of these three alternatives to current law were forecast to be far below any of the percentages shown in Table 1 over the period from 1934 through 2002. Indexing the exemption amount under H.R. 5638 would be expected to keep taxable returns as a percentage of adult deaths from rising unless the value of assets held by the wealthiest decedents increased by more than the rate of inflation.

 Table 3. Estimated Taxable Estate Tax Returns as a Percentage

H.R. 5638 would index the applicable exclusion (exemption) amount of $5 million for inflation after 2010. It would not, however, index the $25 million amount that marks the beginning of the second rate bracket. That means that, over time, the range of values subject to tax at the capital gains rate would shrink as the lower bound, marked in effect by the applicable exclusion amount, rose to reflect inflation while the upper bound of $25 million remained unchanged. Oppositely, as inflation and economic growth increased asset values, a greater amount of very large estates would be taxed at twice the capital gains rate than if the $25 million rate threshold was also indexed for inflation.

For purposes of the Internal Revenue Code (IRC), the consumer price index (CPI) for any calendar year is defined as the average of the monthly CPI (for all urban consumers, published by the Department of Labor) as of the close of the 12-month period ending on August 31 of that calendar year. The cost of living adjustment for a particular calendar year is based on the CPI for the prior calendar year relative to the CPI for a base year.⁷ (Using the September 1 -- August 31 prior year measurement enables the cost of living adjustment to be calculated and announced in advance of the next calendar year when it will take effect.) For adjustments to the individual income tax, the base year is 1992.⁸ For the annual gift tax exclusion, the base year is 1997.⁹ Under H.R. 5638, the base year for the estate tax exclusion would be 2009.¹⁰

Most inflation adjustments under the income tax are rounded down to the nearest multiple of $50.¹¹ Inflation adjustments to the annual gift tax exclusion are rounded down to the nearest $1,000.¹² In contrast, under H.R. 5638, the applicable exclusion (exemption) amount under the estate and gift taxes would be rounded (up or down) to the nearest $100,000. This means that indexed amounts of $50,000 or above would be rounded up to the next $100,000.

The annual exclusion under the gift tax has been indexed for inflation since 1999. The Revenue Act of 1932¹³ set the annual gift tax exclusion at $5,000 per donee (with a lifetime exclusion of $50,000). The annual gift tax exclusion was lowered to $3,000 by the Revenue Act of 1942,¹⁴ where it remained for nearly 40 years. The exclusion was increased from $3,000 to $10,000 by the Economic Recovery Tax Act of 1981 (P.L. 97-34).

The $10,000 gift tax exclusion amount was first indexed by the Taxpayer Relief Act of 1997 ( P.L. 105-34). Indexing was to apply to gifts made in calendar years after 1998. The CPI index adjustment was benchmarked to calendar year 1997. The law provided that indexed changes were to occur only in increments of $1,000. Amounts that were not multiples of $1,000 were to be rounded down to the next lowest multiple of $1,000.¹⁵ The first inflation adjustment occurred at the beginning of 2002 when the exclusion increased from $10,000 to $11,000. The second inflation adjustment occurred at the beginning of 2006 when the exclusion increased from $11,000 to $12,000.

Under the provisions of EGTRRA, the lifetime exclusion amount for the gift tax was limited to $1 million starting in 2002, whereas the exclusion for the estate tax continued to rise from $1 million up to $3.5 million in 2009. EGTRRA provided that when the estate and generation-skipping transfer taxes were repealed in 2010, the gift tax would continue. The maximum gift tax rate, however, would be lowered from 45% to 35%, equal to the highest income tax rate.¹⁶

H.R. 5638 would once again unify the estate and gift taxes. Thus, in 2010 and beyond, the same total exemption amount and schedule of tax rates would apply to all assets transferred, whether as bequests at death or as lifetime gifts. Inflation-indexing of the annual gift tax exclusion would continue as under prior law.

² Typically, just under half (48%) of estate tax returns filed are taxable. For further information, see CRS Report RL32768, Estate and Gift Tax Revenues: Several Measurements, by Nonna A. Noto.

³ For further description of H.R. 5638, see CRS Report RL32818, Estate Tax Legislation in the 109th Congress, by Nonna A. Noto.

⁴ For additional information on the history of the estate tax exemption, see CRS Report 95-444, A History of Federal Estate, Gift, and Generation-Skipping Taxes, by John R. Luckey.

⁵ The rate of 2.2% is CBO's long-run inflation assumption. U.S. Congress, Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2007 to 2016 (Washington: CBO, Jan. 2006), Table E-1, p. 136. Available at [http://www.cbo.gov].

⁶ Urban-Brookings Tax Policy Center, "Reported Snowe Estate Tax Proposal: Estate Tax Returns and Liability, 2007-16," Table T06-0147, June 8, 2006. Available at [http://www.taxpolicycenter.org].

⁷ Internal Revenue Code (IRC) Sec. 1(f)(3)-(5).

⁸ IRC Sec. 1(f)(3). Elements of the individual income tax have been indexed for inflation since the Economic Recovery Tax Act of 1981. For further explanation, see the section on "The Mechanics of Indexation" in CRS Report RL30007, Individual Income Tax Rates: 2006, by Gregg A. Esenwein.

⁹ IRC Sec. 2503(b)(2)(B).

¹⁰ Section 2(b) of H.R. 5638.

¹¹ IRC Sec. 1(f)(6).

¹² IRC Sec. 2503(b)(2).

¹³ Act of June 6, 1932, 47 Stat. 169.

¹⁴ Act of October 21, 1942, 56 Stat. 798.

¹⁵ IRC Sec. 2503(b)(2).

¹⁶ For further information about the history of the gift tax, see CRS Report 95-444, A History of Federal Estate, Gift, and Generation-Skipping Taxes, by John R. Luckey.