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Tax History: A Federal Inheritance Tax? We Almost Got One in 1935

Posted on Jan. 27, 2020

Economist Douglas Holtz-Eakin hates the estate tax but likes the inheritance tax. “If someone distributes $1 to 100 million people, that is very different than giving $100 million to one person,” he argued in a piece for the American Action Forum last year. “The estate tax treats them the same, while an inheritance tax would not.”

Holtz-Eakin, president of the American Action Forum, isn’t the only expert eager to swap the aging estate tax for a brand-new federal inheritance levy. Hailing from a different position on the ideological spectrum, New York University law professor Lily Batchelder has been making a similar case for over a decade. In a 2007 article, for instance, she suggested that switching to an inheritance tax would “lower taxes on heirs receiving smaller inheritances and those with moderate incomes, making the tax system better attuned to unearned advantage and ability to pay.”

Fairness is the tie that binds these unlikely allies in their quest for a new federal inheritance tax. More specifically, it’s the shared focus on heirs — and their disparate abilities to pay — that seems to animate most proposals for a new federal inheritance tax.

The interest in taxing heirs, rather than estates, is hardly new. In fact, it almost became a reality in 1935, when President Franklin D. Roosevelt asked Congress for an inheritance tax to supplement (but not replace) the existing estate tax. The proposal ultimately failed, undone chiefly by complaints about complexity — but not before lawmakers gave it a serious look.

Staff Doubts

The 1935 inheritance tax proposal took shape in the final months of 1934, when Herman Oliphant, Treasury general counsel, began asking questions about the relative merits of estate and inheritance taxes. In a November 1934 memo to Oliphant, Treasury staff voiced a clear preference for the former.

“The advantages of the estate tax over the inheritance tax as a revenue producer seem clear,” the staff wrote. “The estate tax is easier of administration and its yield is more certain and more definitely predictable.” Valuation issues, in particular, were sure to be a problem with any new inheritance tax; nettlesome even in the context of an estate tax, they promised to be much worse when trying to tax multiple heirs.

As a means of slowing or even reversing the concentration of wealth, the estate tax was also a reasonable, if imperfect, instrument. “Presumably the most direct approach to the problem of breaking down concentration of wealth by taxation would be the periodic imposition of graduated direct taxes upon the total assets owned by individuals,” the Treasury staff observed. But that sort of comprehensive wealth tax — not unlike proposals floated in the 2020 election cycle — was problematic. “The constitutional restriction of direct taxes makes this form of tax unavailable to the federal government,” the staff wrote. The estate tax — already sanctioned by the Supreme Court and long in operation — was a decent alternative.

Inheritance taxes seemed to have an edge over estate taxes when it came to fairness, the Treasury staff acknowledged. “The reason why taxation of inheritances has always been preferred by the states to taxation of estates is probably that a tax measured by what the beneficiary receives appears to fit the principle of ability to pay more nearly than a tax based on the entire estate of the decedent regardless of its disposition,” they wrote. That advantage was politically salient, especially during the New Deal era, when ability to pay (and fairness arguments more generally) was reshaping the federal tax system fundamentally.

Treasury staff, however, were unconvinced that the fairness advantage of the inheritance tax was real. “The greater conformity of the inheritance tax to the ‘ability to pay’ principle is largely an illusion, since the astute testator will draw his will with the taxes in mind, and will be able to give each beneficiary the net, rather than the gross, amount which the testator thinks fits,” they wrote.

Leaders Persist

If Treasury staff were lukewarm toward the inheritance tax, the same couldn’t be said for the department’s more senior leadership. Oliphant remained a fan of the inheritance tax, as did Robert H. Jackson, general counsel of the Bureau of Internal Revenue. And in December 1934, Roosevelt charged both with the task of preparing a new tax program.

In a January 7, 1935, memo, Jackson offered a long list of possible tax reforms, many focused on the dangers of monopoly and business concentration. But Jackson began his jeremiad against concentrated economic power with a different focus: an impassioned and idealistic warning about the dangers of inherited wealth.

“The transmission from generation to generation by will, or by inheritance, or by gift, of vast fortunes is inconsistent with the present philosophy of government,” Jackson wrote. “The natural desire to provide security for one’s self and his family is served by permitting reasonable inheritances. Beyond security, these vast accumulations represent not a protection of the individual from want, but a control by the individual over the employment and welfare of other individuals, and inherited economic power is as offensive to this generation as inherited political power was to the generation which formed our government.”

Those were strong words — and convincing ones, at least for Roosevelt. In the months to come, as the president began drafting a tax message for delivery to Congress, Jackson’s words remained front and center in every draft.

Jackson’s plan for curbing hereditary fortunes focused on the creation of a new inheritance tax to supplement the existing estate tax. “The inheritance tax is designed to apply to net inheritances and to raise revenue from a group best able to pay,” he wrote in a January 31 memo. “The number of large estates indicates the need for such a tax.”

To bolster his case, Jackson cited some Bureau of Internal Revenue data that he found compelling. “While the gift tax of 1932 was under consideration, and just before it was signed, several large fortunes were put beyond its reach,” he reported. “One taxpayer transferred approximately $100,000,000 and another about $50,000,000. In 1934, one gift tax of over $18,000,000 was paid.”

More generally, inheritance was a privilege exercised disproportionately by the very rich, Jackson contended. “Nearly ⅓ of all the property reported as passing by death in 1932 was concentrated in less than 4 per cent of the estates,” he observed.

It’s unclear exactly how those statistics supported Jackson’s specific proposal for a new inheritance tax. But they supported his broader contention that something was fundamentally broken with the way the American economy was structured, especially when it came to the intergenerational transmission of wealth.

Jackson’s proposed remedy for this intolerable state of affairs was schematic rather than specific. The new inheritance tax designed to supplement the existing estate tax would “begin with moderate rates and shall be swiftly graduated into large brackets to become practically one hundred percent at ___.” Jackson left the starting point for full confiscation unspecified, but his intentions were clear: The hereditary transmission of very large fortunes must be eliminated.

FDR’s Message

On June 19, 1935, Roosevelt delivered his tax message to Congress, and it landed like a bombshell. Lifting language wholesale from Jackson’s original January memo, the president complained that “the transmission from generation to generation of vast fortunes by will, inheritance, or gift is not consistent with the ideals and sentiments of the American people.”

Like Jackson, the president acknowledged that people had a right to provide for their heirs. But he denied that such a right was unlimited. “Great accumulations of wealth cannot be justified on the basis of personal and family security,” he wrote. “They bless neither those who bequeath nor those who receive.”

Large fortunes also gave some families a durable but intolerable sort of power, FDR said. “In the last analysis such accumulations amount to the perpetuation of great and undesirable concentration of control in a relatively few individuals over the employment and welfare of many, many others,” he told lawmakers.

Roosevelt rejected suggestions that a new tax on inherited wealth would harm the economy. “Creative enterprise is not stimulated by vast inheritances,” he insisted. “A tax upon inherited economic power is a tax upon static wealth, not upon that dynamic wealth which makes for the healthy diffusion of economic good.” Taxes on wealth transmission wouldn’t harm “the essential benefits” of a family-owned business, even after its founder had died. “The mechanism of production that he created remains. The benefits of corporate organization remain. The advantages of pooling many investments in one enterprise remain. Governmental privileges such as patents remain,” Roosevelt said.

Indeed, the only enduring loss following the death of a business leader was something that government had no power to control, Roosevelt said. “All that are gone are the initiative, energy and genius of the creator,” he intoned. “And death has taken these away.”

Congressional Response

Initially, administration officials regarded the president’s tax proposals as an exercise in politics rather than policy. “The tax message the President is sending up is more or less of a campaign document laying down the principles as to where he stands,” wrote Treasury Secretary Henry Morgenthau in his diary on the eve of the message’s delivery. “He does not expect any action on this but gives the people a year to think it over.”

When FDR finally delivered his message, however, it quickly became the focus of an intense legislative drive, with Democratic lawmakers eager to translate FDR’s sketchy plans into specific legislation. The House Ways and Means Committee embraced FDR’s call for a new inheritance tax, establishing a levy with rates ranging from 4 to 75 percent depending on the size of a bequest. Both that new tax and a correlated gift tax were designed to operate alongside the existing estate and gift taxes.

The Senate, however, was less enthusiastic about the idea of a new tax. Warned by the staff of the Joint Committee on Internal Revenue Taxation that a new inheritance tax would create many complexities, senators leaned toward a second-best alternative: simply raising rates for the existing estate tax.

On August 13 Morgenthau wrote in his diary that Senate Finance Committee Chair Pat Harrison “wants to go ahead with the estate tax and raise the money that way instead of through the inheritance tax because [Joint Committee on Internal Revenue Taxation Chief of Staff L.H.] Parker advises on the Hill that the estate tax is much easier to administer than the inheritance.”

Administration staff worked feverishly to rescue the inheritance tax, developing a series of arguments designed to sway dubious senators who were otherwise inclined to support the president. “To abandon the inheritance tax entirely and increase estate tax rates for revenue and collateral reasons would not be consistent with the President’s message,” Treasury staff warned in an August 13, 1935, memo.

The president was willing to accept a scaled-back inheritance tax, applicable only to the large bequests, say those exceeding $300,000 (about $5.5 million in today’s dollars). Large estates (with large bequests) were likely to be better equipped to handle the new administrative burdens of an inheritance tax.

But White House officials continued to insist that simply abandoning the inheritance tax would sacrifice too much fairness on the altar of simplicity. “The disadvantage of merely increasing the estate tax is that that would be a less extensive application of the principle of ‘ability to pay’ because it would apply equally to an estate distributed to five heirs as to an estate distributed to a smaller number,” the staff memo contended.

Ultimately, those arguments proved unpersuasive to wavering senators, who approved instead a series of rate increases for the existing estate and gift taxes: The new rates began at 2 percent on “net” taxable estates (estates after the exemption was applied) worth less than $10,000 ($183,000 in current dollars) and increased to a maximum of 70 percent on estates worth more than $50 million ($914 million). Under existing law, enacted the previous year, estates under $10,000 were taxed at 1 percent and estates exceeding $10 million ($183 million) were taxed at 60 percent. The conference committee adopted the Senate plan, including a decrease in the exemption amount used to calculate net estate value from $50,000 to $40,000. And with those changes, Roosevelt’s scheme for revamping the tax treatment of inherited wealth became just another might-have-been in the history of U.S. federal taxation.

Still, the episode is a timely reminder that inheritance taxes have some durable appeal. As Holtz-Eakin observed, there’s something to like about a tax that targets what heirs actually get, as opposed to what decedents manage to accumulate.

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