Taxation is regarded as a necessary evil in today’s society. Nobody parts happily with the considerable portion of their paycheck withheld for income and other taxes. Yet as much as people loathe the income tax, there is something even worse: a category of taxes characterized by silent deferral, and that don’t come due until death. The inheritance or “death” tax represents double, triple, or even quadruple taxation (as income, as dividends or interest, as capital gains, and as inheritance) on the same dollar. Death taxes have given new meaning to the famous Ben Franklin quote that “nothing can be said to be certain, except death and taxes.” Indeed, federal estate and state inheritance taxes have inextricably linked the two—turning the government into a new version of the grim reaper.
In 1826, Pennsylvania became the first state to adopt an inheritance tax. The inheritance tax was first imposed as a tax on inheritance received by non-lineal relatives.1 It has since been amended to include lineal relatives, and its collection has proven to be lucrative. In the 1997-1998 fiscal year, inheritance tax revenues reached $710 million. For that same year, Pennsylvania distinguished itself as one of highest collectors of state death taxes per capita, second only to Connecticut. Pennsylvania collected $51.21 per capita. The state collecting the lowest amount per capita, Alaska, collected only $2.74. Legislators in both parties have proposed a number of measures aimed at alleviating the excessive and undue burden that the inheritance tax has placed on Pennsylvania families. These proposals range from lowering tax rates for lineal and nonlineal descendants to exempting premiums paid for long-term care insurance to placing siblings in the same bracket as lineal descendants to exempting the first $100,000 of an estate.
This report will demonstrate why lowering the state inheritance tax is a policy goal worth pursuing. The inheritance tax not only combines death with confiscatory taxation, but it also is harmful to society in myriad ways. Furthermore, this report shows how the inheritance tax is harmful to the middle class, small business owners, workers, women, minorities, and farmers—the very groups in society that public policy is supposedly employed to help. The inheritance tax undermines savings in favor of consumption and punishes hard work and frugality. It may even encourage consumption of open land.
The inheritance tax situation in Pennsylvania can not be remedied without legislative action. In the 1997-1998 fiscal year, the inheritance tax accounted for 4 percent of general fund revenues. By the 2003-2004 fiscal year, this is projected to rise to 4.5 percent.
Death Tax Hits the Middle Class
Despite popular myth, the reach of the inheritance tax extends beyond the wealthiest Pennsylvanians. Consider the hypothetical predicament of Joe, Jr., a middleclass retailer with a wife and two children. He has worked his entire life at a small hardware shop opened by his father 25 years ago. As is the case in many family businesses, Joe’s father invested capital in growing his business and thought he was ensuring the financial security of his family—and also creating an asset for his son. Joe, Sr., made a comfortable living but did not invest in the high-priced legal and accounting advice needed to completely insulate the business against inheritance taxes.
When Joe, Sr., died suddenly at the age of 60, the hardware shop was valued at $500,000. Joe is now facing a 6 percent inheritance tax, amounting to $30,000 due within nine months of his father’s death. Joe, Jr., and the family business, which he hoped to pass on to his son, are in trouble. Joe is frustrated that he has to pay a tax on an inevitable event that he had no control over.
In order to pay the $30,000 tax, Joe, Jr. will be forced to liquidate or sell the shop off to a national retail chain. Ironically, the rationale for death taxes was to redistribute wealth so that certain families would not amass a majority of the wealth. Unfortunately, the larger business will benefit from this sale, and there will be one less small business in the community to “equalize” the distribution of wealth.
Society will also suffer in other ways. Joe’s workers will lose their jobs, and Joe Jr. will not inherit the family business. After this experience, it is unlikely that Joe will want to start another business. By discouraging small business start-up, consumers will miss out on valuable innovations that so often accompany entreprenuership. Right now, Joe is at the mercy of the current state inheritance tax system, but with the right reforms his burden could be substantially reduced. (See Appendix A for a description of our current system.) The many ways that Pennsylvania lawmakers could help Joe are embodied by their separate proposals, yet all of these proposals reflect one common theme—lowering the state inheritance tax.
Why Inheritance Taxes Should be Lowered—or Eliminated <
The burden of inheritance taxes falls on the middle class. This tax lacks horizontal equity, which would require that all taxpayers worth the same amount of money have the same liability.2 While the rich hire high-priced lawyers and accountants to navigate the loopholes, the middle class cannot afford this luxury.3 In other words, what appears to be a progressive tax contains a regressive dimension. A recent study by the Heritage Foundation focusing on federal death taxes concludes that citizens who cannot pay planning fees frequently pay higher estate taxes.4
It is also worth noting that when it comes to the average middle class citizen, the state is in a unique position to alleviate the burden imposed on his or her heirs. In 1995, the average net value of all estates subject to taxation in Pennsylvania was $175,396.5 Federal death taxes are only imposed on estates worth at least $650,000 (this will gradually increase to $1 million by 2006). So, the average person whose estate is valued at $175,000 would only be harmed by the state inheritance tax—not the federal estate, gift, or generation-skipping taxes.
Inheritance taxes hurt small business, especially those that are family owned. In most small businesses, every available dollar is reinvested into the business because it creates income for the owners. In family businesses, reinvestment also creates an asset for the children.6 According to the National Federation of Independent Business (NFIB), the rationale for the imposition of death taxes is to redistribute wealth so that a few families would not amass the majority of the wealth. Unfortunately, the imposition of inheritance taxes has had just the opposite effect. Common sense would dictate that if an heir is forced to sell to pay inheritance taxes, and potential buyers knew this, then the heir would not have the ability to wait for the best offer. Often, the heir must sell to a larger corporation—exacerbating the problems associated with concentration of wealth and power. The heir will not receive the greatest value for his inheritance, and there will be one fewer locally owned business.7
Lowering the inheritance tax would both create and protect jobs. Business owners allocate their resources in anticipation of future costs. Costs associated with paying the inheritance tax prevent small business owners, the major producers of most new jobs, from hiring as many workers as they would desire. Another benefit of lowering/eliminating the inheritance tax is that after the death of a small business owner, employees will not lose their jobs because heirs are forced to liquidate in order to pay the death taxes.8
Minorities are hurt by inheritance taxes. Many owners of small and medium-sized businesses are very often minorities and/or women. According to the Small Business Advocate, 98.5 percent of Pennsylvania’s businesses with employees are small businesses.9 Ownership of small businesses by women and minorities is on the rise in Pennsylvania. In 1996, women owned 299,800 businesses in Pennsylvania. The number of businesses owned by women increased 64.7 percent from 1987-1996. From 1978-1992, black business ownership rose 35.7 percent, and the number of Hispanic owned firms rose 95.7 percent. For Asian and Pacific Islanders, American Indians, and Alaskan Natives as a group, the ownership of businesses rose by 67.7 percent.
Inheritance taxes depress entrepreneurial activity. It is difficult to calculate how harmful the state inheritance tax is to entrepreneurs. However, the effects of the federal estate tax on entrepreneurial activity have been analyzed by the Congressional Joint Economic Committee. The Committee concluded that:
the estate tax exerts a strongly negative influence on entrepreneurial activity. As distinguished from the direct build-up of capital investment, entrepreneurial activity infuses the economy with risk-takers willing to exploit new technologies and enables families to achieve upward social mobility. By hindering entry into self-employment and by breaking-up family businesses, the estate tax inhibits economic efficiency and stifles innovation.10
While the state inheritance tax rate is less than the federal estate tax rate, it would still have the same effect on entrepreneurial activity. However, it is the reach of the state inheritance tax that endangers middle class business owners while the federal estate tax does not. The federal estate tax is not levied on estates valued at less than $650,000. So, it is the existence of the state inheritance that drives heirs of small business to liquidate and discourages entrepreneurship in the process.
The inheritance tax is unfair. The inheritance tax is blatantly unfair in that it represents double, triple, or even quadruple taxation on the same dollar. For example, the same dollar that is taxed as income, could be taxed again as interest or dividends, as capital gains, and then as inheritance.
The inheritance tax is a tax on “virtue.” The inheritance tax penalizes hard work, savings, and frugality in favor of consumption. While many desire to save money to leave as an inheritance, the incentive to so do is lessened by the knowledge that a portion of those dollars saved will be confiscated by the government. On the other hand, it makes sense to invest in an expensive education. So, by discouraging savings and other profitable activities such as investment or the expansion of a business, the inheritance tax makes consumption more appealing in that the dollars will not be subject to any further taxation.11
Inheritance taxes encourage consumption of open farmland. While Pennsylvania grants special valuation for farmland, the state fails to protect and reward sound environmental stewardship outside of their definition of farmland. The state considers farmland to be that land which is designated for agricultural use, agricultural reserve, or forest reserve. (See Appendix B for definitions and necessary conditions.) However, there are a series of requirements that make it difficult to qualify for this special valuation. For example, if an heir inherits 100 acres that he intends to farm, the land will not be considered exempt for agricultural use because it has not already been in use for three years prior to the decedent’s death. If an heir wants to make his inheritance an agricultural reserve, the land will not qualify for special valuation unless it is open to the public without charge.12
Lowering the inheritance tax will not curb charitable giving. At the federal level, where the rates of the estate, gift, and generation-skipping tax combined range from 37 to 60 percent, there is a great incentive to make charitable donations. When a charitable gift is made for tax-planning purposes, it is usually made to avoid paying federal taxes, not state taxes. In Pennsylvania, giving to charitable and fraternal organizations is exempt, but the incentive to do so is not as great because the lineal or non-lineal heir will only be taxed at 6 percent or 15 percent. Therefore, the argument that the elimination of death taxes curbs charitable giving cannot be employed at the state level. Even if that argument is posed, only a small percentage of charitable giving occurs anyway. In 1995, only 7.1 percent of total inheritance tax returns requested an exemption for charitable and governmental bequests, representing only 5.7 percent of all net assets subject to taxation by the state.13
The trend in state inheritance taxes has clearly moved in the direction of eliminating traditional taxes and imposing only pick-up taxes. (See Appendix C for definitions of death taxes levied by the states.) In 1989, 18 states imposed an inheritance tax, eight an estate tax, and 25 (plus the District of Columbia) solely a pick-up tax. In January 1999, the breakdown was 14, four, and 35, respectively.14
Since 1989, Delaware, Kansas, Louisiana (phasing-out over six years), Michigan, North Carolina and Wisconsin have repealed their inheritance taxes. Thirteen states now impose an inheritance tax, including Louisiana where the tax will be phased out completely by 2002.
In fiscal year 1997, the top five states receiving the most revenue per capita from inheritance taxes were Connecticut ($69.37), Pennsylvania ($51.21), New York ($49.03), Delaware ($43.38) and New Jersey ($38.92). Each of these states levied an inheritance tax in addition to the pick-up tax, while the states at the low end of the spectrum did not. States that received the least amount of inheritance tax per capita in 1997 were: Alaska ($2.74), Idaho ($3.35), Mississippi ($4.57), Utah ($4.99) and Arkansas ($7.35). 15
Pennsylvania levies both an inheritance tax and a pick-up tax. The state collects over two times the median and mean of the per capita for all states. The mean for all states was $19.01, and the median was $14.86.
Reform is necessary to curb a growing dependency on inheritance tax revenues. The percentage of total tax revenues and general fund revenues comprised by the inheritance tax is growing. Reform will be necessary to stop this. Over the past five years, the rate is projected to climb from 4 to 4.6 percent of total tax revenues and from 4 to 4.5 percent of general fund revenues.
Death Knell for the “Death Tax”
While there is a strong case for the elimination of state inheritance taxes, the likelihood of the state willing to forego 4 percent of its general fund revenues is slim. However unlikely the elimination of the tax is, Pennsylvania will benefit from any step in the right direction. Lowering of the rate or increasing exemptions would be a help to Pennsylvania’s families. All of the legislative proposals currently under consideration are aimed at doing this in some way.
Sen. Jay Costa (D-Allegheny) and Sen. Harold Mowery (R-Cumberland) both have proposed legislation dealing with exempting $100,000 of an estate. SB 128 (Mowery) exempts the estates valued at $100,000 or less. SB 318 (Costa) exempts the first $100,000 of the estate. Sen. Costa’s version is preferable because it is applicable to more people. Whereas the Mowery bill would affect only those whose estate was valued at $100,000 or less, the Costa bill would not only grant these exemptions, but it would also exempt the first $100,000 of all other estates valued at more than $100,000. Sen. Melissa Hart (R-Allegheny) has introduced SB 186, which exempts an amount equal to the premiums paid by the decedent or his or her heirs for long-term care insurance taken out for the decedent up to ten years prior to death. The rationale for her bill is explained in its analysis:
More than 40 percent of Pennsylvanians over age 65 will eventually enter a nursing home. With increasing life expectancy and the forecasted continued growth of the elderly population, the need for long term care is expected to expand. Long term care expenses are first paid with personal income; once these resources have been depleted, Medicaid funds certain long term care medical needs. Because nursing home care averages more than $30,000 per year, a middle income individual or couple can quickly deplete a lifetime of savings on long term care. Purchasing long term care insurance can reduce the need to “spend down” private savings and reduce reliance on Medicaid-subsidized nursing home and other long term care services.16
Sen. Joe Conti (R-Bucks) and Sen. Jake Corman (R-Centre) both suggest a lowering or elimination of taxes for various heirs. Sen. Conti’s SB 306 eliminates the tax on direct descendants and raises the rate to 17 percent for everyone else. Sen. Corman’s SB 389 lowers the rate for lineal descendants from 6 to 3 percent and from 15 to 12 percent for everyone else. Using this approach, the best situation would be a combination of their bills. Sen. Conti calls for elimination of the tax for grandparents, lineal descendants, and widow/widowers of children, and Sen. Corman calls for a 12 percent rate for everyone else.
Sen. Jack Wagner (D-Allegheny) has proposed SB 433 that includes siblings in the 6 percent inheritance tax bracket.
If Pennsylvania legislators combined the best elements of all the proposals, it would mean serious relief for Pennsylvania’s families. A possible bill would include:
- An exemption on the first $100,000 of an estate;
- An exemption on the amount equal to the premiums paid by the decedent or his or her heirs for long-term care insurance taken out for the decedent;
- The elimination of an inheritance tax for grandparents, parents, lineal descendants, widow/widowers of children, and siblings; and
- A lowering of the 15 percent rate to 12 percent for all others.
Reducing or eliminating the “death tax” burden promises to help preserve jobs, continue the existence of family owned businesses, and encourage economic growth. Having been first in the nation to enact a state death tax, Pennsylvania should be the first state to signal its death knell for all “death taxes” in the 21st century.
Appendix A: Pennsylvania’s Current Inheritance Tax System
Tax Base: The Inheritance Tax is imposed on the value of the property transferred to beneficiaries of a deceased person and on certain transfers made during the decedent’s lifetime. The value of the transfer is established on the date of the decedent’s death. The Estate tax is based on the amount of the Federal estate tax credit for State death taxes on estates situated in Pennsylvania.
Tax Rates: Generally, lineal beneficiaries are taxed at the rate of 6 percent and collateral beneficiaries are taxed at 15 percent. The Estate Tax is equal to the amount of Federal estate tax credit for State death taxes, less the inheritance Tax paid. Transfers to a spouse of non-jointly held property are tax exempt for decedents dying on or after January 1, 1995.
Source: Governor’s Executive Budget 1999-2000, C17.
Appendix B: Definitions Pertaining to Special Valuation for Farmland
Agricultural use means use for the purpose of producing an agricultural commodity. Necessary conditions: The land must have been devoted to agricultural use for three years preceding the death of the decedent; must be at least 10 contiguous acres in area or have anticipated yearly gross income derived from agricultural use of $2,000; and must be the entire contiguous area of the owner used for agricultural use purposes.
Agricultural reserves are non-commercial open-space lands (1) used for outdoor recreation or enjoyment of scenic or natural and (2) open to the public without charge on a nondiscriminatory basis. Necessary conditions: The land must be at least 10 contiguous acres in area and must be the entire contiguous areas of the owner used for agricultural reserve purposes.
A forest reserve is land (10 acres or more) stocked by forest trees of any size capable of producing timber or other wood products. Necessary conditions: The land must at least 10 contiguous acres in area and must be the entire area of the owner used for forest reserve purposes.
Source: Pennsylvania Tax Handbook, American Lawyer Media, 1999, pg. 421-422.
Appendix C: Types of State Death Taxes
Inheritance taxes are levied on the person receiving the bequest. These taxes are strictly state taxes.
Estate taxes are levied on the estate of the deceased person before assets are distributed to heirs. This tax may be levied by the state, and is levied by the federal government. Gift taxes are imposed on large transfers of wealth from living people. Donors, rather than recipients, are liable for gift taxes. This tax may be imposed by states and is imposed by the federal government.
Pick-up taxes are a variation on the estate tax and are based on an important link between federal and state death taxes. Federal statutes allow taxpayers to claim a credit against state taxes paid up to certain amounts that depend on the estate’s total value. In effect, this allows states to levy a tax and “pick-up” estate taxes that would be levied by the federal government anyway. This tax does not increase the total liability for the heirs since the state is realizing a portion of the federal estate tax revenue. As a result, all states impose a pick-up tax up to the allowable federal credit.
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Jennifer Velenica is a former policy analyst at the Commonwealth Foundation.
- Pennsylvania Tax Handbook, American Lawyer Media, pg. 409. Lineal descendants are all children of the natural parents and their descendants (whether or not they have been adopted by others), adopted descendants and their descendants and stepdescendants, pg. 411.
- Joint Economic Committee, “The Economics of the Estate Tax.” December, 1998.
- William F. Lauber, “Inheritance Taxes: R.I.P.” Citizens for a Sound Economy Foundation Issue Analysis
No. 76, August 28, 1998.
- William W. Beach, “A Scorecard on Death Tax Reform,” The Heritage Foundation Backgrounder No. 1197, June 25, 1998.
- Pennsylvania Department of Revenue, Bureau of Research.
- National Federation of Independent Business, “Inheritance (Estate) Tax Reform.”
- Small Business Advocate, “Small Business: Heart of the Pennsylvania Economy,” Small Business State Profile, 1998.
- Joint Economic Committee.
- Pennsylvania Tax Handbook, pg. 409.
- Pennsylvania Department of Revenue, Bureau of Research.
- Mandy Rafool, “State Inheritance Taxes,” National Conference of State Legislatures, April 23, 1999.
- Patrick J. Geho, “Long Term Care/Inheritance Tax Relief Analysis,” January 26, 1999.