Stateline Story

Federal Estate Tax Repeal Would Affect States

The inheritance or estate tax -- derided by foes as the "death tax" -- could become a casualty of President George W. Bush's $1.6 trillion tax cut program. Repeal of the tax would directly affect 35 states that rely on the federal estate tax law to collect some revenue, and the other 15 would also be likely to feel the impact.

The "death tax" might be living on borrowed time.

A controversial levy that collects on the transfer of accumulated wealth, the so-called death tax -- more commonly known as the inheritance or estate tax -- could become a casualty of President George W. Bush's $1.6 trillion tax cut program. The federal government adopted the tax in 1916 to fund World War I expenses and has relied on it ever since for a small but significant source of revenue -- about $50 billion a year.

But with Bush promising to repeal the tax, its potential loss has started to attract attention at the state level. Thirty-five states rely on federal estate tax laws to collect revenue, and many state financial officers fear they may lose their power to tax estates altogether. Coming at a time of economic cooling and tighter state budgets, the repeal could mean billions of dollars in lost state tax revenue.

"The minute the federal estate tax goes away, so does the state [estate] tax," said Matt Gardner, a policy analyst for Citizens for Tax Justice .

The estate tax applies to inheritances above an exemption level of $675,000. Imposed at a 37 to 55 percent rate, the 85-year-old tax has been dubbed the "death tax" by opponents because it is levied on assets transferred to others at the time of a person's death.

According to a cost estimate by the Joint Committee on Taxation, estate tax repeal would cost the federal treasury $236 billion from 2002 to 2010.

There are sharp differences of political opinion on the efficacy of estate tax repeal. Liberals favor the tax because it prevents the concentration of wealth, which they believe is socially destructive. Conservatives see the tax as a threat to the right of individuals to pursue wealth and protect their financial legacy.

According to a Feb. 6 report by the Center on Budget and Policy Priorities , a liberal think tank in Washington D.C., 35 states which collect estate tax revenues would have lost about $5.5 billion in revenue last year had the repeal had been in effect.

California would have been the biggest loser, with a loss of $937 million, followed by Florida with $779 million and Illinois with $360 million. These states and 32 others are known as "pickup tax" states they piggyback on federal estate tax collections, taking a share of what is owed Uncle Sam.

"It's significant because a lot of our spending is set by law, so a lot of our discretionary spending is a lot smaller," said Sandy Harrison, spokesman for California's department of finance.

The other 15 states levy a separate estate tax. The CBPP report says these 15 states, which include New Jersey and Connecticut, would have lost about $1.1 billion worth of revenue if the repeal had been in effect last year.

States do not rely on the estate tax for a particularly large source of revenue. It accounts for only 1.5 percent of their total tax collection, according to the Federation of Tax Administrators. Sales, income and property taxes are the key sources of state revenue. But the loss of even a relatively small amount of money still could have a deep impact on state finances in light of the current fiscal downturn, analysts say.. "On the margin, this [repeal of the estate tax] matters, even if it's not the property tax, even if it's not the income tax."

But why wouldn't legislators simply try to mitigate federal action with their own tax changes?

Marcia Howard, director of the Federal Funds Information for States , says most states would be unwilling to do so because it would be politically unpopular.

"You'd have to put a whole new tax in the state, you'd have to write a whole new tax code," she said.

In his tax cut plan, which faces tough sledding in the U.S. Senate after passing the House of Representatives last week, Bush proposes phasing out the estate tax over the next eight years. He contends the present system is unfair because it taxes income that was taxed when it was earned.

Patrick Fleenor, chief economist at the conservative Tax Foundation , dismisses the notion that repealing the estate tax would burden state finances.

"It's kind of a silly criticism. If the federal government lowered income tax you'd get the same effect [of reduced tax revenue]," said Fleenor, who has authored many studies examining federal transfer taxation. "Anytime where you have interaction between the federal and state [governments] it has an effect. But you can take that away with the stroke of a pen."

Congress voted to repeal the estate tax last year, but former President Clinton vetoed the move. The amount of assets exempt from estate taxes is scheduled to rise to $1 million in 2006, but Democrats are willing to increase it to $4 million in lieu of eliminating the tax altogether.