A 2010 Tax Strategy for the Democrats: Reform the Estate Tax

Barack Obama's political strategy for this year's mid-term elections seems pretty clear. He will take action, working with the Democrats in Congress to enact legislation, and acting as the chief executive where legislative action isn't possible. The recent health insurance reform, adopted with only Democratic support in Congress, is the most obvious example. Legislation for financial regulatory reform is on the move; some sort of bill will probably make it through Congress this year. Obama's recent recess appointments of 15 nominees is another example of his apparent decision to make 2010 a year of action.

The ballooning federal deficit will likely require a tax increase sooner or later. This being an election year, expect a lot of hemming and hawing, and no increase. There is one tax measure--not an increase--that probably could be enacted this year. And if the Democrats try it and are blocked by the Republicans, the Democrats would score political points for trying.

That would be federal estate tax reform. The Bush 43 tax cuts are bizarrely structured to provide for no estate tax in 2010 but a reversion next year to an old $1,000,000 threshold for the imposition of the tax. This anamoly is, like so many things in Washington, a political ploy, this one designed to make the cost of the tax cuts appear lower than they'd have been if the estate tax had been permanently eliminated. This sleight of hand made it easier for Congress to sign off, with the presumption that someone else would fix the problem when the tax reverted back to the $1,000,000 threshold.

Last year, there was general agreement among Democratic and Republican power brokers that reform of the estate tax should revolve around excluding the first $3.5 million of the estate from taxation and imposing the tax on amounts above that level, with the $3.5 million threshold to be adjusted for inflation. However, amidst last year's squabbling over bank bailouts and bonuses, the surge of Tea Parties, faux bipartisanship over health insurance reform, and pandemic adolescent finger pointing by high ranking federal officials and prominent members of Congress, nothing was done about estate tax reform.

For understandable reasons, estate tax reform this year has been shoved to the back part of the back burner that isn't even lit. But a Democratic initiative to enact the $3.5 million compromise that existed last year might work to their political advantage this fall.

Although this year's temporary repeal of the estate tax sounds like a boondoogle for the wealthy, it actually includes a potential unpleasant surprise for many. When the estate tax is in effect, heirs and other recipients of inheritances receive a "stepped up basis" (i.e., a base value of the higher of the original cost of the asset or its value at the time of the deceased person's death). For many assets, like stocks, real estate and collectibles, a stepped up basis means that when the recipient sells after inheriting the asset, income taxes (usually capital gains taxes) will be calculated by subtracting the stepped up basis from the proceeds of the sale to determine taxable gain.

However, when there is no estate tax, heirs and other recipients of inherited assets do not receive a stepped up basis. They get only a "carry over basis" (i.e., the deceased person's basis, which could be much lower than a stepped up basis for assets like stocks, real estate and collectibles). Thus, if they sell, their income tax is calculated by subtracted the carry over basis from the sales proceeds. This will often result in much greater taxes.

A $3.5 million exclusion from estate taxation would benefit the upper middle class, in particular those whose estates run in the range of $3.5 million to a bit above $5 million. These folks (or their heirs, really) might be worse off with no estate tax. Their heirs would get only a carryover basis, and be potentially subject to taxation on much larger gains than they'd face with a stepped up basis. The $3.5 million exclusion would largely shelter upper middle class estates from estate tax, while conferring a stepped basis that would significantly shelter the heirs if and when they sold the inherited assets.

The larger an estate, the more the benefit from a complete repeal of the estate tax. But that is a temporary circumstance, since the estate tax returns with a $1,000,000 threshold in 2011. Then, both the upper middle class and the wealthier are subject to higher levels of estate tax.

At first glance, it might make sense for the Democrats to simply let the estate tax lapse back down to a $1,000,000 threshold. With the growing federal deficit and a middle class core constituency, the Democrats would seem likely to lean toward soaking the rich (and upper middle class). But elections today are all about capturing the independents, the swing voters in between left and right who often outnumber party loyalists on either side. The estate tax matters to many small business owners and farmers, who can accumulate over $1,000,000 in net worth even if their annual incomes are modest. Many professional and managerial couples in the Northeast or the West Coast can exceed the $1 million threshold by owning a suburban home in a good school district and having a 401(k) account or two. These upper middle class folks are often opinion leaders and frequent contributors to political campaigns. Although their numbers aren't large, their influence can be significant.

Estate tax reform would demonstrate that the Democrats aren't focused solely on extracting more from taxpayers. It would be a step toward tax equity, and an acknowledgment that those who have worked hard, saved diligently and perhaps created some jobs are entitled to keep a reasonable amount of their hard-earned wealth. It would align Democrats with the American Dream, the notion that anyone who works hard and lives prudently should have a shot at the brass ring. The $1 million threshold hits anyone who reaches the iconic status of a millionaire. Although $1 million isn't what it used to be, it still conveys powerful symbolism and having the estate tax kick in right when the American Dream is attained is the kind of thing that heats the water at Tea Parties.

Republicans would have a hard time opposing estate tax reform. The $1 million threshold is something they rejected with the Bush 43 tax cuts, and they would be compelled to vote in favor of raising it. Certainly, some of them would favor a more dramatic rollback of the estate tax. But others would realize that their outcries over the burgeoning deficit would clash with demands for abolishing the estate tax. Charitable and educational institutions in all Congressional districts, needing endowments now more than ever, would lobby for retaining the tax, putting Republican legislators in the position of damaging local institutions if they favor outright repeal.

Thus, the Democrats would probably secure enough Republican votes that estate tax reform couldn't be filibustered or otherwise blocked. Lifting the threshold would probably cost the Treasury some tax revenues, although the impact is less clear than one might think. Resumption of the $1 million threshold might not benefit the Treasury the most; it could benefit estate planning attorneys the most, along with the finance professionals managing the tax shelters that would blossom if the $1 million threshold took effect. If the Republicans somehow prevented the Democrats from reforming the estate tax, the Democrats could score points in the mid-term elections for trying.

Estate tax reform would position Democrats closer to the political middle, and give them credit for fostering tax equity. It wouldn't directly benefit most voters; only around 2% of estates were subject to estate tax when it kicked in at the $1 million level. But reform would brighten their dreams for their children, whom they hope will face estate tax problems.