New Estate Tax Break Comes with High Cost in Revenue, Fairness
While most provisions of Minnesota’s recently enacted tax law improved tax efficiency and fairness, it also provided large tax breaks to some of the state's highest income households through changes to the estate tax and elimination of the gift tax. These changes are expected to cost Minnesota $43 million in FY 2014-15, $144 million in FY 2016-17, and by about $200 million or more per biennium when the law is fully phased-in.
Part 1 of this series examined the benefits of the estate tax, while part 2 rebutted conservative criticisms of the tax. This week, our attention turns to the estate tax changes adopted in chapter 150, the first omnibus tax act of the 2014 legislative session.
The estate tax changes were partly a response to a confusing and uneven rate structure resulting from the merging of two separate calculation methods—a byproduct of the tax’s convoluted history. Under this system, the first $1 million of estate value (i.e., after the exclusions and deductions noted in part 1 of this series) was exempt from taxation. (For estates consisting primarily of farm and small business property, this exemption is effectively $5 million.) However, at $1 million of value, the marginal estate tax rate jumped from 0 to 41 percent, where it remained before dropping to 5.6 percent at a value of $1,093,786. The range from $1,000,000 to $1,093,785 at which this high marginal rate applied is referred to as the “rate bubble.”
It is important to note that federally taxable estate value is reduced (or “deducted”) by the amount paid in state estate taxes. In 2014, the first $5.34 million* of estate value is exempt from the federal tax. For Minnesota, the state estate tax deduction is sufficient to wipe out the entire federal estate tax liability for estates with values between $5.34 million and $5.83 million and reduce the federal tax by 40 percent of the state tax on the portion of estate value above $5.83 million. Through this “federal offset,” a large portion of the 2014 Minnesota tax on estates in excess of $5.34 million is effectively exported to the federal government in the form of reduced federal taxes.
The recently enacted estate tax changes will double the portion estate value exempt from the tax from $1 million to $2 million (phased-in gradually over 5 years) and impose a new unified rate schedule on value in excess of the exempt amount. In addition, the new law eliminates the state’s gift tax.
The graph below shows what Minnesota estate taxes minus the federal tax reduction due to deductibility would be for estates of varying value under the old law (blue line) and the fully phased-in new law (red line) in 2014. This graph is somewhat hypothetical, since the new law’s $2 million exemption will not be fully phased-in until 2018; nonetheless, it provides a good illustration of the effects of the new law relative to the old. In this graph—and elsewhere in this article—“estate value” refers to the taxable value of the estate (i.e., excluding value given to charities, surviving spouse, etc.). In addition, the “Minnesota estate tax” refers to the tax amount prior to subtraction of Minnesota credits and before reductions in the tax for the portion of estate value outside of Minnesota. The graph below does not apply to estates consisting primarily of farm and small business property, which are exempt to $5 million.
The largest tax reductions as a result of the new law occur for estates valued between $1 million and $3 million—a result of the doubling of the exemption. Due to the new rate structure, the tax reductions dissipate as values approach $5.3 million (again based on 2014 federal exemption levels). The dip in both lines for estates valued from $5.34 million to $5.83 million is the result of the deductibility of state taxes, described above.
Some positive features of the new estate tax law should be noted. First, by instituting a new rate schedule, the new law eliminated the “rate bubble” that resulted from the old two-tiered calculation. Second, tax reductions under the new law are concentrated primarily on estates with values below $5.3 million. Estates with values in excess of this amount receive relatively minor tax reductions, ranging from a 3.7 percent reduction for a $5.3 million estate to less than 0.1 percent for a $100 million estate. As a result, Minnesota’s ability to export its state estate tax liability to the federal government through deductibility is nearly fully maintained.
However, these outcomes were achieved at a steep price. The new estate tax law is projected to reduce state revenue by $25 million in FY 2014-15, $112 million in FY 2016-17, and by considerably more in subsequent biennia when the $2 million exemption is fully phased-in. In addition, the repeal of the state’s gift tax—a useful complement to the estate tax in that it reduces the ability to avoid the estate tax by “gifting” assets prior to death—will further erode projected state revenues by $18 million in FY 2014-15 and $33 million in FY 2016-17. When the new estate tax law is fully phased-in, it—along with the gift tax repeal—will likely reduce state revenue by over $200 million per biennium.
The benefits of the new estate tax law—the simplification of the rate structure and the elimination of the “rate bubble”—could have been achieved at a much lower cost. House File (HF) 2108 would have provided the same estate tax simplification benefits, but would have only reduced state revenues by a projected $4 million in FY 2014-15 and $11 million in FY 2016-17. HF 2108 would have had the additional benefit of preserving the state's gift tax, but combining estate and gift tax rates into a single schedule.
Things could have been worse. Estate and gift tax changes in a preliminary version of the Senate tax bill would have reduced revenue by a projected $25 million in FY 2014-15, $180 million in FY 2016-17, and approximately $270 million per biennium when fully phased-in. Conservatives in both bodies unsuccessfully attempted to completely eliminate the estate and gift taxes, effectively cutting approximately one-half billion dollars in biennial revenues going forward.
Even so, the damage done was bad enough. The estate tax provisions in the new tax act will reduce revenues generated by the estate tax—the state’s most progressive tax—by over one-third when fully phased-in, thereby eroding some of the advances in reducing tax regressivity made through other tax changes enacted during the 2013 and 2014 sessions and depriving the state of resources that could have been devoted to critical needs, such as increasing the state budget reserve, which is still considerably below the level recommended by the bi-partisan 2009 Budget Trends Advisory Commission.
In substantially reducing the estate tax, policymakers acted from an exaggerated sense of the tax’s detriments and an under appreciation of its benefits. The result will stand as one of the more disappointing outcomes of the 88th legislative session.
*The federal estate tax exemption is indexed to inflation so that it increases in subsequent years. The analysis in this article is based on the 2014 exemption level.