BULLETIN

B-07/01
February 22, 2001

President Bush's tax reduction proposals call for elimination of the federal estate and gift tax by 2009. A similar measure was passed by the Congress in 2000, but vetoed by President Clinton. Repeal of the federal estate tax will effectively repeal the state estate tax in 40 states and the District of Columbia¹ and have a fiscal and tax policy impact on the others because it would do away with the state death tax credit -- a feature of the federal estate tax with which all states have, to varying degrees, coordinated their death (inheritance or estate) taxes. Repeal of the federal estate tax, presuming no countervailing state legislative action, will reduce state tax receipts by several billions of dollars annually.

Mechanics
The Internal Revenue Code (IRC § 2011) allows a credit against federal estate taxes (on a dollar-for-dollar basis) for state death taxes paid. The state death tax credit is limited based on the size of the estate and a set of graduated rates specified in federal law.²

All states have structured their inheritance/estate taxes to be coordinated with the federal state death tax credit. At the present time, 38 states and the District of Columbia [Table 1] provide that the only state death tax is a "pick-up" or "sponge" tax in which the state death tax is an amount equal to the state death tax credit allowed for federal purposes. In addition, Louisiana and Connecticut have enacted laws to move to a pure pick-up tax by 2004 and 2005, respectively.

P = Pick-up tax only; I = Separate state inheritance tax; E = Separate state estate tax.

Connecticut is phasing out its inheritance tax; under current law, the state will move to a pick-up only tax in 2005.
Louisiana is phasing out its inheritance tax; under current law, the state will move to a pick-up only tax in 2004.
Mississippi phased out its separate estate tax. After January 1, 2000, only the pick-up tax applies.
Montana voters approved an initiative repealing the state's inheritance tax effective December 31, 2000; only the pick-up tax now applies.
Nebraska employs a pick-up tax at the state level. Counties impose and collect a separate inheritance tax.
New York repealed its separate estate tax effective February 1, 2000; the state now has a pick-up tax based on the state death tax credit schedule in effect on that date.
North Carolina moved from an inheritance tax to a pick-up only tax effective January 1, 1999.
South Dakota voters approved repeal of the state's inheritance tax effective June 30, 2001; at that point, the state will move to a pick-up only tax.

Source: Commerce Clearing House, 2001 State Tax Handbook and discussions with state tax administrators.

A pick-up tax works as if the state had enacted an estate tax with rates (and base) equal to the credit schedule specified in federal law. Under a pick-up tax there is no additional net burden to the taxpayer from the state tax; in its absence, additional tax in the same amount would be paid to the federal treasury. Repeal of the federal estate tax will have the effect of repealing the state death tax in those jurisdictions that rely only on a pick-up or sponge tax.³

The remaining states employ a separate estate tax or a separate inheritance tax, although in most cases the definition of many items in the tax conforms closely to the federal estate tax.⁴ In each of these states, the state death tax also provides that in cases where the amount allowed under the federal death tax credit is greater than the liability computed under the separate state inheritance/estate tax, the liability of the taxpayer is the amount of the death tax credit.

The state death tax credit has been a permanent feature of the federal estate tax since 1926. At that time, the federal government was looking to reduce estate tax rates (increased temporarily during World War I) or to repeal the tax and leave it to the states that had traditionally made greater use of the tax than the federal government. At the same time, state leaders were seeking mechanisms to reduce what was becoming an intense competition for wealthy residents. In the years preceding 1926, some states had repealed their death taxes, and two had adopted constitutional amendments prohibiting such levies in an effort to attract wealthy retirees as residents. Enactment of the state death tax credit in 1926 served both purposes. It reduced the federal tax and reduced interstate competition by putting a floor on the level of combined state-federal death taxes.⁵

Fiscal Impact
In FY 1999, total state revenues from all types of death taxes amounted to about $7.5 billion,⁶ or 1.5 percent of all state tax collections as shown in Table 2.⁷ Death taxes ranged from somewhat over 4.5 percent of total state tax receipts in New Hampshire to less than 0.2 percent of all taxes in Alaska.

In the 35 jurisdictions employing only a pick-up tax in 1999, death tax revenues amounted to $3.95 billion or 1.2 percent of state tax revenues in FY 1999. In states employing a separate inheritance or estate tax, death tax revenues accounted for $3.6 billion or 2.1 percent of tax revenues in those states.

Projecting the fiscal impact of the federal estate tax repeal in 2009 is difficult. Such a projection would rely on changes in the value of estates subject to tax as well as the projected impact in those states having a separate state tax operating along side the state death tax credit. The Center on Budget and Policy Priorities, a Washington-based research and advocacy group, has estimated that federal repeal in 2009 would reduce state revenues by upwards of $9.0 billion annually by that time.⁸ That would seem to be a reasonable figure given the large majority of states that rely only on a pick-up tax and projected increases in federal estate tax receipts. Federal estate tax receipts were $29.0 billion in FY 2000, and the Joint Committee on Taxation expects cost of the fully phased-in estate tax repeal to exceed $50 billion per year in 2009.

At a minimum, it can be said that if the federal tax had been repealed in 1999, state revenues would have been reduced by just under $4 billion, not an insignificant amount. In 2000, the impact of all state legislative tax changes was projected to reduce state receipts by about the same amount.

Other Issues
Repeal of the federal estate tax raises additional issues. First, those states that employ a separate state estate or inheritance tax generally follow federal rules regarding the treatment of certain types of property or transactions in computing estate values or bequeathed amounts. This is generally done in the interests of taxpayers as well as compliance and trying to establish a single set of estate planning rules for taxpayers. In the absence of a federal estate tax, these rules are likely to be 'frozen in time' and eventually diverge from state-to-state. There are some who question the ability of states to maintain a separate tax in the absence of a federal levy.

Second, repeal of the estate tax may well have implications for other taxes as it changes expected taxpayer behavior. The lack of an estate tax may well have an effect on transfers of property among individuals, charitable donations and capital gains realizations &endash; each of which may affect other taxes. The difficulty will be in attempting to sort out the issues so that accurate projections of the other taxes can be made.

In addition, there has been some speculation that the absence of a federal estate and gift tax would provide planning opportunities in which wealthy individuals could take advantage of state tax differences to avoid state tax on certain types of income. The New York Times in a front-page piece [01/29/2001] suggested that repeal of the federal estate and gift tax would enable some individuals to establish trusts in non-income tax states, avoid tax on the income to the trust and recover the capital of the trust without an income tax at a later point, even though the individual was a resident of an income tax state. The article also identified that repeal of the federal tax would allow a gifting of appreciated stock to individuals with a low income or negative income, thus allowing a realization of the gain with minimal tax consequences.

	Death Tax	Per Capita	Percent	Type of
	Revs. ($000)	Revenues	of Total	Tax
Alaska	$ 1,726	$ 2.79	0.2%	P
Alabama	$ 62,784	$ 14.37	1.0%	P
Arkansas	$ 32,572	$ 12.77	0.7%	P
Arizona	$ 89,088	$ 18.64	1.2%	P
California	$ 877,901	$ 26.49	1.2%	P
Colorado	$ 65,391	$ 16.12	1.1%	P
Connecticut	$ 250,171	$ 76.22	2.6%	I*
District of Columbia	$ 26,200	$ 50.48	0.9%	P
Delaware	$ 27,058	$ 35.91	1.3%	P
Florida	$ 649,521	$ 42.98	2.7%	P
Georgia	$ 111,192	$ 14.28	0.9%	P
Hawaii	$ 28,738	$ 24.24	0.9%	P
Iowa	$ 72,836	$ 25.38	1.5%	I
Idaho	$ 11,128	$ 8.89	0.5%	P
Illinois	$ 346,978	$ 28.61	1.6%	P
Indiana	$ 148,712	$ 25.02	1.5%	I
Kansas	$ 70,239	$ 26.46	1.5%	P
Kentucky	$ 81,483	$ 20.57	1.1%	I
Louisiana	$ 95,973	$ 21.95	1.6%	I*
Massachusetts	$ 173,867	$ 28.16	1.2%	P
Maryland	$ 126,168	$ 24.40	1.3%	I
Maine	$ 29,768	$ 23.76	1.2%	P
Michigan	$ 174,891	$ 17.73	0.7%	P
Minnesota	$ 58,132	$ 12.17	0.5%	P
Missouri	$ 118,670	$ 21.70	1.4%	P
Mississippi	$ 30,767	$ 11.11	0.7%	P*
Montana	$ 18,302	$ 20.73	1.3%	P*
North Carolina	$ 182,851	$ 23.90	1.3%	P*
North Dakota	$ 7,416	$ 11.70	0.7%	P
Nebraska	$ 17,449	$ 10.47	0.7%	P*
New Hampshire	$ 49,368	$ 41.10	4.6%	I
New Jersey	$ 423,015	$ 51.95	2.5%	I
New Mexico	$ 21,912	$ 12.59	0.6%	P
Nevada	$ 41,472	$ 22.92	1.2%	P
New York	$ 1,071,464	$ 58.88	2.8%	P*
Ohio	$ 141,456	$ 12.57	0.8%	E
Oklahoma	$ 88,796	$ 26.44	1.6%	E
Oregon	$ 47,979	$ 14.47	0.9%	P
Pennsylvania	$ 760,698	$ 63.42	3.5%	I
Rhode Island	$ 46,854	$ 47.29	2.5%	P
S. Carolina	$ 57,190	$ 14.72	1.0%	P
S. Dakota	$ 26,427	$ 36.05	3.0%	P*
Tennessee	$ 89,127	$ 16.25	1.2%	I
Texas	$ 256,277	$ 12.79	1.0%	P
Utah	$ 8,238	$ 3.87	0.2%	P
Virginia	$ 154,078	$ 22.42	1.3%	P
Vermont	$ 23,358	$ 39.34	2.3%	P
Washington	$ 69,701	$ 12.11	0.6%	P
Wisconsin	$ 116,898	$ 22.26	1.0%	P
West Virginia	$ 27,325	$ 15.12	0.9%	P
Wyoming	$ 9,731	$ 20.29	1.2%	P
U.S. Total	$ 7,519,336		1.5%

P = Pick-up tax only
E = Separate state estate tax
I = Separate state inheritance tax
* = See footnotes to Table1
Source: U.S. Bureau of the Census, State Government Finances in 1999

¹ This count includes Louisiana and Connecticut, each of which under current state law, will have moved to a "pick-up tax" only by the time the repeal is effective. Throughout the report, D.C. is considered a state.

² The maximum allowable credit ranges from 0.8 percent for estates with an adjusted taxable value of $40,000-$90,000 to 16 percent for estates with an adjusted taxable value in excess of $10,040,000.

³ This is not automatically the case in New York and Washingon where the state pick-up tax is based on the federal estate tax as it existed on a certain date. Repeal of the federal estate tax would leave the state with an estate tax equal to the current state death tax credit schedule. Absent any state legislative action, this would constitute a separate estate tax filing in New York.

⁴ In Nebraska, the state imposes a pick-up tax; counties impose and administer a separate inheritance tax. There is no credit for the local inheritance tax; that credit is absorbed by the state pick-up tax.

⁵ Advisory Commission on Intergovernmental Relations, "Coordination of State and Federal Inheritance, Estate and Gift Taxes," Washington, D.C., January 1961.

⁶ These revenue figures also include modest amounts of "gift tax" revenues in the 4 states levying such a tax. The President's proposal would also repeal the federal gift tax since the primary purpose of the tax is to prevent the use of gifts prior to death as a means of avoiding the estate tax. This review presumes states would also terminate their gift taxes.

⁷ By comparison, federal estate taxes amounted to $27.8 billion in FY 1999 or 2.3 percent of federal revenues other than Social Security and Medicare taxes.

⁸ Elizabeth C. McNichol, Iris J. Lav, and Daniel Tenny, "Repeal of the Federal Estate Tax Would Cost State Governments Billions in Revenue," Center on Budget and Policy Priorities, Revised December 12, 2000.