Ray D. Madoff's opinion on fixing the federal estate tax: an unbalanced proposal

On November 21, 2009, Ray D. Madoff (professor, Boston College Law School) published a New York Times Op-Ed article, Protect the Farm, Tax the Manor. 

This article is interesting because Madoff proposes a solution for estate tax reform.  It is important because Madoff is highly respected and is well known among practitioners because she is the lead author of Practical Guide to Estate Planning (CCH).

Madoff opposes President Obama's proposal, which would make permanent the applicable exclusion amount of $3.5M and tax rate of 45%, for two reasons:

1. It would provide the government less revenue than under current law (which repeals the estate in 2010 and has it come back with a vengeance in 2011).
2. It would harm farmers and small businesses and constitute "an unnecessary giveaway to Americans who least need it."

Madoff's proposal would first "protect the farm" by providing a separate exclusion amount for farmers and small business owners:

Congress and the president should forge a different compromise that would respond to the concern for the family farmer and business owner, but still impose appropriate taxes on the wealthy heiresses — and heirs — of America. . . .

It is important to us that children be able, if they so desire, to carry on the work of their parents. Thus, it is appropriate for the estate tax to have a large exemption for family businesses — perhaps as much as $10 million, and indexed to rise with inflation.

Madoff would then tax everyone else at a higher rate and provide them with a lower exemption:

American estate tax rates have been as high as 77 percent, so 55 percent would be reasonable when coupled with a general exemption of $1 million to $2 million.

Review:

On one hand, Madoff's proposal comes off as balanced.  She would lower the estate tax for its most vocal opponents -- farmers, ranchers, and small business owners -- but she would raise the tax for others, including those with "manors." 

On the other hand, imposing a higher estate tax on everyone other than farmers and small business owners leans to the left. 

• Madoff makes sure to mention $1M as a possible general exemption amount.  But this lower amount would catch far too many people.   
• It is important to note that she also cites the very high historic rate of 77%.  This reference serves an important psychological purpose.  It makes a 55% tax rate seem small in comparison.  The effect would be far different if we started with absolutely no estate tax, which also was the case at one time, and then jumped up to 55%. 

These numbers -- $1M and 77% -- are not innocuous.  Daniel Kahneman, a Nobel laureate, has shown that "[i]t matters a great deal what the starting point (the reference point) is." (From a short article about his work.) 

Madoff's tilt to the left is also shown in the following cleverly written paragraph:

There is a big difference between wealth acquired through hard work and creativity and wealth bestowed as an accident of birth, and Congress should not be afraid to make this distinction. Keep in mind that inherited wealth is completely free of income taxes. Thus, while a person who earns $200,000 by working must contribute more than $50,000 in federal taxes, a person who inherits $200,000, or even $200 million, pays no income taxes at all.

The first sentence is clearly true: there is a difference between money that is earned by a person and money that is given to a person.  But the rest of the paragraph is misleading for the following reasons:  

1. Inherited wealth is not free of income taxes.  Earned income has already been subject to income taxes.  Built-in gains on property, on the other hand, has not been subject to tax.
2. The federal estate tax is a second tax on money that is from earned income.  The first tax is the income tax.  The second is the estate tax, which is a tax imposed on the privilege of transferring money at death.

Overall, I find Madoff's proposal to protect farmers and small business owners appealing, but I am uncomfortable with her treatment of everyone else.

(Please note that I could not give Madoff's proposal the balanced scale icon.  Instead, I gave each part of her proposal a different icon because each has a different lean.)

[Updated for clarification on 11/21/09 at 8:00 pm]