How Minnesota Estate Tax Collections Might Actually Lower Overall Revenue Collections
In 2014, Minnesota’s estate tax collected $177 million in revenue. On net, however, the estate tax likely collected much less revenue after accounting for its impact on other tax revenues. In fact, the estate tax may not raise any revenue at all.
The substantial size of the estate tax—the average payment was $146,000 in 2012—creates strong incentives for taxpayers to distort their behavior to avoid or reduce the tax. Strategies to come up with the money to pay the tax also distort behavior. These distortions tend to reduce or remove economic activity in the state. This lost economic activity translates to lost state and local revenue tied to the activity. It’s entirely possible these revenue losses are greater than the gains from the estate tax.
How exactly does the estate tax affect other revenues?
The incentive to avoid or reduce the estate tax and the need to pay the tax encourages estate planning, life-time transfers, working less, investing less, consuming more, selling businesses, dissolving businesses, and moving out of the state physically or through the creation of trusts in other states. All of these behavioral changes impact tax collections to some degree.
Here some are some specific actions people take in response to the estate tax that can reduce tax revenues from other sources.
- Change residence to another state. The most obvious impact on tax collections is tied to people who change their residence to another state to avoid Minnesota’s estate tax. When someone changes their residence, they stop paying Minnesota income tax. If they leave the state entirely, then they’ll also stop paying sales and property taxes. Those remaining in Minnesota for part of the year will pay less in sales taxes, depending on how much of the year they remain. They might also pay less in property tax if they choose a more modest second home.
- Move assets to a trust in another state. Wealthy individuals can avoid the state estate tax by relocating assets into a trust. People tend to establish these trusts in other states that don’t tax income or capital gains. Thus, any income and capital gain generated by the trust will also avoid Minnesota taxation, a substantial revenue loss. Both the Dayton family and the Carlson family (Radisson Hotels) maintain so called “dynasty trusts” in South Dakota. Though distributions from these trusts to a Minnesota resident are subject Minnesota income tax, appreciation of the assets are not.
- Gift assets to expected heirs prior to death. Income taxes are also impacted by gifting strategies. People can avoid Minnesota’s estate tax by reducing the size of their estate by making gifts to expected heirs during their lifetime. The person receiving the gift will likely have a lower income and, therefore, be subject to a lower income tax rate. Consequently, any income generated by the gift will likely produce less income tax revenue. This is particularly true at the federal level where the progressivity of income tax rates can result in substantial differences in rates paid by the donor and receiver of the gift. Still, gifted assets will likely pay a lower income tax rate in Minnesota, especially with the added progressivity of the new fourth tier tax rate.
- Create a Family Limited Partnership. Business owners can create a family limited partnership to divide the rights to income, appreciation, and control of the business to family members. Transfers to children are subject to the federal gift tax, but the transfer and any appreciation will be free from the estate tax. Because the rights to income can also be divided, a family limited partnership can also result in substantial income tax savings by sharing income with children in lower income tax brackets.
- Work less. People can choose to retire to a life of leisure or they can choose to keep working and accumulate more wealth to pass on to heirs. Because an estate tax reduces the returns to work, it discourages work and makes leisure more attractive. To the degree people actually work less due to the estate tax, the state will receive less income tax revenue.
- Save and invest less. Just as the estate tax reduces the returns to work, it also reduces the returns to saving and, as a result, encourages consumption and discourages saving. Less saving and investment results in lower investment gains, which results in lower tax revenue from gains. Less investment also leads to less capital formation—e.g., fewer tools, machinery and computers that produce goods and services—a key contributor to productivity growth and, in turn, income growth. Over the long-term, lower income growth due to lower capital formation will result in lower income tax revenues. (Note in this instance the tax impact is not just negative. If the estate tax encourages less saving and greater consumption, then it should increase sales tax revenue.)
- Dissolve a business to pay the estate tax. Heirs receiving a business may dissolve the business to pay the inheritance tax. While state and federal laws allow heirs to spread out payments over time, there may still be difficulty in raising the necessary cash to pay the tax. In this case, the dissolved business with stop paying state and local taxes, not to mention all the other community benefits a business delivers in terms of jobs and services. A recent study in the Journal of Entrepreneurship and Public Policy found the phase out of the federal estate tax after 2001 “lead to a higher growth in the number of firms, especially small ones.”
The net revenue impact of any one of these economic distortions can certainly be debated. The lack of data available to study the behavior of the wealthy makes drawing firm conclusions difficult. As economist Wojciech Kopczuk concluded after reviewing the existing research, “the extent of estate tax avoidance is hard to assess.”
However, when taken together, there’s a very strong case to be made that changing residence, moving assets, creating family limited partnerships, gifting prior to death, working less, saving less, and dissolving businesses reduce state and local revenues by something more than the estate tax collects.
Consider the fact that it is by far easier to avoid the state estate tax than the federal estate tax. First, gifting—the simplest avoidance strategy—is more effective at avoiding state estate taxes. All gifts made 3 or more years before death are free from state taxation. By contrast, at the federal level all taxable gifts (currently gifts over $14,000) made during a lifetime will be taxed according to the same exemption amount (currently $5.43 million) and rate schedule as the estate tax. Second, changing residence is probably the next easiest avoidance strategy, especially for wealthy people who already own two homes. This option, of course, only really works to avoid the state estate tax. People do leave the country, but very few.
Now consider Stanford economist Douglas Bernheim’s widely cited conclusion that “true [federal] estate tax revenues may well have been negative” in the period he studied. Likewise, Harvard economist Martin Feldstein wrote in the Wall Street Journal, “when the incentive effects of the tax are taken into account, the net impact of the estate tax is probably to reduce overall tax revenue.”
If the incentive effects of the federal estate tax can reduce overall revenue, then certainly the incentive effects can reduce overall revenue at the state level where the incentives to change residence and make unlimited gifts are available and easy to act on.
This is true even though, as noted above, the more progressive federal tax code will result in greater income tax revenue losses under those avoidance strategies that transfer assets to people with lower tax rates. The additional state revenue losses from changing residence and gifting likely compensate for a state’s less progressive income tax.
The most meaningful study, by Jon Bakija and Joel Slemrod, on whether state estate taxes impact decisions to change residence found “robust evidence of some sort of behavioral response to state taxes by the rich.” While this study shows a robust relationship, it is also estimates sales, property and income tax revenue losses from this migration “are unlikely to be large relative to revenues collected.”
Still, depending on whether someone moves five years or ten years before death, the study estimated total revenue losses between 10.7 percent and 33.1 percent of the revenue gain from the state estate tax. This is not an insignificant revenue loss when taken together with all the other state estate tax avoidance strategies that threaten to reduce state sales, property and income tax revenues. Furthermore, as will be discussed in a later blog post, this study likely underestimates revenue losses for Minnesota today.
Adding up all the possible revenue losses from the various avoidance strategies discussed here provides a strong argument these losses overwhelm the revenue gains from Minnesota’s estate tax, which presents a strong case for completely eliminating Minnesota’s estate tax.
The risk the estate tax undermines other revenue sources, not to mention the other economic damage it causes, is just too high to justify the small amount of revenue collected.