How the Democrats tax proposal affects Minnesota
On Monday, Sept. 13, House Democrats released their tax proposal, which is supposed to pay for their $3.5 trillion spending plan. Among other things, the proposal raises the corporate tax…
By driving out wealthy citizens, it results in a loss of net revenue for the state’s coffers.
Britain’s Prime Minister David Lloyd George is supposed to have said of the Inheritance Tax, “Death is the most convenient time to tax rich people.” A century on, these taxes, known as
inheritance, estate, or death taxes, remain with us. The Economist wrote recently that, “A permanent, hereditary elite makes a society unhealthy and unfair” and concluded that “the positive argument for steep inheritance taxes is that they promote fairness and equality.”
This assumes that people will simply hand over their wealth. But the majority of the consequences of any action are unintended ones. Estate taxes do other things besides bring in revenue. Specifically, they incentivize people to take action to avoid paying them. There are a number of ways in which people can do this, so many, in fact, that, according to the 2006 report of the Joint Economic Committee, “two liberal economists have noted, ‘tax liabilities depend on the skill of the estate planner, rather than on capacity to pay.’” As President Trump’s former Chief Economic Adviser Gary Cohn put it more bluntly, “Only morons pay the estate tax.”
One of these methods is simply to move from a jurisdiction with an estate tax or with one at a high rate to one without or with a lower rate. In the United States, where estate tax rates vary from state to state, this is a particularly important avenue of estate tax avoidance.
So, the effects of estate taxes work in two directions, from a government revenue point of view. On the one hand, they increase overall revenues by the amount due from taxable estates. We can call this the revenue effect. On the other, they reduce overall revenues
by the amount of taxable income and wealth that people leaving the jurisdiction to avoid the tax take with them. We can call this the incentive effect. If the latter amount is greater than the former, then the estate tax actually lowers government revenues.
The revenue side of the equation is straightforward enough. In 2016, Minnesota’s state government took in $183.2 million in estate tax revenue. This represents just 0.8 percent of all state tax revenues. The average revenue over the ten years 2007 to 2016, was $149.4 million. Over this period, the exemption was lower, but revenues were still comparatively small.
But while the dollar value of the revenue effect is known, that of the incentive effect is harder to calculate. No figures exist for the number of people who leave Minnesota because of its estate tax or what their tax liabilities might be if they stayed. However, there is information from surveys and official statistics that allows us to estimate the dollar value of the incentive effect which we can then set against the revenue effect. This enables us, for the first time, to estimate the costof Minnesota’s estate tax.
Taxes and incentives
Incentives are a large part of economics. People act to increase their welfare. They compare estimates of costs to estimates of benefits arising from given actions. Whether it is schoolteachers, realtors, drug dealers, sumo wrestlers, or bagel sellers, incentives inform people’s decision-making. In the financial sphere, the decisions over whether to work, spend, save, or invest, are driven by one’s estimate of the net benefits of doing so.
Taxes affect incentives. They impact an individual’s estimate of his or her take-home pay, the prices they mightface, their dividends, or their capital gains. In each case, a tax will lower the estimated benefits of working, spending, saving, and investing. It is not controversial to say that taxes affect incentives. Much public policy is based on the idea that if we tax things, we get less of them (e.g. smoking and drinking alcohol). When policymakers levy such taxes, they are admitting that they believe that taxes have a disincentive effect. Curiously, however, policymakers are frequently loathe to apply this logic consistently. While they tax smoking and drinking in the belief that there will be less smoking and drinking, they tax work and investment believing that people will go on working and investing just as before.
The estate tax in Minnesota
Minnesota taxes estates more heavily than most. It is one of only fourteen states plus the District of Columbia to levy an estate tax. The state employs a “zero bracket” to exempt estates under $2.1 million. Eight of those fourteen states and the District of Columbia have a higher exemption. The state is currently phasing in an increase in the exemption, ultimately scheduled to reach $3 million in 2020. Above this, Minnesota imposes a six-bracket estate tax. The state’s starting rate of estate taxation—12 percent— is higher than any of the other jurisdictions that levy one and equal to the top rate in both Connecticut and Maine. Its top rate is 16 percent. Only the state of Washington has a higher top rate. (See Figure 1 and Figure 2)
The effects of the estate tax
Individuals seeking to avoid the estate tax have a number of options open to them. They can make gifts and charitable donations. They can switch their wealth into tax free vehicles. Or they can just leave.
There is evidence that a substantial number of people do just this. In 2016, Center of the American Experiment released a report titled Do Minnesotans Move to Escape the Estate Tax? It found that, from 1995 to 2007, the average value of estates reported on federal returns were consistently about the same in states with and without an estate tax. But beginning in 2008, two years after the federal credit for state death taxes was fully repealed, states with no death tax began reporting higher average estate values. In 2014, the average estate value in states with no death tax was $7.5 million, compared to $6.1 million in states that impose a death tax. From a high of 104.2 percent in 2002, the average estate value reported on federal tax returns in states that retained a death tax declined to 81.6 percent of the value of estates in states with no death tax.
After Minnesota increased the top income tax rate, amended the estate tax, and added a gift tax in 2013, the Minnesota Society of Certified Public Accountants surveyed their members. They found that “more than 86 percent of respondents said clients had asked for advice regarding residency options and moving from Minnesota.” Ninety-one percent said the number of clients asking about moving increased from previous years.
Another 2016 report from the Center, Minnesotans on the Move to Lower Tax States, found that of the ten states receiving the most taxable income from Minnesotans leaving the state, only Washington had an estate tax in 2014, although North Carolina also had one until 2013. Of those states contributing income, on net, to Minnesota, three continue to impose a robust estate tax since 2014. However, like North Carolina, Indiana and Ohio only recently repealed their estate taxes. Furthermore, Iowa and Nebraska technically impose an inheritance tax, but in the case of Iowa it does not fall on lineal heirs and Nebraska’s tax on lineal heirs is just 1 percent. Thus, over most of the 10-year period, seven of the ten states contributing net income to Minnesota imposed some type of death tax.
Whereas people can move their domicile, financial accounts and even businesses out of state to avoid estate tax, they cannot move a farm. If people are moving to avoid the estate tax, then the immobile farm assets remaining in the state will year after year account for a greater share of wealth reported on state estate tax returns. A recent study by the Minnesota Department of Revenue suggests this is exactly what is happening. When a new law was passed in 2011 permitting a Minnesotan estate to claim a $4 million deduction for qualified farm and small business property when passed on to qualified heirs, the Minnesota Department of Revenue projected the farm property deduction would reduce estate tax revenues by only $2.3 million in FY 2013. In fact, the revenue loss was actually around $16.3 million, 7 times higher than projected. Without the farm deduction, estate tax collections from estates with qualifying farms would have been 11.4 percent of total estate tax collections, a surprisingly large share.
And there are also residents who don’t move to a state because of its taxes. Economists David Clark and William Hunter find that “all migrants aged 55 to 69 avoid counties in states with high inheritance and estate taxes.” Karen Conway and Andrew Houtenville find that, among the elderly, “low personal income and death taxes also encourage migration.” Jon Bakija and Joel Slemrod find that “high state inheritance and estate taxes and sales taxes have statistically significant, but modest, negative impacts on the number of federal estate tax returns filed in a state.” Ali Sina Önder and Herwig Schlunk find that “the elderly prefer to migrate to states with low inheritance taxes.”
Individuals seeking to escape high estate and inheritance tax rates do not even have to leave the state completely. Depending on state domicile laws, it can often be possible to establish legal residence in another state without moving there full time, particularly if an individual—often a retiree with significant flexibility—is willing to reside elsewhere for part of the year. Minnesota requires a nonresident to reside outstate over half of the year, and to have the bona fides of residency established in that outstate location. A current Minnesota resident can spend over half of the year outstate, establish residency in that outstate location through sufficient changes in driver’s license, voting, homestead status on real estate taxes, etc., and yet retain a part-year residency of less than 183 days in Minnesota.
The effects of Minnesota’s estate tax
So which effect of the estate tax weighs heaviest in Minnesota; the revenue effect or the incentive effect? If it’s the incentive effect, then the tax represents an overall income loss to the state government. But, owing to a dearth of official data, finding out which is the dominant effect is no easy task. The revenue side of the equation is straightforward enough. In 2016, Minnesota’s state government took in $183.2 million in estate tax revenue. (See Figure 3).
But how do we quantify the incentive effect? To answer this, we need some estimate of the number of people who leave the state due to the estate tax and the tax revenue they take with them. When an individual leaves a state, he or she does not just take that year’s tax revenue but all the subsequent years as well.
Fortunately, we have information that allows us to estimate these figures. In 2016, Twin Cities Business magazine published an article titled “Minnesota’s Great Wealth Migration.” This was based on a survey of 400 accounting, legal, wealth management, private equity/investment banking, family business consulting, and related financial services companies in Minnesota, asking them about their clients. From this we have estimates of the number of wealthy Minnesotans who moved to avoid the state’s taxes generally. We also have an estimate of their median taxable income of $677,000 annually. From this we can estimate their annual state income tax liability and, with figures from the Institute on Taxation and Economic Policy, their state sales and excise tax liabilities. From the Census Bureau, we have data by age and income on income tax filers who left the state covering the years 2011-2012 to 2015-2016. This enables us to estimate how many earning and taxpaying years these workers had left for state income tax, or years of life for state sales and excise taxes.
Applying a present value calculation to these amounts, we can estimate the total value of income and sales tax revenues that left Minnesota in each year as a result of the estate tax. This is the incentive effect side of the equation. These are given in Table 1. Looking only at individuals aged over 55, whom the literature suggests are most sensitive to the estate tax, we can assume that they work until they are 70 and that 67 percent of those aged 55 to 65 and 80 percent of those aged 65 and over who leave because of tax do so because of the estate tax. In this case, the estate tax was a net revenue loser for the Minnesota state government in three of the last five years. For example, while the estate tax brought a total of $183.2 million in revenue to the state government in 2015-2016, the people who left because of the estate tax took with them an estimated $230.5 million in forgone income and state and excise taxes. Overall, the estate tax cost the Minnesota state government $47.3 million in lost revenue in 2015-2016, as shown in Figure 4.
The idea that if you tax something you get less of it is standard public policy when it comes to cigarettes or pollution. Even so, policymakers who apply this logic in these cases abandon it when it comes to things like the estate tax. In this case it is assumed that we can tax something and get just as much of it as we did before. This would seem to be unsound theory. Our estimates suggest it is likely to be the case in practice.
I opened this article with a quote from Prime Minister David Lloyd George. I’ll close it with a quote from his countryman, Rolling Stone Keith Richards: “The whole business thing is predicated a lot on the tax laws… It’s why we rehearse in Canada and not in the U.S. A lot of our astute moves have been basically keeping up with tax laws, where to go, where not to put it. Whether to sit on it or not. We left England because we’d be paying 98 cents on the dollar. We left, and they lost out. No taxes at all.”