Why bill to end ‘stepped up’ basis of Minnesota’s asset taxation is bad

Yesterday, I testified in the House Committee on Taxes in opposition to HF 1689, a bill brought by Rep. Aisha Gomez (DFL) which would abolish the ‘stepped up’ basis of taxation on inherited assets.

What is that?

If an asset bought for, say, $100 appreciates in value over time, it could be worth, say, $1,000 at the time the person who purchased it (the decedent) dies and leaves it to an heir. In this case, the value of the asset is ‘stepped up’ so that their capital gains tax liability is reduced. This happens because, if the heir sells the asset for, say, $1,500 at a later date, their capital gains tax liability is calculated on the gain from $1,000 to $1,500, not the gain from $100 to $1,500. Under HF 1689, in this example, by eliminating the ‘step up’ the capital gains tax would be applied to that gain of $1,400 rather than the $500.

Is it a good or bad thing?

In a certain context, this might not be such a bad thing. As economists Taylor LaJoie and Huaqun Li have written for the Tax Foundation:

Removing step-up in basis comes with advantages and drawbacks, especially in isolation from reforms in other areas such as estate, capital gains, and gift taxes. For example, repealing step-up in basis would make the code more neutral by removing a tax expenditure that allows taxpayers to entirely exclude returns on saving from taxation. It makes the code more stable by broadening the tax base and increasing revenue.

But the first sentence there is crucial: whether abolishing the ‘step up’ is on balance good or bad depends on “reforms in other areas such as estate, capital gains, and gift taxes.” HF 1689 proposes none of those (two years ago, in fact, I was testifying against another of Rep. Gomez’ bills, that one to increase the estate tax). Minnesota’s estate taxes, for example, will remain some of the heaviest in the United States. Becoming the only state to abolish the ‘step up’ on top of these high rates of estate tax will only serve to make us even more of an outlier.

Problems with HF 1689 specifically

There are two further specific problems with this bill.

First, the $1 million threshold is not indexed for inflation so, with bracket creep, more and more Minnesotans will be hit with this tax over time. Second, the bill apparently contains no accommodation for spouses. It may treat a married couple differently depending on whether they both die in the same tax year versus whether they die in separate tax years. 

As it stands, this bill is both badly conceived and poorly drafted and, on those grounds, I opposed it. 

Arguments for and against

I hadn’t actually planned on saying anything about the effects of this tax hike on migration but when a testifier in favor of the bill, Eric Harris Bernstein, Policy Director of ‘We Make Minnesota‘, said that there was no evidence that these migratory effects existed, I felt compelled to respond.*

I referred to a paper for the National Bureau of Economic Research (NBER) titled ‘Taxation and Migration: Evidence and Policy Implications‘ by economists Henrik Kleven, Camille Landais, Mathilde Muñoz, and Stefanie Stantcheva, in which they “review a growing empirical literature on the effects of personal taxation on the geographic mobility of people and discuss its policy implications.” They find that:

There is growing evidence that taxes can affect the geographic location of people both within and across countries. This migration channel creates another efficiency cost of taxation that policy makers need to contend with when setting tax policy.

This paper became the subject of some discussion. Some if it was very strange. Rep. Jennifer Schultz (DFL) pointed out that it was only a working paper that hadn’t been published in a journal. In fact, the NBER is fairly prestigious and, anyway, the paper actually was subsequently published in the Journal of Economic Perspectives last year.

Mr. Bernstein argued that most of the evidence reviewed in the paper dealt with international mobility. But that, of course, simply reinforces the point. I can tell you from experience that moving from one country to another is a massive pain in the backside. If this paper found “growing evidence that taxes can affect the geographic location of people” when international migration is involved, just think how much greater those effects are when we are only talking about moving from Minnesota to South Dakota.

I was grateful to the chair, Rep. Paul Marquart (DFL), for giving me the opportunity to respond to these points. It also allowed me to talk about research which looks specifically at the impact of estate taxes on migration.

A paper by economists Enrico Moretti and Daniel J. Wilson, again from the NBER, titled ‘Taxing Billionaires: Estate Taxes and the Geographical Location of the Ultra-Wealthy‘, looked at “the effect of state-level estate taxes on the geographical location of the Forbes 400 richest Americans and its implications for tax policy”. First, they find that:

Overall, billionaires’ geographical location appears to be highly sensitive to state estate taxes.

Second, they find that:

Surprisingly, despite the high estimated tax mobility, we find that the benefit [in terms of revenue gained] exceeds the cost [in terms of revenue lost] for the vast majority of states.

But not for Minnesota. Moretti and Wilson estimate that we are one of four states which lose revenue as a result of our estate tax. Interestingly, they note that the four states where this is the case are also the four states with the highest top rates of personal income tax: Hawaii, Minnesota, Oregon, and Vermont. The conclusion is obvious: you can have a high rate of estate tax or a high top rate of income tax but you can’t have both. With proposals also afoot in St. Paul to hike the top rate of income tax, this finding is important.

The discussion drew to a close shortly after this. Much of the remaining comment from those favorable to the bill was hand waving to the effect that the evidence can show whatever you want it to. I take it, then, that any notion of evidence based policy is dead and buried and we’re all, now, just flying by the seat of our ideological priors. After a year when we have been told to follow ‘the science’ and ‘the data’, this is rather disappointing.

* Some policymakers apparently believe this untruth also.

John Phelan is an economist at the Center of the American Experiment.