The estate tax and charitable bequests: elasticity estimates using probate records.

INTRODUCTION

The federal estate tax allows a deduction for every dollar bequeathed to charitable organizations. By effectively lowering the relative price of charitable bequests, the deduction provides future decedents with a strong incentive to make charitable bequests over bequests to other heirs.

Previous studies on this topic usually find that both the estate tax (or tax price) and after tax wealth are significant determinants of charitable bequests. However, to determine the efficiency of the estate tax, previous studies also estimate wealth and price elasticities of charitable bequests. (1) Since the efficiency of the tax will depend on both of these elasticities, a precise estimate of the price elasticity is important for policy. Unfortunately, due to data limitations, price elasticities from previous studies may be biased by multiple factors. First, cross-sectional studies are often forced to rely on strong assumptions about the marital deduction or the model's functional form to identify the price effect. (2) If these assumptions fail, the price elasticity will be overestimated. Second, all of the previous studies derive the charity price from the tax schedule in place at the time of death. Since charitable bequests are determined at the time the will is written, a more accurate price might be derived from the date-of-will tax schedule. Measurement error from using the incorrect price will bias the price elasticity estimate toward zero. Finally, datasets used in previous studies only include estates that file a federal estate tax return. Since only the wealthiest estates are required to file a federal return, these studies omit most of the wealth distribution. According to Piketty and Saez (2001), only 4.35 percent of all decedents filed a federal estate tax return in 1997. Consequently, price elasticities from these studies are relevant only for the very wealthy. Price elasticity estimates for the non-wealthy are important for state tax policy because many non-filers face state estate and inheritance taxes.

By employing data from 1980-82 San Francisco County probate decedents and exploiting the tax changes that occurred during this period, this paper adds to the existing literature in several ways. First, since the identification approach uses cross-year variation in tax rates, I eliminate the marital deduction as a source of variation and rely less on functional form assumptions. Second, using available information on the date of will, I estimate models with tax prices derived from the date-of-will tax schedule. This allows a comparison between the date-of-death and date-of-will tax prices and provides evidence about which is the stronger determinant of charitable bequests. Finally, I estimate price elasticities for the non-wealthy portion of the wealth distribution.

Results from Tobit regressions suggest that assumptions about functional form can bias price elasticity estimates for filers of the federal estate tax return. Including a quadratic wealth term in the charitable bequest equation captures much of the nonlinear wealth effect in this data. I find that employing the marital deduction as a source of variation does not greatly bias the price elasticity. However, I present evidence that the assumption of predetermined spousal bequests, which is needed to employ this source of variation, is not an accurate model of the charity-spouse bequest decision. The date-of-will tax price and date-of-death tax price are both found to be significantly related to charitable bequests. Price elasticity estimates for estates that filed a federal estate tax return range from -1.45 to -1.25 when the date-of-death price is used, and -2.54 to -1.23 when the date-of-will price is used. These estimates are within the range of previous studies. For non-wealthy estates that did not file a return, price elasticities range from -6.16 to -5.72 when the date-of-death price is used, and -3.13 to -0.62 when the date-of-will price is used.

The remainder of this paper is organized as follows. The second section reviews the empirical approaches of previous papers, the third section describes the previous research, and the fourth section describes the federal estate tax and California inheritance tax. The fifth section and sixth sections describe the data and discuss the identification approach, respectively. The seventh section presents results and the eighth section concludes.

REVIEW OF PREVIOUS EMPIRICAL APPROACHES

Sources of Variation

Within-Year Variation

A major challenge in studies of the estate tax and charitable bequests is the separate identification of wealth and tax price effects. (3) Since the tax price is largely a function of estate size, these variables are likely to be highly collinear. Identification can be particularly difficult in cross-sectional studies because there is little variation in price that is independent of estate size. Previous studies, which typically employ a single year of cross-sectional data, are forced to rely solely on within-year variation in marginal tax rates for identification. Using the nonlinearity of the tax schedule, the broadness of the tax brackets, the marital deduction, and other sources of within-year variation, these studies have been very successful in obtaining significant estimates of wealth and price effects. (4) Unfortunately, within-year variation will produce unbiased estimates of the price effect only under certain assumptions. In particular, variation from the marital deduction and nonlinearity of the tax schedule require strong assumptions about spousal bequests and the functional form, respectively. Relaxation of these assumptions will not only reduce the potential bias, but also eliminate the main sources of variation. Thus, researchers face a tradeoff of identification for unbiasedness. The remainder of this section describes these identification assumptions in greater detail and illustrates why biased price estimates will result if the assumptions fail.

The marital deduction generates an exogenous source of variation under the assumption that spousal bequests are determined before charitable bequests. For estates of the same wealth, variation in spousal bequests creates variation in the taxable estate and, hence, in marginal tax rates. This assumption is dangerous if, instead of being predetermined, spousal bequests are determined jointly with charitable bequests. In this situation, reliance on the marital deduction as a source of variation will yield a biased estimate of the tax price effect. Larger spousal bequests imply both a lower marginal tax rate and a smaller charitable bequest, thus indicating a positive association between tax rates and charitable bequests (and a negative association between price and charitable bequests). Cross-sectional studies can easily avoid this bias by ignoring the marital deduction, but doing so eliminates a potentially important source of variation.

Variation from the nonlinearity of the tax schedule will produce unbiased price estimates as long as the correct functional form is employed. Typically, previous studies utilize this source of variation by assuming that only linear price and estate terms enter the charitable bequest equation. The implicit assumption is that polynomial and interaction terms of estate and price are not significant determinants of charitable bequests. The problem with this identification approach is that because it is impossible to know the true functional form a priori, price estimates will always be biased (Feenberg, 1987). Moreover, since price is a nonlinear function of estate size, price may serve as a proxy for excluded nonlinear estate terms (Bakija, 2000). Attempts to reduce this bias by adding nonlinear terms increase the chance of perfect multicollinearity between the price and estate variables. Again, there is a tradeoff of unbiasedness and identification. The empirical approach utilized here tackles this problem by including nonlinear wealth terms to reduce bias, and relying on cross-year variation to avoid multicollinearity.

Cross-Year Variation

The cross-year variation in this study is generated from changes in the federal estate tax and California inheritance tax across years. These tax changes are described in the fourth section. Cross-year variation is advantageous because the variation in marginal tax rates is independent of spousal bequests and functional form. Further, since these specific tax changes affect the entire wealth distribution, the variation is largely independent of estate size.

Date-of-Will Versus Date-of-Death Tax Price

Previous studies all use a tax price based on the date-of-death tax schedule. The implicit assumption in these studies is that the tax rate at the date of death is the only rate individuals consider when making the charitable bequest decision. Since the decedent's will typically dictates the amount left to charity, a more plausible assumption might be that the date-of-will tax rate is the rate individuals consider. (5) However, even this rate may be incorrect because, whether they do it or not, individuals always have the option to update their wills up until the date-of-death. Individuals who do not update their wills to reflect tax changes implicitly accept the date-of-death tax price. Perhaps the most realistic assumption is that some bequests are based on the date-of-will tax rate, and some are based on the date-of-death tax rate.