Statement of

Keith Collins
Chief Economist
U.S. Department of Agriculture

before the Committee on Agriculture, Nutrition, and Forestry
United States Senate

February 25, 1997

Mr. Chairman and Members of the Committee, I appreciate the opportunity to appear before you at this hearing on tax issues of importance to farmers. With me today is Ron Durst, U.S. Department of Agriculture's (USDA) expert in farm tax issues. Our goal today is to present basic information on the major taxes of interest to U.S. agriculture. In my remarks, I will identify these taxes, particularly estate and capital gains taxes, and indicate their importance to U.S. agricultural producers. I will also discuss the Administration's FY 1998 budget proposals affecting estate and capital gains taxes. USDA does not have the Administration lead on tax policy; therefore, any issues related to tax policy or the broader economic effects would have to be addressed by the Department of Treasury.

Taxes Affecting U.S. Farmers

Farmers like other taxpayers are subject to a variety of taxes at all levels of government. To put the different types of taxes in an overall context, the major taxes paid by farm sole proprietors total between $25 and $30 billion annually. At the Federal level, these taxes include the Federal income and self-employment taxes as well as Federal estate and gift taxes. Federal taxes account for about two-thirds of the total taxes paid by farm sole proprietors. Of these, the Federal income tax is the most important. In 1993, the most recent year for which data are available, farm sole proprietors paid $16.0 billion in Federal income taxes on their farm and nonfarm income, including capital gains from the sale of farmland and other assets. They paid an additional $1.9 billion in self-employment taxes. Farm partnerships and corporations undoubtedly paid substantial Federal income and payroll taxes as well. However, insufficient information exists to provide a reliable estimate of these taxes.

Federal estate and gift taxes in comparison to the Federal income and self-employment taxes are relatively small. Based on a recent analysis of farm level survey data, Federal estate and gift taxes paid by persons with farms were estimated at about $500 million. However, as will be discussed later, this does not mean that Federal estate and gift tax policies are of little importance to the farming community.

State and local taxes account for about one-third of the taxes paid by farm sole proprietors. The major taxes are state and local income taxes which total about $3.5-$4.0 billion per year and real estate and other property taxes which account for about $4 billion per year.

Federal Estate and Gift Taxation

Federal estate and gift taxes represent only about I percent of total Federal revenues with total Federal estate and gift taxes accounting for $17.2 billion in 1996. However, while the aggregate importance of Federal estate and gift taxes is small relative to other Federal Government revenue sources, the potential impact of these taxes on an individual or group of individuals, such as farmers, can be substantial.

The most important aspect of the Federal estate tax which largely determines the percentage of estates subject to the tax is the unified credit, which provides an exemption from the estate tax for most estates. The unified credit was increased substantially in 1981 to a credit of $192,800 that was phased-in through a gradually increasing credit each year until 1987 when it became fully effective. The current credit is equal to $192,800 which, under the current tax rate structure, exempts the first $600,000 of an estate. As a result of the credit, with only minimal planning, a married couple should be able to transfer a minimum of $1.2 million in assets to their heirs without incurring Federal estate and gift taxes. About 5 percent of U.S. farms have a net worth in excess of $1.2 million.

The importance of the unified credit for farmers can be illustrated by examining the size of farm that can be transferred without incurring any Federal estate tax. In 1981, based on U.S. average values for farm real estate, the unified credit allowed 214 acres of farm real estate to be transferred tax-free. By 1987, as a result of the drop in farmland values and the substantial increase in the credit, which was clearly intended to overcompensate for inflation, about 1,000 acres could be transferred tax-free. As a result of the recovery in land values over the last decade, today the amount of farm real estate that can be transferred tax-free has declined by 32 percent to 675 acres, but remains over 200 percent greater than the 1981 level.

Over the years, the impact of Federal estate and gift tax policies on the ability of farmers to transfer the farming operation to the next generation has been a major concern among farmers, They have been concerned that their heirs would have to incur large debts or sell all or part of the farm to settle the estate. It was precisely this concern that led to the enactment of the special use valuation provision available to farmers and other small businesses. This special valuation provision allows farmers to value their farmland at its farm value rather than its fair market value, which may reflect development potential for non-farm use. While the savings from the special use valuation provision vary, in many instances the value of the real estate portion of the estate can be cut in half While the total reduction in the value of the farmer's estate is limited to $750,000, relatively few farm estates are affected by this limit. Based on 1994 IRS data, the average reduction in value for Federal estate tax purposes for those electing special use valuation was $343,000.

The level of savings available under the special use valuation provision makes it a very valuable estate planning tool. There are restrictions designed to limit benefits to the estates of individuals who themselves or members of their family were actively engaged in farming and whose heirs agree to continue farming for a period of 10 years and actually do so. Furthermore, benefits of the special use valuation provision vary by region and are greatest for those estates comprised primarily of land compared to those with farm machinery and other types of property.

Despite the availability of the special use value provision, a larger share of farmers compared to other taxpayers continue to be subject to the Federal estate tax because they are wealthier than the general population on average. A recent study by USDA's Economic Research Service, examining the impact of Federal estate and gift taxes on farmers, found that an estimated 6 percent of farmers' estates end up owing Federal estate and gift taxes, compared with just over I percent of all estates.

The study, based on 1994 farm-level survey data, found that the average estate of-about $461,000 could easily be transferred to the heirs of the estate free of Federal estate tax liability with little or no planning. However, the analysis suggested that there are a large number of farm estates with assets well above the current $600,000 unified credit exemption. Using the 1994 data, the study estimated the number of farm estates at 29,340 with 4,150 having gross assets in excess of $600,000. However, after deductions, only 1,741 of these estates were taxable. The average Federal estate tax for these estates was estimated at $285,000. Given an average net worth of $1,587,000, this resulted in an average tax rate of about 18 percent. The special use valuation provision was found to be especially important in reducing both the level of taxes and the number of taxable estates. The provision reduced both the number of taxable estates and total Federal estate and gift taxes for all farm estates by about one-third.

Federal estate taxes are normally payable within 9 months after the date of death. With an average tax rate of 18 percent and over 75 percent of the farm estate's assets consisting of farm real estate and other farm assets that could not be easily liquidated without disrupting the farm business, many of those farm estates subject to the tax could face a liquidity problem. This liquidity problem is reduced somewhat by the availability of an installment payment provision. To qualify, at least 35 percent of the value of the estate must be a farm or other closely held business interest. Under the provision, estate taxes may be paid over a 14-year period with interest only for the first 4 years and equal principal and interest payments over the last 10 years. A special 4 percent interest rate applies to the taxes due on the first $1 million in value of the farm or other closely held business with the regular interest rate applicable to tax underpayment on amounts over $1 million. In some instances, this provision can be the difference between the liquidation and the continuation of the farm business. Based on 1994 IRS data, the average Federal estate tax deferred by those estates with farmland who elected the installment payment provision was about $836,000.

Administration's Proposal to Ease Estate Tax Burden

In order to address the liquidity problem that estates containing farm and other closely held businesses often face, the Administration has proposed a number of changes to the installment payment provision. The $1,000,000 million cap on the 4-percent interest rate has been in effect since 1976. The Administration's proposal would increase the value of the farm or other closely-held businesses eligible for the special low interest rate from $1 million to $2.5 million. The current 4-percent interest rate would be cut to 2 percent and the rate on the amount over $2.5 million would be reduced to 45 percent of the normal interest rate on tax underpayment. Interest paid on the deferred estate tax would not be deductible for either estate or income tax purposes. The types of businesses eligible for the installment payment provision would be expanded by making the form of business ownership irrelevant. The Secretary of the Treasury would also be allowed to accept security arrangements in lieu of the special estate tax lien which has in some cases made it difficult for heirs to obtain credit to finance the day-to-day operations of the farm business.

Capital Gains Taxation

The subject of tomorrow's hearing is capital gains taxes, so I would like to comment briefly on these taxes. Under current law, nominal capital gains are included in income upon realization. For taxpayers in the 15 and 28 percent brackets, gains are fully taxed at ordinary income tax rates. Individuals in the 31, 36, and 39.6 percent tax brackets pay a maximum capital gains tax rate of 28 percent. The 28 percent maximum rate effectively provides exclusions of 10, 22 and 29 percent for individuals in the 31, 36, and 39.6 percent tax brackets, respectively.

Since assets used in a trade or business, including farming, are eligible for capital gains treatment, policies aimed at lowering the tax rate on capital assets have important implications for farmers. Agricultural assets eligible for such treatment primarily include breeding and dairy livestock and farmland.

As a result of this treatment, the realization of a capital gains is an important component of income for farmers. In 1993, one-third of all farm sole proprietors reported capital gains. This is about 3 times the rate for all taxpayers. The average capital gain reported was $14,900 for a total of $12.0 billion. Nearly half of these gains were from assets used in farming.

In 1993, farm sole proprietors paid an estimated $2.4 billion in Federal income taxes on gains from the sale of capital assets. In that year, 56 percent of all capital gains reported by farm sole proprietors was reported by those with adjusted gross incomes over $100,000. Gains from the sale of assets used in farming are more widely distributed, with about 40 percent of these gains reported by such farmers.

One alternative suggested for reducing the tax rate on capital gains is indexing the basis of capital assets for inflation. Indexing is intended to subject to taxation real gains, not inflationary gains. The primary benefits of indexing in agriculture would accrue to owners of farm-land held for long periods of time since a large part of the increase in value is often attributed to inflation. Other farm assets eligible for capital gains treatment, such as raised livestock used for breeding or dairy purposes, generally have a zero basis and would not benefit from indexation.

For example, based on average U.S. values, an acre of farm real estate purchased in 1966 and held for 30 years would have increased in value from about $158 to $890 for a $732 per acre gain. However, of this $732 nominal gain about $167, or about one-fourth, represents a real increase in value. At a 28 percent Federal income tax rate, the tax liability on the sale would be $205. Taxing only the real gain would reduce the tax liability to $47.

This example is overly simplistic and masks the difficulty of using indexation to limit the taxation to real capital gains. First, much farmland is acquired through debt financing, and no consideration is given to the reductions in the real value of debt due to inflation. While the asset may experience inflationary gains in value, the real reduction in the farmland owner's debt is not considered part of income for tax purposes. Second, the interest paid on the debt may be deducted and interest paid reflects both the real rate of return as well as the rate of inflation. Third, proposals for indexation have been accompanied by a 50 percent exclusion on capital gains from taxation. The exclusion, in combination with indexation, non-consideration of real reductions in debt and interest deductibility, would go well beyond correcting for the effects of inflation on capital gains.

The effect of a large unrealized gain on farmland held for long periods in combination with the step-up in the basis of assets at death is to discourage farmland sales. This restricts the availability of land for purchase but may increase the amount of land available for rent. On the other hand, preferential treatment of capital gains in farming could increase investment in agriculture thereby increasing production capacity. This would both reduce commodity prices and raise farmland prices.

Administration's Capital Gains Proposal

The Administration would replace the current provision that allows the rollover of gain from the sale of a principal residence into a new residence and the one-time $125,000 exclusion for individuals 55 years or older with a new larger exclusion. This exclusion would allow a married couple who have owned a home and occupied it as a principal residence for at least 2 out of the last 5 years to exclude up to $500,000 in gain on the sale or exchange of such residence. This would exempt over 99 percent of home sales from capital gains taxes. The farm residence portion of the farm would be eligible for this new exclusion.

Conclusion

In conclusion, U.S. farmers face a variety or taxes. Of the total taxes paid by farm sole proprietors, estate and capital gains taxes account for a relatively small share. Even so, these taxes can affect farm ownership and management. It should also be noted that the special use valuation and tax deferred provisions for estate taxes for farms result in an annual revenue loss to the Treasury in excess of $100 million. Given the President's proposal to balance the budget and the competing demands for scarce resources, it is not possible to propose further reductions in taxes for farmers at this time.

Attached to my testimony are tables that provide the number of farm operator households in different asset classes by age, region and type of enterprise. The asset values are not the tax base but are presented to indicate some of the characteristics of the larger U.S. farms.

That completes my testimony, and we will be happy to respond to questions.