The Baseline Scenario has a nice overview of the political issues around the estate tax.  The estate tax, politely referred to as The Death Tax, is motivated both by principles of fairness and principles of economics.  The fairness motivation is obvious.  And death seems like a focal moment for redistributing wealth.

The economic motivation also points toward the moment of death as a natural timing for taxation.  The economic cost of taxation is the distortion of freely made choices that it induces.  Sales taxes reduce the gains from trade, income taxes reduce the incentive to work, etc.  On the other hand, activities and resources that are in fixed supply can be taxed without distortion.  Well, death is in fixed supply, we all get exactly one.  And while the timing can be controlled to some extent, the effect of income after death on its timing is surely second-order.

However, economic arguments against estate taxation point out that it distorts behavior before death increasing consumption over investment.  The estate tax translates into a tax on investment because, in the event of death, a fraction of the payoff will be confiscated.  Provided that a bequest is a normal good, this reduces investment.

There is a simple way to amend the estate tax to undo this distortion and increase tax revenue. The government can offer a tax shelter in the form of a life-insurance policy where the household pays c in cash to the government in return for shielding a fraction q of wealth from estate taxation.  The effect is to capture some of what would have been extra expenditure on consumption in the form of a direct transfer to the government, and compensate the estate by reducing taxes after death.

A standard textbook analysis of per-unit vs lump-sum tax shows why this raises revenue and makes the estate better off.  The estate chooses how much wealth to allocate to consumption (alive) and bequest (dead.)  The top budget line shows no estate tax, the steep budget line shows the estate tax, and the third budget line shows the estate tax coupled with the lump-sum payment.  the estate consumes less, leaves a larger bequest, is better off and pays more in total taxes.

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