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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April 22, 2009 at 6:33 am
Darf Ferrara
I understand that it is intuitively unfair that some people have more than others starting out in life, but it’s not obvious to me why maximizing the amount of gov’t revenues is a good thing. Any where the money ends up in private hands, it will almost certainly be used more efficiently than money in the public sector.
April 22, 2009 at 8:13 am
Chris Janc
Darf said: “but it’s not obvious to my why maximizing the amount of gov’t revenues is a good thing”
Exactly! First we need to llok at the question from the perspective of just who the money belongs to. If you are a pro government type, the above argument makes all the sense in the world. If not, the above argument is just a lot of distraction from the main point that the money does not inherently “belong” to the government so why are we trying to find more efficient ways of them taking it from us?
April 22, 2009 at 10:56 am
jeff
You don’t need to believe that we should be maximizing tax revenue for this proposal to make sense. Improving estate taxes would allow us to reduce taxation using more distortionary instruments like income tax.
July 24, 2010 at 1:27 pm
twicker
Hi, Darf, Chris:
Darf — you said:
“Anywhere the money ends up in private hands, it will almost certainly be used more efficiently than money in the public sector.”
Not necessarily, and definitely not “almost certainly.” Leaving aside the problems of defining “efficiently”:
When:
(a) People reap rewards they themselves didn’t have to work for (e.g., an inheritance), and
(b) Those people’s expenditures — specifically, the expenditures tied to those rewards — have zero oversight (e.g., private funds from an inheritance, v. public funds with political oversight),
Then those people are substantially *less* likely to use the money more efficiently than any government where the government has even the most minimal of oversight.
As to the point about “maximizing government revenues:” as Jeff pointed out, it’s not about “maximizing government revenues” (that has more to do with who voters elect and how they choose to spend and generate revenues). This is about *this specific tax* and having it operate as efficiently as possible *for its purposes.*
As I’ve proposed on Jeff’s most-recent comment, a good middle ground might be to have the tax be on whatever part of the inheritance the inheritor *spends*, and for it to be taxed as regular income. For that person, it’s essentially one-time income, and should be taxed as such — but, like a 401(k), only when it’s actually spent like income. If it stays in savings/investments/the family farm/the family business, etc., then it’s not taxed; any funds brought out of the inheritance for spending count as income at the time they’re brought out (whether or not the spending is generally accepted as “efficient” — e.g., cost-effectively winterizing your home — or as “inefficient” — e.g., flying around the world 50 times in first class just for the heck of it).
This gets at a number of complications both with the “current” system (where estates are taxed) and with a no-tax system:
1) The current system promotes short-term spending by those who have savings, particularly as they get older and more particularly if they have children/grandchildren.
2) The current system also promotes short-term thinking among the children/grandchildren, where, if a child knows (or strongly suspects) that s/he will be receiving an inheritance of at least $X (after taxes), and that s/he can’t make the tax bill any lighter (s/he just gets $X), then s/he has a motive for racking up debt/overspending to some point around $X (possibly even above $X, given overconfidence effects). As before, this does *not* promote “efficient” spending.
3) A no-tax system dramatically worsens #2, since the entire inheritance becomes tax-free unearned income. It also means that the children are likely to see the money as “free,” and, thus, not feel a responsibility to care for it (you’d see a lesser effect in some families and for some businesses/homesteads, but still a much-greater effect than if there were some system for adding some accountability).
Taxing these same capital gains as income would mean that, every time the child/grandchild went to spend some of the inheritance, s/he would face her/his responsibility to the nation and to her/his fellow citizens (i.e., s/he would pay some tax); thus, any decision to spend unearned income would include some degree of acceptance of both that responsibility and, likely, some thinking about whether or not the money was, in fact, being used “efficiently” for that person (i.e., there would be some degree of accountability).
July 26, 2010 at 2:34 am
a
“…If not, the above argument is just a lot of distraction from the main point that the money does not inherently “belong” to the government so why are we trying to find more efficient ways of them taking it from us?…”
Funny, I think of it more as finding ways of us taking it from them. We are the government. Few of us have estates large enough where this is a problem. Hence us taking it from them. Think about it.
April 22, 2009 at 9:35 am
withoutthesleep
Am I viewing this wrong, or are the axises labeled incorrectly? The “steep” line shows no change in death consumption, but a reduced alive consumption. If this was a budget line under the estate tax, wouldn’t it be vice versa? Maybe I misunderstand.
April 22, 2009 at 10:54 am
jeff
yes the axes were mislabeled. thanks for pointing that out. i think i got it right now.
July 24, 2010 at 9:11 am
How To Reinstate the Estate Tax « Cheap Talk
[…] repealed and it will come back in full force in 2011 unless some new legislation is passed. I have praised estate taxes […]
July 24, 2010 at 9:30 am
Fmb
Large savings intended for bequest also serve a precautionary savings role not addressed by this proposal.
July 24, 2010 at 1:34 pm
twicker
Fmb — indeed, they do, including providing precautionary savings for one’s children. Unfortunately, as I’ve mentioned in a comment above, both the tax-the-estate system and the don’t-tax-any-inheritance-or-estate system have further problems in that the recipients only see a lump-sum receipt of assets, where those assets have no taxes and are essentially a free gift. IMHO, for preservation of the precautionary savings, and for prompting people to think intergenerationally, we should move to a system with no tax on the estate and only tax any amount of assets that are converted from savings/investment/capital to cash for consumption.
July 25, 2010 at 1:34 pm
Orkmid
Congratulations, you’ve reinvented flower bonds.
July 25, 2010 at 2:02 pm
michael r. brown
It’s economically better to minimize the amount of government revenue.
July 25, 2010 at 7:53 pm
twicker
even better is to make sure that the governmental revenue either meets, or slightly exceeds, governmental expenditures. In the first case, you open up the credit markets more to the private sector; in the second (and assuming you’re not using the surplus to pay down debt), then you can build a “rainy-day” fund that would allow you to continue to provide all the services the people want even if tax revenues dip in case of, say, a recession.
Your real argument is that it is best to have as small a government possible — the smallest practical for performing the duties it should perform, while leaving all else to the free market and to individuals. That’s a different goal than simply “minimiz[ing] the amount of government revenue.”
July 26, 2010 at 11:33 am
Random Rich Guy
Except for the largest estates, estate taxes are largely avoidable via trusts and gifting. The real question is what motivates people to generate large estates? Suppose I’m 50 years old and have about $20MM, where is the motivation to take risk to build a larger estate? Every dollar that I save will be taxed twice — when earned and when I die. If only 25% of my income goes to purposes that I direct, is that enough to decrease my output significantly. Might I better work to transfer the economic benefits to my heirs in my lifetime and invest in a low-risk, low-return manner to protect my personal lifetime consumption? Please give me a reason to work harder because I don’t see one — or better yet, give suggestions on how to protect wealth in a low-risk, low-return, low-tax fashion (gold might be pricey but silver has possibilities)…
July 26, 2010 at 7:33 pm
twicker
@Rich Guy: Quick note that the “taxed twice” argument really makes no difference, one way or another.
When you work for your money, you pay an income tax.
If you buy anything (at least in most states), you pay a sales tax. If you buy gasoline, you also pay a federal tax.
Further, when you pay *anyone* for actual performance of a service or provision of a product, that person takes part of that money to pay *their* income/sales/etc. taxes. The business may also use a portion to pay its taxes.
Etc.
Having a government requires funding, and some of what you spend or distribute will *always* go to taxes to maintain a government. Apart from anarchy, you’ll never be without “double” taxation (though it’s actually more like n-taxation; as an example, even without estate taxes, your descendants will pay taxes when they use their inheritances to buy stuff).
Remember that one of the reasons to tax estates is that the inheritor(s) haven’t yet inherited anything, so it would be dramatically unfair to tax them on money/assets they don’t yet have and force them to pay tax amounts they may not be able to afford prior to receiving their inheritance (this also goes to the fairness discussions of @a and @Charles Dolci) — thus, you tax the estate, which has the assets (and whose executor can decide on the most efficient way to pay the tax), and you don’t (note that an estate is not an actual, physical person, btw — that person is now dead).
As for your discussion about how this poses a penalty on savings and investments — you’re quite right, though the penalty is pretty small for most people (since, even before the Bush changes, there were exemptions that kept the vast, vast majority of Americans from paying such a tax). Precisely the reason I favor instead a full, tax-free transfer, which is then considered “unrealized income,” and which converts to being considered income whenever it’s taken out of savings/investment (much like the money put into a 401(k), 403(b), or non-Roth IRA). Leave it in the asset (the business, the farm, the mutual fund, whatever), and it sits and grows. Pull it out and spend it, and — hey, presto — you have income. The only difference would be that there would be no early-withdrawal penalty, unlike a 401(k)/403(b)/traditional IRA.
July 26, 2010 at 8:43 pm
Random Rich Guy
Twicker,
Of course, you’re right that taxes are imposed on almost all economic activities. My main points are simple: (1) estate taxes discourage economic behavior by the most financially capable; (2) anyone in those circumstances doesn’t need to leave a big estate; (3) compound tax rates (income + estate taxes) matter for incentives to leave an estate; (4) estate size is not a given — incentives matter. It seems to me that much of the discussion of estate taxes treats the dead-weight costs on the wealthy as a public good in itself instead of looking at the likely negative dynamic effects of high tax rates. I know that I would pay a larger estate tax bill if the estate tax rate is 15% than 50%. Perhaps I should thank the political process for helping guide my time allocation decisions; but, I can’t help thinking that this is not the best outcome for the general welfare.
July 26, 2010 at 4:49 pm
Charles Dolci
I apologize for not reading all the comments, so if my response is diuplicative of an earlier most my apologies.
Two problems with the author’s premises.
One, he states without any argument to support his OPINION that “The estate tax … is motivated …. by principles of fairness ….. The fairness motivation is obvious.”
Sorry, but the fairness motivation is not obvious. If I created the wealth why is it so wrong that I should decide who should be the beneficiary of my unspent wealth. Perhaps the author is impelled to claim that “the fairness is obvious” because he would be hard pressed to support that claim with a rational argument. And while we are at it, the question “Fair for whom?” needs to be addressed.
Second, the author claims “Well, death is in fixed supply, we all get exactly one.” I can’t argue that we all only get one death – but that seems to be largely irrelevant. The government is not taxing death, it is taxing the estate i.e. the unspent wealth created by the person – the death just affects the timing of the taking.
I also don’t understand this business about the death tax increasing the propensity for consumpption over investment – but I will chalk that one up to my lack of sophistication. Unless the consumption is directed solely at consumables (e.g. sumptuous meals and expensive wines, trips to Europe) the consumption and investments will be part of the estate and will be taxed. If I decide to buy a Ferrari before I die (consumption) that is part of my estate and the gov’t is going to get a part of that. If I buy stock in GE, or invest in a start up or lend money to a new business or buy new capital for my business (investment) that is all part of my estate and the gov’t is going to take a chunk out of that as well. The only thing that is pormoted is “inefficient” (mostly) consumption.
Sorry- I guess I have three things.
Third, the suggested solution ” 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.” Oh, that will really go over well, just like Social Security. The gov’t promised citizens an old age pension when they retired, but the Supreme Court has ruled that, in fact, citizens have no enforceable claim to Social Security benefits, even though they have paid into the system for their entire lives. What the gov’t giveth the gov’t can taketh away (or more accurately “What gov’t taketh the gov’t can keepeth”).
Why should I trust the government to keep its word on a life insurance policy when it has already taken the position that it can reneg on its social security promises?
No thanks, I think I will just piss it away on wine, women and song before I die. That is a more constructive use than whatever the gov’t will do with the wealth I have created.
July 26, 2010 at 5:50 pm
jeff
To everyone commenting on “fairness.” When I said “the fairness motivation is obvious” what I meant was “it is obvious why people believe this is fair.” I don’t mean “it is obvious that taxing estates is fair.” Indeed there are few statements involving the word fair whose truth is obvious (apart from this one.)