To Whom Much Is Given: Why We Need to Tax Inheritance

Five dollar bills(Photo: 427) It has been widely reported that the top 1 percent of Americans control 40 percent of the nation’s wealth, and the richest 400 individuals control as much as the bottom 150 million people, but what not everyone knows is how much of that wealth is inherited. Roughly half of the wealthiest Americans inherited all or much of their wealth, and the United States ranks near the bottom of rich countries in terms of intergenerational mobility. What’s more, the vast majority of inherited wealth goes entirely untaxed. Under current law, heirs can inherit an estate of up to $5 million without paying a cent in federal taxes. In fact, it’s likely that a sizable portion of that income was never taxed in the first place. About 56 percent of the largest estates are bequeathed in the form of unrealized capital gains, and under current law, no one pays taxes on that income – ever. The tiny portion of inherited wealth that is taxed is severely undertaxed. The average effective tax rate on inheritance is less than 3 percent, a fraction of the average rate on other kinds of income. In other words, someone who inherits his or her wealth without lifting a finger pays substantially less taxes than someone who earns the same amount through hard work.

The current estate tax is set to expire and revert to Clinton-era levels after 2012, making it a likely bargaining chip in this year’s budget battles. The question is: what kind of bargain will it be? Conservatives like Mitt Romney call for the immediate and permanent repeal of the estate tax. In fact, all of the Republican candidates for President endorse the idea, and many members of Congress continue to push for it. The stakes are higher than you might think. Economists estimate that repealing the estate tax would cost the federal government $670 billion over ten years (compared to existing law), making the tax code significantly more regressive and compounding the social, political and economic harms of extreme wealth inequality.

Alternatively, a modest reform of the estate tax, like closing the loopholes that allow wealthy individuals to avoid paying it, or requiring heirs to pay capital gains taxes on the assets they inherit, would dramatically increase the amount of revenue it generates. If inheritance were simply taxed at the same average rate as other kinds of income, the ten-year yield would be trillions, rather than billions, of dollars. The additional revenue could be used to pay down the national debt, to finance infrastructure or research projects, or to offset tax cuts in other areas – something both conservative and liberal politicians claim to support. And the arguments for taxing inheritance go far beyond fiscal responsibility.

First, taxing inheritance promotes greater equality of opportunity. Most Americans are comfortable with a limited degree of outcome inequality (that is, income inequality), but giving every individual a more or less equal opportunity to succeed is a core American value, arguably implied by the declaration that “All men are created equal.” Large inheritances counteract this ideal, as Jefferson himself argued.

Second, taxing inheritance creates a more meritocratic society. Inherited wealth is at odds with the competitive spirit of America. It rewards privilege and idleness rather than creative enterprise and hard work – not only because it gives an unfair advantage to heirs who have attained their wealth by essentially winning a family lottery, but also because it has a negative effect on the productivity of those heirs. As FDR put it, “Creative enterprise is not stimulated by vast inheritances. They bless neither those who bequeath nor those who receive.”

Third, taxes on inheritance are progressive, primarily affecting those who have benefited most from the political and economic system. As Teddy Roosevelt put it, “The man of great wealth owes a peculiar obligation to the State, because he derives special advantages from the mere existence of government.” The bankers who owe their jobs to recent government bailouts come to mind, or the founders of Google and Facebook, who capitalized on a technology pioneered by tax-funded government research. Fortunes are not made in a vacuum, and taxing inheritance is one way that society collects on the debt incurred by wealthy individuals for the collective sacrifice and enterprise that made their success possible.

Fourth, taxing inheritance curtails large concentrations of wealth, reducing distortion in the marketplace. Large inheritances are an unproductive use of capital, and studies show that extreme inequality, besides being terrible for society, is harmful to economic growth.

Finally, taxing inheritance encourages charitable giving, since donations are deductible. Economists estimate that repealing the estate tax would cause at least a 12 percent decline in charitable giving.

So, what’s not to like about taxing inheritance? Apparently a lot, at least for those who have taken it upon themselves to protect the interests of the top 1 percent. George W. Bush succeeded in phasing out the estate tax during his presidency, culminating in its repeal in 2010. The compromise that Barack Obama struck with Congressional Republicans to restore the estate tax through 2012 is in some ways even worse. With a $5 million exemption and a top marginal rate 20 percent lower than it was in the 1990s, the current estate and gift tax is a fig leaf covering an enormous giveaway to the wealthiest Americans. And yet, for some, even this is too much to ask.

Since the 1920s, opponents of the estate tax like the economist Milton Friedman have argued that, “it discourages saving and asset accumulation and encourages wasteful spending.” Friedman called this a moral argument, but it is really an empirical claim, with moral underpinnings. The empirical claim is that estate taxes depress savings. If individuals know their estates will be taxed after they die, they will spend their assets frivolously while alive. The underlying moral claim is that saving is good and should be rewarded, while wasteful spending is bad and should be discouraged. The problem with the empirical claim is that it is entirely unsupported by the facts. The theory that taxes in general discourage savings – called the income effect – is highly contentious. It is especially implausible in the case of the estate tax, since the tax doesn’t take effect until after the individual has passed away. In fact, the theory that individuals will save more in order to achieve a target amount for their heirs – called the substitution effect – appears to fit the data better, suggesting that the impact of the estate tax on savings may actually be positive. If we accept the underlying moral claim that saving is good and wasteful spending is bad, this first argument might come out in favor of higher taxes.

Opponents of the estate tax also complain that it taxes income that has already been taxed during the lifetime of the decedent – a so-called “double tax.” But one of the primary functions of the estate tax is to act as a backstop to income that has not been taxed at all – namely, the portion of large estates that is bequeathed in the form of unrealized capital gains. Furthermore, the idea that assets should be taxed once and only once is absurd. Every dollar in the US economy can, in principle, be taxed an indefinite number times, especially when it is transferred from one individual or business entity to another, whether by commerce, paycheck or inheritance.

Oddly, another argument that conservatives like Friedman make against the estate tax is that it doesn’t raise enough revenue, “because the estate planners have been so successful in devising ways to escape the tax.” Exactly why this is supposed to be an argument for repealing the estate tax rather than an argument for reforming or raising it is anybody’s guess. Surely the best way to counteract the fact that, “The truly wealthy and their estate planners avoid the tax” is to make it more difficult for them do so, not to eliminate the tax. Besides, in what universe is $670 billion a small amount of revenue?

One of the most rhetorically charged arguments for repealing the estate tax is that it places a burden on family businesses and farms, making it more difficult to pass these assets to the next generation. As is often the case with populist rhetoric, however, the policy it justifies benefits the privileged much more than the populace. The American Family Business Institute, which has been lobbying Congress to repeal the estate tax since 1992, purportedly represents the interests of small family businesses and farms. However, AFBI does not disclose any of its actual members, and its “funding chairman” is an investment banker who stands to inherit his family’s $1.5 billion fortune! In any case, only a tiny percentage of small businesses and farms qualify for the estate tax, and the tax code already makes allowances for these estates.

Finally, critics of the estate tax claim that death is not an appropriate time to impose a tax. They consider this argument self-evident, but the reasoning behind it is unclear. Societies have been imposing taxes on inheritance since, well, since there were societies. The Egyptians, Greeks and Romans all levied a tax upon death, as did much of feudal Europe. Congress first imposed a legacy tax in 1797, and it established the estate tax in 1916. Breaking from this tradition would be justified if there were a compelling moral reason to do so, but it’s hard to say exactly what this reason would be. Is it because estate taxes place a psychological burden on the recently deceased? Or is it because death is an inconvenient time to ask the heirs of large estates to worry about paying taxes? There’s probably no time most people would consider a good time to pay taxes, but surely the amount one actually inherits mitigates this harm. Convenience is not a legitimate criterion for taxation. If it were, people would discover an abundance of reasons to find paying their taxes inconvenient.

Despite its merits, the estate tax could certainly be improved. The best alternative would be to switch from the estate tax to an inheritance tax, which would tax the amount that each heir inherits as income, rather than taxing the estate itself. Coupled with a reform of the way inherited capital gains are taxed, the overall yield could increase dramatically. Lily L. Batchelder of the Brookings Institution lays out compelling a proposal along these lines. As she points out, inheritance taxes are more sensitive to the financial circumstances of individual heirs, and they encourage wealthy individuals to spread their estates more broadly. It simply makes more sense to tax heirs rather than benefactors.

Whatever the mechanism, the United States should tax inheritance better and more than it does. Considering our fiscal needs, the uncertainty of tax policy after 2012, and the multiple economic and social reasons to regulate inheritance through progressive taxation, now is the time to rethink inheritance taxes in the United States, and to reaffirm the ideals they embody.