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Are inheritance taxes unfair?

Summary:
Are inheritance taxes unfair? Many people think they are. "Why should I be taxed twice on money I've earned during my lifetime?" they say.  This is, of course, a fallacy. Dead people don't pay taxes. Living ones do. So inheritance tax is not double taxation of money the dead person earned while they were still alive. It is taxation of an unearned windfall for the people to whom they leave their assets, usually their children. Other forms of unearned income, such as interest on savings and capital gains, are taxed. Why should someone be taxed on unearned income they receive as a result of investments made from their own earnings, but not on unearned income they receive as a result of investments made from someone else's earnings? That doesn't look very fair, does it?  Well, according to the economist Greg Mankiw, it is still unfair: From my perspective, the estate tax is a bad way to tax the rich because it violates the principle of horizontal equity. The basic idea is that similar people should face similar tax burdens. This opens a whole new can of worms. After all, if the rich and the poor are similar, then a 20% basic rate of tax rising to a 45% top rate of tax is unfair to the rich. Those in favour of flat taxes usually raise this point. Perhaps Mankiw is one of them.

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Are inheritance taxes unfair?


Are inheritance taxes unfair? Many people think they are. "Why should I be taxed twice on money I've earned during my lifetime?" they say. 

This is, of course, a fallacy. Dead people don't pay taxes. Living ones do. So inheritance tax is not double taxation of money the dead person earned while they were still alive. It is taxation of an unearned windfall for the people to whom they leave their assets, usually their children. Other forms of unearned income, such as interest on savings and capital gains, are taxed. Why should someone be taxed on unearned income they receive as a result of investments made from their own earnings, but not on unearned income they receive as a result of investments made from someone else's earnings? That doesn't look very fair, does it? 

Well, according to the economist Greg Mankiw, it is still unfair:
From my perspective, the estate tax is a bad way to tax the rich because it violates the principle of horizontal equity. The basic idea is that similar people should face similar tax burdens.
This opens a whole new can of worms. After all, if the rich and the poor are similar, then a 20% basic rate of tax rising to a 45% top rate of tax is unfair to the rich. Those in favour of flat taxes usually raise this point. Perhaps Mankiw is one of them. But there are very good reasons for taxing the rich more highly than the poor, not least of which is the fact that a similar burden of taxation lies much more heavily on those struggling to pay for essentials than it does on those who want for nothing. "Similar" is in the eye of the beholder.

But let's stick with inheritance tax. Mankiw goes on to provide an example to show why inheritance tax is unfair:

Consider the story of two couples. Both start businesses when they are young. They work hard, and their businesses prosper beyond anything they expected. When they reach retirement age, both couples sell their businesses. After paying taxes on the sale, they are both left with a sizeable nest egg of, say, $20m, which they plan to enjoy during their golden years.
So we are not talking about unfair taxation of the rich versus the poor. We are talking about unfair taxation between rich people. And we are not talking about unfair taxation of one couple's nest egg over the other, either. Inheritance tax would equally be charged on what is left of each couple's nest egg when they die. So what is unfair about that?

One couple lives frugally in order to be able to pass the majority of their wealth on to their children and grandchildren. The other couple has a lavish lifestyle. They have a great party in their declining years, but they leave much less to their descendants. According to Mankiw, these differences in lifestyle choice make inheritance taxes unfair:

So here's the question. How should the tax burdens of the two couples compare? Under an income tax, the couples would pay the same, because they earned the same income. Under a consumption tax, Mr. and Mrs. Profligate would pay more because of their lavish living (though the Frugals' descendents would also pay when they spend their inheritance). But under our current system, which combines an income tax and an estate tax, the Frugal family has the higher tax burden. To me, this does not seem right. 
Now, of course Mankiw has conveniently ignored the existence of state-level sales taxes (or, in Europe, VAT), which would disproportionately be paid by the Profligate family. But he approves of unequal taxation anyway. He is happy for the Profligate family to pay disproportionately higher taxes because of their lavish spending, but not happy for the Frugals to pay disproportionately higher taxes because of their excessive saving.

Mankiw's comment "To me, this does not seem right" exposes the real basis for his opposition to inheritance tax. We have departed from the realm of economics. His argument is a moral one. Frugality is good, profligacy is bad. Tax policy should reward the good and punish the bad. Therefore the Frugals should be excused from taxation on their saving habit, even if the Profligates are taxed on their spending.


The moral belief that saving is inherently good and should be rewarded is deeply ingrained. And in the distant past, when eating the seed corn meant famine next season, there were very good reasons for rewarding saving and punishing consumption. Indeed, that is still the case in many developing countries today.

But in a world where there is not only too much capital floating around but widespread unwillingness of the owners of that capital to put it to productive use, rewarding excessive saving and the transmission of wealth down the generations is counterproductive. In developed countries, there are now very good reasons to tax excessive saving and reward consumption - and indeed this is what the very low interest rates of central banks around the world are doing. We don't view negative interest rates as a tax on saving, but that is what they are.

Mankiw's view of the "family" is perhaps counter-intuitive. He treats the family as an infinitely-lived unit, not as a series of overlapping generations. Inheritance tax is thus taxation of the family's wealth, not its income.

If we were to do a discounted cash flow analysis of the returns from the Frugal family's nest egg out to infinity (this would be an annuity calculation), we would see that their returns are far higher than the Profligate family's returns. This is due to the Frugal family's patient lifestyle, which Mankiw wants to reward. But I am struggling to see why we should not tax these higher returns. Indeed, I can see some extremely good reasons not only for taxing them, but for taxing them rather highly.

Of course, Mankiw's model is fundamentally flawed. Families are not infinitely-lived, and preferences are not uniform across the generations. The children of Frugals can be Profligate: the children of Profligates can be Frugal. But whatever their own preferences, the fact is that because they inherit wealth, the children of Frugals have a financial advantage that Profligates will never have.

The different lifestyle choices of the Frugals and the Profligates thus create wealth inequality, not for themselves but for their descendants. However hard they work, the descendants of the Profligates will never be as wealthy as the descendants of the Frugals, unless at some point a future Frugal becomes Profligate and blows the lot.

Looked at in this way, we might take the view that NOT imposing inheritance taxes is fundamentally unfair, since it gives an unearned advantage to future generations and progressively widens wealth inequality. Perhaps 100% would be a little steep, but given the compounding effect of intergenerational wealth transfers, inheritance taxes can in my view be pretty high without being remotely unfair.

There is an even more vital reason to tax intergenerational wealth, too. Humans are naturally selfish, envious and belligerent. Those who have wealth tend to hang on to it like mad, while those who don't have wealth tend to try to take it from them. If there is no mechanism for dampening the tendency of wealth inequality to widen down the generations, eventually we have a reset. Usually that takes the form of war, which wipes out lots of wealth (and people). Sometimes we have a revolution, a form of war which explicitly targets the holders of wealth for retribution.

I don't know about you, but I would much rather have explicit taxation of intergenerational wealth than an unstable political economy that generates wars and revolutions because of the buildup of wealth inequality over the generations.

Related reading:

Wealth inequality in the United States since 1913 - Saez & Zucman (pdf)
Capital in the 21st Century - Piketty (book)






Frances Coppola
I’m Frances Coppola, writer, singer and twitterer extraordinaire. I am politically non-aligned and economically neutral (I do not regard myself as “belonging” to any particular school of economics). I do not give investment advice and I have no investments.Coppola Comment is my main blog. I am also the author of the Singing is Easy blog, where I write about singing, teaching and muscial expression, and Still Life With Paradox, which contains personal reflections on life, faith and morality.

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