Posner on Estate Taxation

I agree with Becker that inheritance taxes are preferable to estate taxes and that consumption taxes are preferable to income taxes. However, I do not share his strong opposition to the federal estate tax. The government needs revenues, and taxation is the principal means of obtaining those revenues. An ideal tax from an economic standpoint is one that generates substantial revenue without distorting the allocation of resources. These turn out to be linked concerns. A narrow-based tax, such as a tax on sports cars, is undesirable from this standpoint because, unless the tax rate is very low, in which event little revenue will be generated, the tax will deflect consumers to close substitutes that are not subject to the tax, and thus little revenue will be generated, because of substitution away from the taxed product. A recent article in the New York Times calls the estate tax “perfect” on the ground that it does not distort the allocation of resources because people can’t escape death. Were this true, the estate tax would be analogous to a “head tax”—say a tax of $1,000 a year on every U.S. citizen. Such a tax would be difficult to escape because substituting away from the taxed activity (or rather status) would require expatriation, which is very costly to an individual. The tax would generate almost $300 billion a year in revenue. The estate tax is not nearly so “perfect” as a head tax, because contrary to the Times article it is easily avoidable, as a head tax is not. I emphasize “easily”; for that is the reason the problem with the estate tax is not, as it might seem to be, that it is a tax on savings and can thus be avoided only by consuming all one’s wealth before death and therefore is likely to distort people’s consumption decisions, which would make it an inefficient tax. People who have no bequest motive—that is, who are not interested in having a positive balance when they die—are not greatly affected by estate taxation because they already have every incentive to dissipate their wealth before they die. People who do have a bequest motive are not much affected by the estate tax either, because they can transfer their assets to their children or to other intended heirs before death, reserving the income from the assets for their lifetime (the equivalent of an annuity, which expires on the annuitant’s death, leaving nothing for distribution to heirs). As a result of these incentives and opportunities, the estate tax does not generate much revenue for the government. It collects some, however—and I do not consider 1 percent of total federal tax revenues a trivial amount—and its distortionary effects are probably modest. Becker is correct that it is costly in effort expended by lawyers to minimize the impact of the tax on their clients (though he may exaggerate the cost by attributing the entire income of estate-planning lawyers to tax counseling, when even in the absence of estate taxation legal counseling would be required for the preparation of wills and other documents required for large estates). But in that respect, it is no different from the income tax. Were the estate tax abolished, the revenue it generates would have to be made up by some other tax, which is as likely to be as distortionary as the estate tax and would invite avoidance efforts by tax lawyers. The more interesting question to me, though I have no good answer to it, is whether the estate tax should be stiffened, or other measures used to limit bequests. An article in last Friday’s Wall Street Journal, echoing remarks that President Summers of Harvard made at a conference at the Kennedy School that same day, notes a possible, and possibly troublesome, decline in social mobility in the United States. Wealthy people seem increasingly able to guarantee that their children and even grandchildren will remain in the upper income tier, leaving fewer places for the children and grandchildren of the poor to occupy. Through “legacy” admissions (as at Harvard!), expensive private schooling and tutoring, including tutoring in taking college admission tests, as well as by means of direct transfers of wealth, wealthy people are able to “purchase” a secure place for their children and grandchildren in the upper class. Even if, as Becker argues, social mobility has not actually declined in recent decades, it is lower than it used to be and the conditions for a decline seem in place. But the normative implications are unclear. For example, one concern with declining social mobility is a fear that rich kids won’t work as hard as poor ones, so that economic growth will lag. But if they don’t work as hard, they will lose jobs to the poor. They may continue to live quite well by clipping coupons, but the poor (or rather the former poor) will occupy the high-paying jobs. And because rich kids can take financial risks that the poor cannot, and risk-taking is important to innovation and hence to economic growth, bequests may lead to an increase rather than a reduction in economic growth, though this depends on the balance between the drag on growth from rich kids’ working less hard and the spur to growth from their taking more financial risks. Furthermore, the positive correlation between parents’ and children’s wealth may conceal the actual causality. It may be that the parents are wealthy in part because of a genetic endowment that they pass on to their children, who because of that favorable endowment would become wealthy even if they didn’t inherit any money. But probably wealth does enhance the advantage in having such an endowment. If lack of social mobility is a problem, nevertheless it is unlikely to be solved by trying to limit bequests, since wealthy people can transfer much of their wealth during their lifetime. To have an impact on the transmission of wealth across generations, therefore, a stiff tax on bequests would have to be complemented by a stiff tax on gifts, and “gift” would have to be broadly defined to include such things as paying $50,000 a year for tuition and expected donations at a fancy private school in New York City. And really stiff estate and gift taxation, even if feasible, would be undesirable because of the disincentive effect on the work effort of those people—and they are numerous—who, to a significant degree, are motivated to become rich by a desire to make their children and grandchildren better off than they would otherwise be. There is a traditional concern with dynastic fortunes—that is, with accumulations of wealth that are so great that they confer disproportionate political power on a family. The founder will usually be too busy making money to participate heavily in public affairs, though there are exceptions, such as Joseph P. Kennedy, President Kennedy’s father; Michael Bloomberg, New York’s mayor; and George Soros, the billionaire backer of the Democratic Party. The next generation, the generation of the inheritors rather than the creators of wealth, may decide to devote full time to public matters, for good or for will. Concern with accumulating political power over generations lies behind the esoteric “rule against perpetuities,” which forbids making a bequest that will not take effect until more than 21 years after the death of currently living persons—this to prevent transmitting wealth to one’s remote unborn descendants. As a curious tandem to the movement of abolish the federal estate tax, many states are allowing the rule against perpetuities (a rule of state rather than federal law) to be undone by the device of the well-named “dynasty trust,” whereby a wealthy person places money in trust with instructions that the trustee invest the money for the benefit of specified beneficiaries, such as the descendants—however remote—of the creator of the trust for as long as there are such descendants. Depending on the amount doled out by the trustee in each generation, the trust might over time accumulate enormous assets simply by the operation of compound interest. The device is quite recent yet already some $100 billion have been placed in dynastic trusts. See the study by law professors Robert Sitkoff and Max Schanzenbach, forthcoming in the Yale Law Journal. Should we worry about the dynastic trust? Probably some degree of wealth inequality is potentially destabilizing politically. But on the other hand the creation of centers of private power acts as an offset to growing governmental power and so may actually serve to preserve liberty. Notice in this connection that abolishing the estate tax would reduce the incentive to make charitable bequests, which are tax exempt. I should note finally two possibly illusory aspects of the proposed abolition of federal estate tax. One is that states may respond by increasing their own estate taxes, which are less efficient than federal estate taxes because it is easier to evade a tax by moving from one state to another than by expatriating oneself, and so such taxes affect locational decisions more than the federal tax. Second, the current estate tax gives heirs a “stepped up” basis in capital that they inherit. That is, should they later sell a capital asset that they inherited, the cost basis for computing how much capital-gains they owe will be the value of the asset at the death of their testator rather than the cost that the testator incurred to acquire it originally. So abolition of the federal estate tax would be offset to an unknown degree by increased capital-gains taxation of heirs, and also by increased administrative expense since it is often difficult to determine the original value of an asset that was acquired many years earlier.

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