Confused About Taxes

By James Kwak

In the Times a couple of days ago, Gregory Mankiw made a half-hearted case for eliminating the estate tax that was so weak I’m not even sure he convinced himself. The core of his argument is that the estate tax violates the principle of horizontal equity, according to which “similar people should face similar burdens.” The problem, on his view, is that between two rich couples that each amass $20 million, the Profligates who consume their wealth before death end up paying lower taxes than the Frugals who maintain a modest lifestyle. “To me, this does not seem right,” Mankiw concludes.

First of all, it’s not even clear why this example violates horizontal equity. The Profligates and the Frugals are not “similar people”—Mankiw specifically constructed the example that way. They may have each earned the same amount of money, but they have vastly different consumption habits.

Second, it’s not clear that the Frugals are paying more tax than the Profligates. Their estate will pay higher taxes, but by then they are dead; the estate tax does not directly limit their personal consumption in the slightest. In fact, the ones whose estate will pay the tax are the ones who apparently are not interested in consumption in the first place. Now, the defense of Mankiw is that the Frugals do care about how much money they can pass on to their children, so the estate tax does affect their utility. But that brings up the third, and most important point . . .

Only an economist, and an economist of a certain type, could evaluate the fairness of the estate tax by comparing two wealthy families. Mankiw’s point is that the estate tax is unfair to the Frugals—as compared to whom, exactly? Remember, Mr. and Mrs. Profligate spent most of their money before they died; their children get next to nothing. The Frugals’ kids end up with about $16 million ($20 million less the 40% federal estate tax on the amount above the exemption), but they’re still the richest people in the story. The Profligates’ kids get the remaining crumbs of the parents’ once-impressive fortune—yet we’re supposed to feel sorry for the Frugals.

But the people we should really be thinking about are everyone else’s children. It’s a little peculiar to profess to care about equal treatment and then proceed to talk solely about rich people. What about Mr. and Mrs. Poor and their children, who far outnumber the Profligates and the Frugals? The Poors’ children inherit nothing because their parents died with nothing; the Frugals’ kids inherit $16 million although their parents died with $20 million. There’s no reason to think the second generation of Frugals is any more deserving than the second generation of Poors—yet they are born into comfort and security, while the Poors face hardship and anxiety. From this perspective, the only fair estate tax would be one with a rate of 100%. And even then, the Frugals’ kids would be better off than those of the Poors, since they would have the most productivity-enhancing childhood that money can buy.

The bottom line is this: You can’t argue against the estate tax on fairness grounds, unless your powers of abstraction are so awesome that you can some how overlook the fact that most people wish their parents had to pay the estate tax.

As I said, I’m not sure that Mankiw bought his own argument, because he then concedes that “not all economists share my judgments about the estate tax.” So he pivots into a different point that he thinks “everyone can agree on”: that “we need more stability in the tax code than we have had in the past.” And we can only have stability, he claims, if opposing sides can compromise on outcomes that both find tolerable.

This argument about tax code stability is just a special case of the more general claim you often hear that businesses need regulatory “predictability” so that they can make long-term plans. And in both cases, this position is either naive or disingenuous. The United States is still a democracy. And in our democracy, a party that controls both the White House and Congress can do more or less what it wants, at least when it comes to economic policy. For an example, look no further than the George W. Bush administration, which eliminated the estate tax (for only one year, because it had 51 but not 60 votes) back in 2001. Even if some nonexistent master statesmen were able to come to sort of grand bargain on the estate tax, nothing would prevent Paul Ryan, Mitch McConnell, and (say) President Ted Cruz  from eliminating it in 2021. Complaining about “uncertainty” is just a sophisticated way of complaining about the fact that your side might lose.

The big misdirection in Mankiw’s column, however, goes unstated: talking about the estate tax in isolation from the rest of the tax code and, for that matter, the economy. At the end of the day, the estate tax is about the inter-generational transmission of wealth. From that standpoint, the rest of the tax code effectively imposes a negative estate tax.

The main reason is step-up of basis at death. Ordinarily, when you sell an asset, you have to pay capital gains tax on your profits (sale price minus purchase price). But when you die, your heirs get to increase their cost basis to the value of the asset at the time of your death—so no one ever pays tax on the appreciation during your lifetime. This is very clearly a negative estate tax, since it makes assets worth more to your heirs than they were to you. In addition, you don’t pay capital gains tax until you sell an asset—so the longer you hold onto an asset, the lower your effective tax rate. This obviously benefits the wealthiest families the most, since they have the least need to sell assets. And if you do ever sell an asset, you get to pay capital gains tax at a preferential rate.

In short, most of the tax code benefits families with more wealth than they can consume in one lifetime. In this context, the estate tax is really just an imperfect, partial, insufficient way to slightly mitigate the inter-generational transmission of wealth and the development of an aristocracy of hedge fund managers and their children. The big question isn’t whether we should have an estate tax or not. It’s whether we should take much more aggressive measures to give all children a fair shot at a comfortable and prosperous future. Eliminating the estate tax, without addressing the sources of inter-generational inequality, would only accelerate the transformation of American into a new feudal society.

20 responses to “Confused About Taxes

  1. Which bears on the phony double taxation argument when most of it was never taxed even once.

  2. This debate on taxation and inequality, as with many others, would really benefit if we make clear distinctions about types of wealth and the ways people use it. Are we talking about cash and the ability to consume? Is it a business? Is it land, which may have complex use and liquidity characteristics? Are we talking about a private “charitable” foundation or using money to influence politics? Each of these different bags of wealth has different moral impact, and it would do a modern polity really well to see and distinguish between them clearly.

    Right now there’s a tendency not to do that, to say that the Koch brothers’ or the Clinton’s money, or Mark Zuckerberg’s money is simply “their money” to do as they wish. Then we’re back to debating if that money is “too much” and we’ll never agree. While we may readily agree that $1 billion is scandalously too much for consumption, should be forbidden in politics, and the answers for businesses, land, or charities are all “it depends”. If we partition inequality and wealth into categories we’ll make more progress.

  3. James Kwak is simply a weasel. Why would anyone want to send money to the government where $1.00 ends up as $0.05 to the “poor.” I would rather the money go to a charity where, depending on the charity, $0.75 to $0.80 goes to the “poor” or at the targets of the charity. There is no reason to think that the federal government is better at allocating resources than a private institution. It’s probably that James thinks he’s smarter than anyone else and that he and his big government morons could be better at it. Anyone who thinks that true is delusional. If you want an estate tax in the context of entire tax reform where this tax is a piece of an overall revised tax structure then we can debate that, but those that cherry pick one element of the code because it impacts so few people is a weasel. And, by the way, there are going to be many 2nd generation of your poor people who will get rich and not want to pay this tax either. Your assumption – at least implied – is at best misguided and everything you probably hate about Donald Trump if he implied it (and he probably has). Go back to your ivory tower and pound sand.

  4. Now if the gvt were to take 50% at death, you sure as hell would find someone to give that money too before it happened, you know , someone you could trust to give the money back when needed.
    Now if you were/are staunch gvt supporter and hate the kids, you can STILL give your money back to the gvt to whom you are so dedicated too.
    It’s not rocket science folks, just plain old common sense.

  5. You make several good points in this article, but I think you are mistaken when you claim that “You can’t argue against the estate tax on fairness grounds[.]” To keep the math simple, imagine a person who makes $100 million in his lifetime and pays a 20% tax on his income, such that he pays $20 million into the government coffers and keeps $80 million for himself. Imagine another person who makes $1 million in his lifetime and pays the same 20% tax rate on his income, such that he pays $200K into the government coffers and keeps $800K for himself. It cost the first person $20 million for the right to live in the U.S. during his lifetime. It cost the second person only $200K. It is easy to see how this could be deemed unfair on an absolute basis. The first person has to pay 100 times more than the second person, and a total of $19.8 million more than the second person, for the same right to live in the U.S.. Under an absolute concept of fairness, everyone should be charged the same flat rate for the right to live in the U.S., just as everyone is charged the same flat rate for a movie ticket or hamburger regardless of income.

    Nonetheless, the result could be deemed fair on a relative basis because they are both paying 20% of their income. It also could be deemed fair, or even unfair to the second person, on a progressive basis because the rich person is left with $80 million on which to live while the second person is left with only $800K on which to live. Progressive fairness would leave them both with the same amount, requiring a tax on the first person of $99.2 million. All of these outcomes could be deemed fair depending on the particular concept and criterion of fairness one choose to employ.

    If one employs the concept of absolute fairness, under which it seems unfair that the first person should have to pay 100 times more than the second person for the right to live and work in the United States, then the notion that another large chunk of his income should go to the government upon his death seems even more unfair. For example, assuming an estate tax of 50%, the first person would pay $20 million in income tax and $40 million of estate tax, for a total payment of $60 million. The second person would pay $200K in income tax and $400K in estate tax, for a total payment of $600K. The first person would end up paying $59.6 million more than the second person for the right to live in the U.S., whereas, without the estate tax, he’d only be paying $19.8 million more. In other words, the estate tax would make the “unfairness” worse.

    Interestingly, concepts of fairness change through stages of childhood development. Children’s first concept of fairness is of the absolute variety—everyone should get the same absolute amount of birthday cake. As they grow older, children’s concepts of fairness become more complex, and they begin to consider more factors such as merit, need, and incentives.

    There is a second “fairness” argument to be made in favor of the estate tax—the argument from merit. The notion here is that because a person “made” the money, he should have the right to determine to whom it goes. Many wealthy people object to the estate tax because they feel that any money given to the government will be wasted on useless programs, given to corrupt politicians to line the pockets of their cronies, spent on programs that are counterproductive to the nation’s interests, or spent on things that are inconsistent with the person’s values. If, for example, the governor or your state had taken control of your tech company upon your departure and appointed his son as CEO, denying you the right to appoint the successor that you thought would best serve the company’s interest, it might strike you as unfair that you could not determine the future of company that would not have existed but for your creative efforts. This is the same notion of fairness that might typically surface if someone snatched away a batch of cookies someone else has baked and began to pass the cookies out to all their friends. With respect to this notion of fairness, it would be interesting to see if the wealthy would object as strenuously to the estate tax if they were given the right to name one or more charities to whom the tax would go.

    It’s not my purpose here to defend the estate tax, a particular concept of fairness, or the arguments for or against one of the particular concepts. I just want to suggest that the issue is more complicated than your article makes it appear, and that conservative uneasiness with the tax may not be as baseless as it sometimes seems.

  6. The estate tax is coupled with a special exemption that allows people to receive income and not pay taxes on it. Gifts and estate bequests are some of the only sources of income that are not taxable to the receiving individual or entity.

    IMO, it’d be much simpler if we eliminated the estate tax and also eliminated the special treatment of income received from an estate. Require beneficiaries to treat bequests and gifts like lottery winnings, which is what they really are.

    The original owner of the wealth is then free to dispose of their wealth in whatever manner they want. However, like other transfers of income, the government has a right and a duty to impose an income tax on the recipient of any income from the estate.

  7. You make some good points, e.g. the effect of the step-up in basis. I would like to add something else. There are two points that are rarely made when talking about the estate tax. The first is that without it, one must raise non-estate taxes to make up for the lost revenue. Thus the choice for someone wealthy enough to pay estate tax, is whether they would rather pay a lower rate during their lifetime and have their estate taxed at death, or would they rather pay a higher rate during their lifetime and no tax at death. When put that way, I think many would opt for the estate tax and lower taxes during their lifetime. It is a false choice to offer them estate tax or no estate tax without specifying the changes required to make up the lost revenue. The second point is that wealth inequality is bad for the demand side of the economy (as the wealthy spend less of their wealth than do the less wealthy), and the estate tax does help redistribute income from the wealthy downward, resulting in greater economic growth.

  8. What if you did away with the estate tax and the step up in basis as sort of existed for a while in 2010? Basis would carry on thru inheritances etc. You would then get such things as basis on some stocks being less that $1 per share if held over a couple of generations in the right company. It would be interesting to see a comparison of revenue under the estate tax to the no step in basis rule.

  9. Albrecht Zumbrunn

    You don’t even mention one feature of the “profligate” vs. “frugal”: The profligates are paying taxes as they go along their merry lives: Sales tax (or VAT depending on where they live), Hotel taxes etc. They will sell assets to finance their next pleasure trip and pay capital gains tax. They will pay much more even in gasoline taxes than the frugal. They probably have a vacation home or several and pay property tax on those.

    All of these the heirs of the frugals do not pay.

  10. Eliminating the estate tax, without addressing the sources of inter-generational inequality would only accelerate the transformation of America into a new feudal society”…

    But, keeping the estate tax, as an excuse for not addressing the other and much more important sources of intergenerational inequality, would speed up even more such transformation.

    Current risk weighted capital requirements have our banks no longer financing our children’s riskier future but only refinancing our safer past. That is high treason to that holy intergenerational social contract Edmund Burke wrote about.

    I have just read a document that recommended planning for retirement in such a way you use up all you have and make sure “you leave nothing on the table”.

    Martin Wolf (and many with him) also proposes that the government exploits now all “high quality infrastructure jobs”… and leave the debt to our grandchildren because interest rates on public debt are so low.

    I sincerely think we have some serious issues when it gets down to our intergenerational obligations.

  11. Sorry, NOT Martin Wolf, on that part of “high quality infrastructure jobs” I was referring to a recent article by Lawrence Summers

  12. As noted, the (temporary, proposed permanent) elimination of the estate tax during the GWB years (when Mankiw served) also eliminated basis step-up. It’s incomplete, almost disingenuous, therefore, to bring up basis step-up in the context of estate tax elimination without mentioning that.

    More interesting is to discuss the combination of eliminating the estate tax plus eliminating basis step-up. It would get rid of some of the biggest sob stories that people dislike about the estate tax (some closely held sole proprietorship or family farm is forced to sell out in order to pay the taxes; they’d owe nothing right now if there weren’t intending to sell, only owe capital gains when selling.) It would discourage selling and transfer of assets, to be sure, by comparison to the current situation, though I think it’s fair to consider the current situation as biased towards selling.

  13. Well said, John Thacker.

    Also strange that Kwak doesn’t note that the biggest beneficiaries of basis step-up are heirs of estates at or just below the estate tax exclusion amount, who get the benefit of the basis step-up without paying estate tax. Seems like most of the record-keeping arguments for basis step-up have gone away in the current era of computerized record-keeping, including mandatory cost basis reporting by brokers.

    On a somewhat related note, changing the current tax treatment for charitable donations of appreciated assets also strikes me as logical and overdue. The current treatment is to get a charitable deduction for fair market value but not owe capital gains on the difference vs. basis. There’s no real logic to that treatment: either the deduction should be limited to cost basis or capital gains tax should be owed on the gain versus basis (treating it like a sale followed by donation of the cash). The politics on that one get tricky, however. Not only do wealthy donors like the current system, but so do non-profits, including colleges and universities.

  14. The Trickle Down Tax Burden.
    We know the government needs the money to feed the poor and the children and all that, but ……
    At the 0.1 percent level, it will be fine if the 1 Percent will just pay the tax burden that they can ignore.
    At the 1 percent level, the same goes, it’s for the 10 percent to pick up their slouch.
    At the 10 Percent level, it gets to be more of a battle because the lawyers and accountants live just a level above …… but, hey, do what you can to get it down there to the 40 percenters, because we all know that these guys can’t get their Congress-people to return their emails.
    Nailed it !
    Wealth and Income Inequality R Us.

  15. “Eliminating the estate tax, without addressing the sources of inter-generational inequality, would only accelerate the transformation of American into a new feudal society.”
    The consequence is not logical or even rational. How is feudal society constructed from “leveling” the playing field so that everyone is at a disadvantage in relation to status quo ownership society? It seems to me that Feudal society pretty much evolved and derived from Estate
    systems of inequality becoming institutionalized as political-military (quasi-corporate) extended families roughly correlated under descent systems of inheritance (and competitively derived from inter-generational segmentation). In other words, eliminating the estate system would not lead into feudal society, but accelerate a process of corporate advantage and fascist political society.

    I think Pavlos Papageorgiou got it right on the money. It is not a one size fits all situation under one heading of estate inheritance rights. it is a matter of mitigating excess fairly, and making sure that earned merits and credits are not stolen by the state from hard working families. The mitigation of wealth taxes can be ratcheted into distinct brackets that adjust for social and public rights and interests of a justice based society. At the least, tax credit for inter-generational descendants that are at the level of extreme wealth could be fairly placed in trust and treasury bonded against future tax liabilities and treated as an asset life insurance instrument. i am sure that if enough constructive heads were put together a reasonable mitigation of estate taxes could be adjusted to scale and scales of justice would be satisfied as well.

    my hats off to Pavlos Papageorgiou !

  16. At what point though Bruce does the inheritance simply become an extended trust to be tapped from at will by the fiduciaries(or even the long arms the gvt for that matter). I think the crucial year of make or break is 71. After that it’s an institutionally managed full life insurance policy by default formula created by non other than, the trusty tentacles of the Federal Reserve.
    Those are some scales of formula(tic) justice, indeed.


    One algorithm to rule them all – Federal Reserve Board

  18. A lot of anti-government rhetoric here on behalf of millionaires. I’m surprised that outside of the Republican congressmen who take money from said millionaires to fund their campaigns that this is such a hot-button issue.

    The estate tax only reaches the very richest of Americans, (those who can easily afford to pay it). From a fairness standpoint, we’re also not really taking away from the people who earned that income. It’s their beneficiaries, likely their children, who “suffer.” These beneficiaries didn’t earn that fortune, they were born into their inheritance. This should be a slam dunk. If the government needs to fund things like universal paid family leave, dipping into this pot seems like one of the surest ways to go (beyond borrowing it at our ridiculously low interest rates).

  19. R Kamm – You miss the point. No one pays a tax for the right to live in the United States. You pay a tax for earning money in the United States. If you earn more money, you should pay more money. The US has one of the most fertile soils for producing millionaires, and the US government has been fertilizing it for years. You should have to pay for that long term investment.

    If you really want fairness, consider the fact that private property is just another government service. Maybe we should let people opt opt and not have access to the courts or police services if they don’t pay taxes, but I doubt we’re going to do that. We know what would happen. That’s why taxes should really be on wealth, not income if we are going to be fair.

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