Death Tax Less Harmful Than Other Taxes

March 14th, 2010 at 12:26 pm | 1 Comment |

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FF Symposium: Traditionally, conservatives have argued for repeal of the estate tax, characterizing it as an unfair “double tax.” FF Contributor Cetulus however argued for conservatives to back the estate tax as an alternative to high marginal income tax rates. Brian Domitrovic, author of Econoclasts, responded that the estate tax would only discourage work and investment.

Conflict of Interest Watch: Cetulus practices gift and estate tax law.

Many thanks to Professor Domitrovic for his thoughtful reply to my defense of the estate tax. Though we disagree on the estate tax, I should note that we agree on fundamentals. I am a supply-sider; Prof. Domitrovic, author of a brilliant and definitive history of supply-side economics, is as well. We both believe that the tax system should raise the most revenue with the least economic damage.  I go on to argue that a death tax — or what I prefer to call a lifetime-deferred tax — harms the economy less than a tax on income earned during life. Rather than repeal the death tax, therefore, Republicans should support it as a pro-growth alternative to the income tax.

Prof. Domitrovic demurs on the grounds that, in an ideal tax system, no tax would be imposed at death.  He cites in particular the “inflow-outflow” tax devised by the late Norman Ture. The Inflow-Outflow Tax is essentially an income tax combined with a 100% deduction for savings, so that income only gets taxed to the extent consumed. In this optimal tax system, inheritances would not be taxed until spent.

Fine: I concede that in the best of all possible tax worlds, there would be no death tax. Needless to say, that is not the world we live in.  Imperfections that would not exist in a perfect world may, paradoxically enough, make an imperfect world less so. I refer Professor Domitrovic to the Theory of the Second Best (expounded with admirable clarity by Larry Solum here): we have to make due with what we have. Nothing about an optimal tax system refutes my argument that the estate tax makes our existing tax system better.

To start with, the Inflow-Outflow Tax is highly unlikely to be enacted. Congress — to say nothing of the Treasury Department — does not have the competence to design and implement a comprehensive new tax system.  Further, the Inflow-Outflow Tax would be politically unpopular.  Not only, contrary to current law, would it include gifts and inheritances in the definition of income, but Prof. Domitrovic’s illustration assumes that asset appreciation would be included as well, even if unrealized.  Historically, there has always been strong political opposition to taxing pure “paper gains,” however sensible it is in theory.

Further, an Inflow-Outflow Tax would, I take it, have to tax income from prior years. Otherwise, the tax could be easily avoided.  In Prof. Domitrovic’s illustration, the taxpayer has $1 million of income but spends $250,000 on cars and vacations.  Since he saves $750,000, he only gets taxed on the $250,000. Well, suppose he saves the entire $1 million, waits one year and buys all those fancy things in a year 2 when he has no income. Will the income earned in year 1 forever escape taxation? I would assume not.  It would appear, therefore, although I confess that I’m new to the proposal, that the Inflow-Outflow Tax would tax an individual’s entire lifetime income!  That is, the government would keep track of everything that a taxpayer has earned throughout his life and tax it all to the extent not saved. It is virtually inconceivable that that the Federal government will ever muster the political will and the bureaucratic resources to implement such a tax.

In the meantime, we have to work with what we have.  I argued in my first post that the estate tax beats an income tax.  Yes, it is a tax on savings and investment, albeit deferred until death.  But so is the income tax, which is imposed annually during life. A lifetime-deferred tax discourages savings and investment much less than an income tax.  Thus, if we must tax savings and investment at all, a death tax is better.

Prof. Domitrovic rebuttals are, I think, unpersuasive. He fears that the estate tax discourages entrepreneurial activity and favors lifetime consumption. Even if true, this would not undermine my argument, for the question is not whether the estate tax discourages work, savings and investment, but whether it does so more than a lifetime income tax. In any event: come on! Thousands of rich people die every year without even having bothered to execute a will.  Surely the desire to provide for future generations is rather low on the list of most people’s priorities. It certainly does not explain why people go to work, start new businesses or even save up money.

A tax at death even shrewdly harnesses our biological make-up.  Who are these visionary entrepreneurs responsible for creating the wealth in our society? Surely not the elderly, who are too busy husbanding what they have to think of daring new schemes for making more.  Rather, entrepreneurs are young.  From a Darwinian perspective, they take risks because they are at an age when they need to compete for mates. Young entrepreneurs are almost totally untouched by a desire to hoard for the next generation. A death tax has no effect on them.

Prof. Domitrovic also mentions that the estate tax favors consumption over savings. Well, it all depends on the rate. My guess is that even a death tax of 50% would not cause much increased consumption (although I would be open to evidence to the contrary). Moreover, once again, consuming is something that young people do.  Older individuals have less need to show off by buying stuff.  They only expensive thing that the elderly tend to buy is medical care.  Not to get off point, but a broad-based death tax would seem to be an efficient way for the government to expand health care access.  Essentially, under a 50% death tax rate, the government pays for half of all end-of-life care. The death tax could replace Medicare for all but the poor.

Finally, even without comparing the estate tax to the income tax, Prof. Domitrovic’s own perfect-world principles should lead him to support the estate tax.  I am struck by the remarkable similarity of Prof. Domitrovic’s ideal tax — which, as noted, is ultimately a tax on income earned over a taxpayer’s whole lifetime, reduced by savings and investment — and the actually existing estate tax. For, what is the estate tax other than a tax on the wealth accumulated during life?  Under Prof. Domitrovic’s ideal tax, the government would only tax that portion of increased wealth that has not been saved or invested.  But passing on wealth to the next generation is more like consumption than savings.  By giving, say, $1 million away to my heirs, I am “purchasing” heirs that are $1 million richer.  The estate and gift tax thus taxes wealth only to the extent of (certain kinds of) consumption.  If there is one actual tax that mirrors what an ideal tax would do, it would be the estate tax.  Therefore, Prof. Domitrovic should support it.

P.S. It seems to me that Amory Blaine raises a serious challenge to supply-side economics. It is the same challenge that Joseph Schumpeter raised when he argued that socialism, just as much as capitalism, could in fact harness men of supernormal ability.  Ambitious men seek honor more than riches. If that’s true, then perhaps tax policy isn’t so important after all. A rare insight for a Princetonian!

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