Econ 101: Is the Estate Tax Good or Bad?

     The Senate recently blocked a vote on the bill that would have reduced the inheritance tax. In the media and in Congress, people have asked a lot of questions about the tax.

     Why would we want to reduce or eliminate it? Wouldn’t this be a tax break for the rich? Wouldn’t its reduction result in a major addition to the federal debt? Doesn’t the tax reduce the disparity of income and isn’t that a good thing?

The Rich

     First, if we learn anything from the study of economics it is that individuals respond to incentives. When we place a tax of 46 percent on the assets you pass on to your descendants, then you are going to behave differently than if there were no tax. It should be obvious that the first effect of the estate tax (and its coordinating taxes, the gift tax and the generation-skipping tax) is to cause people to save less. Empirical studies, such as a 2000 Bureau of Economic Research Working Paper, make this clear.

     What this means is that we consume more today rather than putting resources into the production of research, machinery, factories and other things economists call capital. This means workers will be less productive in the future, because they will have fewer and less powerful tools to produce with. A 2001 American Council for Capital Accumulation study found the economic distortions caused by the tax were on the order of $34 billion per year.

     Who loses from this? Not the rich, since they are now consuming more than they otherwise would have. The poor and middle class lose because they will be less productive and thus will earn less in the future.

Effects on the economy (and by extension, the deficit)

     We must also put into perspective the amount of revenue generated by the estate tax. Collections under the tax amount to between one and two percent of federal receipts. However, once we account for the behavioral changes caused by the tax, there is substantial evidence that the net revenues are actually negative. The lowered economic activity caused by the tax results in reduced receipts from corporate and personal income tax that offset the amount raised.

     The tax also is very expensive to comply with. A 1992 National Tax Journal study found the compliance cost was $1 for every $1 raised. Combining these costs with the reduction in output it causes, it is clear the estate tax is a burden on the U.S. economy.

Income disparity? How it affects real people

     Those who end up paying the tax are people who fail to plan ahead.  If you are wealthy and have expensive lawyers, you can find ways to make sure you shelter your assets. Indeed, an early study of the tax called it a voluntary tax, because you can avoid paying it by having the right legal advice.

     Who would find it worthwhile to spend thousands of dollars to set up trusts and other shelters to avoid the tax and are capable of spending the time to do this? Not the first-generation entrepreneur who is busy producing goods and services. Old-time wealth is likely to be the most capable of avoiding the tax.

     This, coupled with a study by Professor Gregory Mankiw that showed the correlation between lifetime earnings of successive generations is relatively low, casts serious doubt on the effectiveness of the estate tax in evening out the income distribution. In fact, by making it difficult for small estates to become big estates, it may work to increase the disparity in income over time.

     While Congress has recognized the negative effect this tax has on small business and family farms by providing certain exemptions, a July 2005 Congressional Budget Office Report showed that the current tax still has a harmful effect on those families that are trying to keep a business or farm family-owned. This is because such a business can have a substantial amount in assets with a modest cash flow. When the original owners of the business pass away, the estate is hit with a large tax, which cannot be paid from the cash flow of the business.

     The business either is broken up or is saddled with more debt than it can handle and becomes vulnerable to a buyout. In addition, rather than putting money into the business, expanding its capital and hiring new workers, the owners buy life insurance policies that will allow them to pay the estate tax. This is a drag on the economy that primarily affects those who would purchase the additional output and who would otherwise be employed by the firm.

     The estate tax system creates all sorts of improper incentives and only exists because people are jealous of the wealth of others. How do people become wealthy enough to have a $100-million estate? In a market economy, only by producing something that consumers want. We should be encouraging people to invent products and methods of production that make such efficient use of resources that everyone can purchase them.

     The reason Bill Gates is so rich is that his products can be produced cheaply enough that millions of people can purchase them, and the products are so good that millions of people want to purchase them. Should we therefore punish Mr. Gates by taking away much of what he manages to save from this? Should we encourage him to spend every dollar on himself rather than leave it to the federal government? Or should we reward innovation and encourage the buildup of our capital stock?

     The estate tax makes it difficult to make economic decisions and results in unintended consequences, the burden of which falls primarily on the lower and middle classes. Rather than giving in to the politics of envy, we should have a tax structure that encourages innovation and saving. That is how the poor will become wealthy.

Dr. Gary L. Wolfram is the George Munson Professor of political economy at Hillsdale College in Hillsdale, Mich. He also serves as an adviser to the Business & Media Institute.