The Estate Tax

At present, the federal estate tax maxes out at 40% of the amount of an estate over 10 million dollars.  Almost no one pays it, because of the large exemption.

The best argument I’ve heard against the estate tax is that if the bulk of the estate is something that is not liquid, like a farm or a business, there may be no way to raise the money to pay the tax without selling the family farm or the family business.

For those with more liquid assets like stocks and bonds and a dozen houses, well the estate tax isn’t that big a deal.  Heres why.

Estates change hands about every 25 years, which arguably is the length of a generation.

The long term average appreciation in the stock market is around 7%.  In 25 years, a stock market investment might grow by 5x.  If you start with 20 million, in 25 years you will have about 100 million.

With the estate tax, your notional 20 million drops to only 16 millions, because 10 million is exempted and you pay 40% of the rest.

After 25 years, that 16 million would only increase to 86 million.

In this case, the estate tax cost the equivalent of about 4 years of growth.

Even if the exemption were zero, the estate tax would represent about 8 years of growth every 25 years.  The fortune just keeps growing.

Of course this analysis is true only if you just leave the money in the market.  Historically, fortunes last about three generations before being diluted and generally squandered.  However, once you get into serious money, it is kind of hard to spend enough to keep the rest from growing to infinity.

If the policy objective of the estate tax is to prevent self sustaining multigenerational fortunes, it doesn’t accomplish its purpose.  However it does kill those family farms and family businesses.  What might be done?

Idea 1: Make the estate tax payable over a generation, rather than as a lump sum.  In effect, this is a wealth tax, rather than an estate tax.  If my figuring is right, the 40% estate tax applied every 25 years is very close to a 1.3% wealth tax applied annually.  This has the same effect on cash estates, but might be managable for those family farms and businesses. Like the estate tax, this would apply only to wealth over 10 million.

Idea 2: Bump the tax rate on income for the 1% to raise the same amount of money.  Evidently, the estate tax raises about 20 billion per year. In 2014, an income of 465,000 put you in the 1% and the average income of the 1 percenters was 1.2 million, and there were about a million 1% households – that is 1.2 trillion in income, and the income tax surcharge to replace the estate tax would be . . . 1.6%

These two ideas are not that far apart.  On the whole a 1.6% income tax surcharge is easier, because  income is reported, and wealth is (a) not reported and (b) often consists of unrealized gains.

All this leaves unresolved the question about the policy goal.  Is the estate tax or a possible replacement just a way to pay for government? Or is it really intended to reduce income or wealth inequality?  If the latter, we need a much larger discussion about how to accomplish the goal, because the estate tax doesn’t do it.  Repealing the estate tax will surely make inequality worse, but keeping it only slows down increases in inequality, and not by that much.

 

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