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Inheritance tax, estate tax, and death duty are the names given to various taxes which arise on the death of an individual. Technically, "inheritance tax" and "estate tax" are different, in that inheritance tax may be payable by the heir while estate tax is levied prior to the receiving of the inheritance. In many cases, however, the distinction is of little importance and the terms are used interchangeably; in the United Kingdom, no distinction is made and inheritance tax is equivalent to estate tax. In the U. S. an estate tax is paid out of the deceased’s estate before it is distributed. The same total tax is paid, therefore, whether there is one heir or more and the same tax is paid whether the heirs are rich or poor.
Such death duties are controversial both in terms of economics and ethics. Although they have a long history, the imposition of contemporary inheritance and estate taxes has been relatively recent and debate has increased as the numbers of people affected has risen in the twenty-first century. The logic of disallowing those who earned their wealth to choose how to distribute it upon their death (except by philanthropy) is controversial and the economic impact on savings potentially problematic. Perhaps even more serious, once applied only to the affluent, generating substantial revenue for the government who justified this as it would be spent on programs that would benefit society as a whole rather than allowing a few to continue to amass excessive wealth, the estates of an increasingly large proportion of middle-class people in many countries are now at a level that incurs such taxes.
The existence of such a tax underscores the problems inherent in all forms of taxation, issues that cannot be solved by legislation because they reflect weaknesses in human nature. It is only when human nature changes from selfishness to caring for others and society as a whole that these problems can be resolved, both by those designing the system and by those paying and collecting the taxes.
In different jurisdictions, the tax code may make reference to inheritance tax, estate tax, or even death duty. Generally, except in the United States, the terms estate tax and inheritance tax are used interchangeably.
In the United States, there is a difference between estate taxes and inheritance taxes. Estate taxes are levied on representatives of the deceased person, while inheritance taxes are levied on the beneficiaries of an estate. Inheritance taxes are generally levied by state authorities and estate taxes are imposed by the federal government.
The estate tax is a tax on net worth, the value of all property owned minus debt and any estate expenses. Essentially the tax is an “everything tax.” It is a tax on cash and bank accounts, stocks, bonds, real estate, businesses, equipment, and machinery, automobiles, and other property, life insurance policies, artwork, even personal belongings.
Inheritance tax is paid by the heir and may vary according to the heir’s relation to the deceased, the heir’s income and wealth, and the amount inherited. If an inheritance tax is progressive then the total tax paid varies according to the number of heirs and their wealth.
In both the U.S. and Great Britain, egalitarians tend to prefer an inheritance tax since this gives the deceased an incentive to spread wealth across many heirs (John Stuart Mill proposed an inheritance tax, for example) while pragmatists tend to support the estate tax because it is easier to administer and tends to raise more revenue than the inheritance tax (precisely because it cannot be avoided by increasing the number of heirs).
Gift tax is a related type of tax, applying to gratuitous transfers of money and property between living persons.
Inheritance taxes have a long history dating back to the Roman Empire, which levied taxes on inherited property to provide pensions for retired soldiers. Contemporary inheritance taxes are based on the feudal arrangement of the Middle Ages whereby the sovereign was the ultimate owner of all land and property, and permission was required to transfer property on the death of the immediate owner. In many European countries property could be transferred by payment of a "relief" when no direct descendant laid claim. Contemporary estate taxes can be traced back to such payments.
Although initially levied in the seventeenth century, estate taxes in the United Kingdom were established in their current form at the end of the nineteenth century. In the United States, various estate taxes were imposed for short periods, on both the state and federal levels. Pennsylvania was the first state to impose inheritance tax in 1826, and many states continue to tax inheritance. In 1916, a federal estate tax was imposed to help finance World War I, and it has remained in force since that time.
For the purpose of illustrating how inheritance/estate tax is generally calculated, the United States is used as an example.
The first step is to calculate the fair market value of the entire estate. This includes cash, bank accounts, stocks and bonds, real state, insurance, and similar items of value. Included are life insurance and annuity proceeds payable to the estate or the heirs as well as the value of certain property transferred within a specified time period prior to the death. This last item involves a connection between gift taxes (and their exclusions) and inheritance tax.
The total fair market value of all these items is termed the "gross estate." The next step involves the calculation of any adjustments to the gross estate. Typical adjustments include the remaining balance on a mortgage, funeral expenses, the fees associated with settling the estate (which might include items such as estate administration fees or payments made to an attorney), and a "marital deduction" that can be taken for property that is left to a surviving spouse.
Once all the deductions have been taken from the gross estate, the remaining balance is considered the net value of the property—or the inheritance tax basis. The final deduction prior to calculation of the tax is the lifetime tax exclusion (or unified credit), which was $1 million in 2002, rising in steps to $3.5 million in 2009, and which includes taxable gifts. The remainder of the estate is taxable, at a rate that ranges from around 40 to 60 percent.
Inheritance tax used to impact only the very wealthy, but in the twenty-first century, the proportion of people affected has become much larger. This has led to animated discussions about whether to limit, amend, or suppress inheritance taxes in many countries, particularly in Europe. The debate erupted when death duties, once paid only by the affluent, began to affect middle-class Europeans in significant and increasing numbers.
"Inheritance tax used to be a problem for the rich. Now it's a problem for you and me," said Anne Young, a tax expert at an Edinburgh financial-services firm. Young has estimated that as many as one third of British households have estates that could be subject to tax. She includes herself in this group (Gumbel 2006).
This increase in value of estates, with concomitant tax liability, has been blamed on the rise in house prices. Unlike their parents, European baby boomers tend to own their homes. As prices have risen these homeowners have enjoyed increases in the value of their assets. However, in many cases, this has pushed their net worth over the national minimum thresholds for inheritance tax, which have not been adjusted to keep up with changes in house prices. The result is that almost anyone owning a detached house in London or southeast England has an estate valued over the U.K. tax-free limit (Gumbel 2006).
Inheritance taxes have been controversial since their inception. A few excerpts from the writings of prominent economists should precede the discussion:
This does not imply that once-earned wealth perpetuates itself forever. On the contrary, even if a fortune were completely immune from risk it would tend to quickly dissipate so long as there is more than one heir in each generation. In a free market wealth is continually changing hands… Increasing and even maintaining a fortune requires entrepreneurial skill. …Consider how much easier it is to waste a million dollars than it is to make a million dollars. Nevertheless, wealth will typically last more than one generation so it is reasonable to argue that at least two generations of heirs are significantly harmed by the estate tax (von Mises 1981, 338–40).
In modern times the funds raised by the estate and gift tax have accounted for only a small proportion of government revenue…. In 1990 death and gift taxes raised just over $15 billion in revenue, approximately $11 billion of which was because of the Federal estate and gift tax the remainder because of state death and gift taxes (Tabarrok 1997).
Those in favor of taxes on a person's estate argue that the amount of the tax is small and occurs only once, that it reduces savings to a lesser degree than income taxes, and is useful for redistributing wealth. Opponents argue that such taxes have a negative effect on incentives, discouraging people to build up their estate since a large part will not be given to their heirs. Those against this form of taxation claim that this leads to reductions in savings and hurts business incentives. In such cases it can be argued that the limit to the usefulness of such taxes exists when the accumulation of wealth is discouraged to the extent that the economy of the nation is harmed.
Bequest theory is an inter-generational transfer theory of saving. Hence, a tax on the transfer of property between the generations can affect savings by changing the behavior of the bequestor or the heir. The effect on the bequestor is composed of two parts: The price effect and the wealth effect.
The tax raises the price of bequests and therefore reduces the desired bequest. The effect on savings, however, is ambiguous. The price effect can be summarized in terms of elasticities. If the demand to give bequests is inelastic the price effect works to increase savings. Little data exist on this elasticity but a demand curve must be elastic above some price, otherwise a consumer could be made to spend all of his income on the single taxed good (Wagner 1977, 19).
For example, in order to bequeath an estate of $1 million to his daughter an individual must save $1 million if there is no tax, but if there is a tax of 50 percent and he still wishes to bequeath $1 million he must increase his savings to $2 million. In most circumstances the bequestor may reduce the amount of bequest, but so long as the reduction in final bequest is less than 50 percent the price effect works to increase saving. At rates around 50 percent the demand for bequests is probably elastic, but if the rates were raised by any significant degree the amount of savings would be reduced.
Reinforcing the reduced savings because of the price effect is the wealth effect. For a given size of bequest, an increase in the estate tax is equivalent to a reduction in wealth. The desire to give bequests decreases (increases) as wealth decreases (increases). In other words, bequests are a “normal” good.
An inheritance is a large, one-time, increase in wealth. Income smoothing requires that the bulk of this wealth be saved. A decrease in the heir’s inheritance is therefore ipso facto, a large decrease in savings. Indeed, if the bequestor and heir have similar wealth and value scales, the heir will want to save the principal portion of the estate so that it can be passed on to his own heirs. This is what accounts for the fact that family fortunes are typically the accumulated savings of more than one generation.
Bequest-saving tends to be long-term and continuous and therefore allows for what F. W. Taussig called "sustained accumulation and permanent investment" (Taussig 1920, 249). This is especially true when savings are passed along in the form of family businesses.
Traditionally, many economists believed that the most important reason people saved was to give bequests. Alfred Marshall (1949, 227), however, held that "family affection is the main motive for saving." Similarly, Joseph Schumpeter (1942, 160) called the "family motive the 'mainspring' of savings," and F. W. Taussig (1920, 249) argued that for long-term savings "the main motives are domestic affection and family ambition."
Elsewhere Taussig (1920, 509) called inheritance "the great engine for the maintenance of capital" and, in his highly regarded principles text, Frank A. Fetter (1913, 371) argued that "much of the existing wealth probably never would have been created if men did not have [the] right of gift." In fact, the entire capitalist order for Schumpeter is founded on the "family motive:"
When the capitalist-entrepreneur-bourgeois is sundered from longterm family ties he becomes, to borrow a phrase, a wage slave or bureaucrat-cog easily crushed by the state and its philosophical apparatus (Schumpeter 1942, 160).
Those who are able to bequeath a material inheritance are also often able to bequeath a sound moral and educational inheritance. Along with pecuniary and physical capital the founding generation bequeaths human capital. In a capitalist society, therefore, the institution of inheritance is more than a moral institution, it is part of the process whereby wealth is transferred to those who can best use it to serve the wishes of consumers
One reason most neo-classical economists ignore the effect of the estate tax on the heir’s saving is the argument that the government can also “save” the estate tax by investing it in capital projects. Generally, however, there are several flaws with this argument:
First, the wealthy tend to have low rates of time preference, which allows family fortunes to be invested in long-term projects, as seen in Taussig’s "sustained accumulation and permanent investment" (Lawrence 1991).
Second, and more fundamentally, there is a crucial difference between government investment and private sector investment. "Only the private sector investment can be defined as welfare-enhancing" (Rothbard 1956). Private sector savings are necessarily allocated to maximize consumer and producer well-being. Rothbard (1970) has made a strong case that so called government investment is better understood as consumption by government officials rather than savings.
Adam Smith’s distinction between unproductive and productive labor was never more apt than when he wrote:
All taxes upon the transference of property … are all more or less unthrifty taxes that increase the revenue of the sovereign, which seldom maintains any but unproductive laborers; at the expense of the capital of the people, which maintains none but productive (Smith 1904).
To evaluate the effect of higher estate (or inheritance) taxes, it is therefore necessary to examine the "life cycle theory."
The theory of saving was the central component of post World War II Keynesian macroeconomics but the bequest theory was completely abandoned during this period. In its place was put the life cycle theory of saving by the main protagonists: Franco Modigliani and Richard Brumberg (1954).
The life cycle theory places the main motivation for saving on the desire to provide for retirement. The theory implies that savings should follow a “hump” pattern. Young adults begin the saving process by borrowing; as their career stabilizes they pay off old debts and begin to save; then, when retirement begins, they draw upon their savings until they die. In the simple model, everyone wishes to consume up to the moment of death and then die penniless. In more complicated models a bequest motive is tacked on as an afterthought.
Yet, far before the life cycle theory was born, Alfred Marshall recognized an important fact which casts doubt on the theory:
Men seldom spend, after they have retired from work, more than the income that comes in from their savings, preferring to leave their stored up wealth intact for their families (Marshall 1949, 228).
In other words, the elderly do not dissave as the life cycle theory predicts. Marshall’s observation has been verified by a number of studies. Far from dying penniless, the elderly often die richer than at any other point in their life. In addition, econometric work by Kotlikoff and Summers (1981) indicates that "the stock of wealth is far too large to be accounted for by life cycle reasons."
Hence, the theoretical and empirical shortcomings of the life cycle theory indicate that the bequest motive is an important determinant of savings. This means that far from being negligible increases in the estate tax and gift tax could significantly reduce total savings.
In addition to various economic impacts of estate and inheritance taxes, there are also ethical considerations. Basically, this issue involves justifying the imposition of large taxes on the estate of the wealthy, people who earned or inherited their wealth and wish to transfer it to their descendants or other beneficiaries of their choice. This issue strikes at the heart of the rights of ownership.
Economists and other writers have attempted to rationalize the imposition of estate and inheritance taxes by appealing to the principle of equality of opportunity. Economist and Nobel Prize winner James Buchanan, for example, argued that:
A guarantee of “some” equality of opportunity is inherent in the political philosophy of the free society (Buchanan 1975, 303).
Harold Groves (1939, 248) noted that equality of opportunity is often accepted as desirable “by the most ‘rugged’ of individualists.”
However, there are problems in the justification of inheritance taxes in terms of equality of opportunity. To increase opportunities for individuals to excel is a worthy goal but to restrict the opportunities of some in order to create “equality” among all is impossible, not to say "monstrous." In fact, among the opportunities it is desirable to increase is the opportunity to inherit wealth.
Inheritance taxes on the rich do not significantly improve the lot of the poor. Even if the taxes raised from the rich were redistributed to the poor, instead of spent on consumption by the state, the wealth of the poor would increase only trivially. Thus, in practical terms, equality of opportunity is a poor justification for the negative impact of such taxes on the wealthy.
Closely linked with the idea of equality of opportunity is the principle of "desert." Many who reject as morally repugnant confiscatory income taxes accept the inheritance tax because the individual does not “earn” his inheritance and is therefore undeserving. Harlan Read stated the thesis boldly in his Abolition of Inheritance:
All estates are unearned by the heirs and should therefore, be taken by taxation (Read 1918, 279).
However, this argument in logically weak since the (correct) idea that a man deserves what he earns does not necessitate the conclusion that a man does not deserve what he does not earn.
The difficulties of defining “deserve” and “earn” and their relationship notwithstanding, if one accepts the assumption that in some sense the heir does not deserve his inheritance because he has not earned it, the question now becomes: How does it follow from this that the state deserves the inheritance? It is the owner of the estate who earned it and not the government. Furthermore, if the owner of the estate earned it and, thus, deserves it, he must also deserve the right to allocate the estate as he wishes. Thus, even accepting that a man does not deserve what he does not earn, this is no justification for inheritance taxes.
In many ways, both practical—for long-term capital projects and efficiency of capital investment—and as noted by prominent economists including Adam Smith, David Ricardo, Alfred Marshall, F. W. Taussig, and others, the transfer of wealth between generations is beneficial. As as long as parents care for their children the dominant means of doing so will be through family inheritance.
The transference of wealth through the family benefits bequestor and heir, strengthens family ties, and increases long-term savings, which are the basis of economic growth. When the state intervenes significantly in this process it does so at the expense of the smooth operation of family, society, and economy. The estate tax has the greatest impact on these grounds, as Murray Rothbard has noted:
The inheritance tax is perhaps the most devastating example of a tax on pure capital (Rothbard 1970, 113).
However, until those who accumulate significant wealth in their lifetime show themselves able to use it to benefit society as a whole, in ways that reduce the need for government efforts, the imposition of these types of death duties continue to be seen as necessary and justifiable, provided the taxes are sufficiently progressive to ensure that only those with the greatest wealth are significantly impacted.
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