The Economics of Estate Taxes

What have economists learned about estate taxes? Here's a summary of some of the research on this issue from Wojciech Kopczuk for the NBER Reporter:

Estate Taxation, by Wojciech Kopczuk, NBER Reporter: Taxation of estates and inheritances is one of the most controversial issues in tax policy. While this type of taxation is viewed by some as an integral part of a system that guarantees equality of opportunities, others describe it as a "death tax" and argue that it is both inherently unfair to levy a tax at death and that it is particularly costly to do so, highlighting its adverse effect on wealth accumulation, discrimination against savers, negative consequences for the survival of small businesses, and a multitude of avoidance opportunities.

From an economist's point of view, estate taxation touches on a wide array of important topics. It is a form of a tax on capital. It is heavily progressive, with U.S. federal tax rates currently approaching 50 percent and exceeding 70 percent in the past. It is closely tied to the propagation of inequality and the impact of redistribution. It affects the intergenerational mobility of wealth. Its impact and its cost depend on the presence and nature of a bequest motive. How individuals plan for leaving an estate depends also on their acceptance and attitudes toward their own death, thus providing a natural place for looking for examples of the importance of psychological considerations. The U.S. estate tax is nominally a tax on individuals, but its incidence depends on family structure and interrelationships. The tax has been dubbed a "voluntary tax," highlighting that tax avoidance and administration issues are also very important.

Estate taxation has figured in economic research in three different ways. First, one may be interested in understanding how the actual estate tax affects economic decisions. Second, there is an important theoretical question regarding the role that this type of taxation should play in the tax system. Third, the existing data on estate taxpayers provides a source of information that can shed light on central economic, but non-tax, issues. In my research, I have pursued each of these directions.

In a few of my papers, I looked at how transfer taxation affects economic decisions. The notion that the estate tax forces people to make difficult late-in-life, even deathbed, decisions, has its place in the political discourse about the tax, but is it really true? Using linked estate and income tax data, I studied how estates of people who suffered from a lengthy illness differ from estates of those who died instantaneously.  I found that the size of the reported estate (of wealthy estate taxpayers) is as much as 20 percent lower for decedents whose terminal illness lasted months or more, but I also showed that this effect is unlikely to be explained by medical expenses or lost wages. Instead, I found strong evidence pointing to a flurry of estate planning activity following the onset of a terminal illness, that results in a reduction in the value of the reported taxable estate and therefore tax liability.

How strongly do estates respond to estate taxation? By exploiting more than 80 years of IRS data covering multiple tax regimes, and age variation of estate tax decedents, Joel Slemrod and I estimate ... that the estate tax does in fact reduce reported estates, either because it curtails wealth accumulation or induces tax avoidance, or both. ... In another joint paper, we also show that the estate tax has important implications for charitable contributions. Finally, we demonstrated that the reported timing of death is sensitive to tax considerations: in a four-week period surrounding estate tax reforms, more taxable deaths are observed during the "low-tax" regime than during the "high-tax" regime. We were, unfortunately, unable to conclude how much of this response represents the strength of willpower of tax-averse individuals and how much reflects cheating by their beneficiaries, but this finding provides another example of the variety of behavioral responses that individuals pursue in response to tax incentives.

From the theoretical point of view, one way of thinking about taxation of estates is as a tax on capital. Under the standard model of perfect altruism, the question of how to tax estates reduces to the question of how to tax capital with infinitely lived agents, and there is a large and growing literature on the subject. However, the relationship between a tax on estates and a tax on wealth or capital income depends crucially on the nature of the bequest motive. Any theoretical analysis of estate taxation requires taking a stand on the nature of intergenerational links. Unfortunately, despite a lot of research on this topic, there is no consensus regarding the types of bequest motive or even the prevalence of any bequest motive.

Joseph Lupton and I revisit the influential work of Michael Hurd, who demonstrated that people with and without children have similar consumption patterns in the old age, thereby putting in question the possibility that they have different bequest considerations. We relax the assumption that children are a deterministic indicator of a bequest motive, and instead show that consumption patterns of the elderly are explained by a ... model with both bequest-motive and no-bequest types. We estimate that the first group constitutes three-fourths of the population but that for most people the difference between the bequest and non-bequest consumption patterns is small, and only at the very top of the wealth distribution do these differences become economically important. Overall, we find no evidence that having children is an important indicator of the presence of a bequest motive.

One popular argument for taxation of estates is that a tax on "accidental" bequests ... is particularly efficient because it does not stimulate any behavioral response. I show that this reasoning is potentially misleading, because [this] may be due to a market failure that can be addressed by government policy. Theoretically, such an intervention could reduce or eliminate accidental bequests altogether and would be preferred to their taxation....

Although the timing of death is uncertain, it does occur eventually with probability one, and a forward-looking planner should have a contingency plan in place. As mentioned earlier, my research shows that much estate planning takes place shortly before death, suggesting that procrastination in this context is plausible. One possibility is that standard models do not accurately represent how people incorporate mortality risk in their behavior. Borrowing from the psychological literature on terror management theory, Joel Slemrod and I explore the consequences of utility-reducing fear in acknowledging one's own mortality. We equip agents with a fear function that increases with subjective mortality risk and the ability to repress information. We conclude that such agents are "behavioral;" in particular, we find that such individuals have an incentive to behave in a time-inconsistent fashion regardless of whether they actually repress information or not.

The U.S. federal estate tax was introduced in 1916. It has always applied to a relatively small group of the wealthiest decedents; applying at the peak of its coverage in the 1970s to over 7 percent of adult deaths, and at its minimum coverage to less than 0.5 percent. Its long history and its focus on the top of the distribution make estate tax statistics a natural source for studying long-term changes in wealth concentration. This is what Emmanuel Saez and I have done. We ... find that wealth concentration decreased rapidly in the 1930 and 1940s but there is no evidence of an increase in past 20 years. This latter result is particularly puzzling in light of the sharp increase in income concentration over this period. ...

One potential explanation that we offer for the lack of an increase in wealth concentration is that increases in income concentration were driven by labor rather than capital incomes, so it may be that not enough time has passed for the increase in wealth accumulation concentration to materialize. ...

My work with Lena Edlund provides a different perspective for thinking about long-term changes in wealth concentration. We observe that the gender distribution of estate taxpayers evolved over time. In particular, the number of women among the very wealthy estate taxpayers (top 0.01 percent) rose until the 1960s, but has been declining since the 1970s. We argue that the gender distribution of the wealthy group reveals the relative importance of self-made and inherited wealth. ... There are of course many potentially confounding factors that can affect the number of women at the very top of the wealth distribution, such as bequests to widows, changes in gender-specific mortality and the age gap between spouses, community property rules and tax treatment of married couples that we discuss in detail. We reach the conclusion that the relative importance of self-made wealth in the twentieth century indeed followed a U-shaped pattern: it decreased in the 1930s and 1940s, and has been increasing since the 1970s. Reconciling it with the flat wealth concentration series in the past 20 years therefore requires that the relative wealth from inheritances has been declining, while self-made wealth has been increasing. ... The results also provide an important qualification to the interpretation of the drop in income and wealth concentration in the 1930s and 1940s: our findings suggests that entrepreneurial wealth declined during that period more than inherited wealth did. This is further supported by historical lists of the wealthy, which show that the importance of inherited wealth at the top of the wealth distribution peaked after World War II.

Whether the estate tax in the United States will remain an important issue depends on the fate of its ongoing phase-out that culminates in complete repeal scheduled to occur in 2010. As is well known, the repeal is part of a set of provisions that sunset in 2011, so that current law specifies that in 2011 the estate tax will revert to its 2001 version. Policymakers have provided researchers with a rich set of experiments that will help in years to come in understanding the effect of estate taxation itself and, perhaps more importantly, other economic decisions related to death and intergenerational transfers.