Friday, November 02, 2007

State of the play academically on wealth transfer taxation

Yesterday I went to a session at Columbia Law School where my colleague, Lily Batchelder, was presenting her paper, "How Should an Ideal Consumption Tax or Income Tax Treat Wealth Transfers?" Lily is doing excellent and important work in this area, ranging from her actual policy proposal as part of the Hamilton Project to the more theoretical inquiries she is pursuing now. But even apart from any one individual's distinctive view of the area, I think it's important to say something about the current state of the play, which Lily helps make her clear both through her own contributions and through the prior empirical literature she cites.

Ten years ago, I would have said the jury is out in the academic and tax policy literature, so far as the merits of wealth transfer taxation are concerned. E.g., there is no particular reason one should favor wealth transfer taxation just because it's progressive, given that in principle equal progressivity could be obtained with or without it, through adjustments to other tax instruments.

From a 2007 perspective, however, I think the case for wealth transfer taxation has pretty much been made. A key point that Lily's work makes clear is that inheritance taxation - where the tax depends on the circumstances of the recipient - is theoretically superior on informational grounds both to estate taxation - where it depends on the size of the bequest - and to no tax at all on wealth transfers. The inheritance tax option uses more distributionally relevant information than do the other mechanisms. E.g., my wellbeing clearly depends on the wealth transfers I receive, plus other stuff I have or can earn, so the tax system is depriving itself of distributionally relevant information if it ignores the wealth transfers or fails to interact them with what else I have.

Now for a refinement, potentially reversing the seeming import of what I just said. The clear superiority, on informational grounds, of inheritance taxation over the alternatives does not tell us that the inheritance tax rate should be positive. This depends on a whole raft of relevant inputs, including (as Lily's work makes clear) the case for subsidizing gratuitous transfers due to the "altruistic externality" that Louis Kaplow may have been the first to emphasize. So to say we should have an inheritance tax isn't to say we should burden inheritance relative to not having a wealth transfer tax - just that in theory it ought to be taken into account somehow, which straight exemption fails to do.

But here is what I would argue is the clincher in terms of a positive inheritance tax rate (again, recognizing that there are complicated multiple inputs). Recent empirical research concerning bequest motives and practices, including, e.g., work by Wojciech Kopszuk of Columbia University, suggests that "accidental bequests" (those reflecting imperfect lifecycle saving and annuitization rather than bequest motives) are a sufficiently large piece of the whole to suggest that the distortionary effects of taxing wealth transfers, e.g., the discouragement of work and saving by future decedents (which we all are), are likely to be substantially lower than they would be if bequest motives were doing more of the work. So there are likely to be substantial efficiency advantages to this device for taxing work and saving, relative to the use of standard annual income or consumption taxation.

All this is not just high theory, of course. The estate tax is actually scheduled to disappear in 2010 and then re-appear in its pre-2001 form in 2011. This is a crazy and implausible sequence of rule changes, leaving aside the fascinating "throw momma from the train" research opportunities that it would offer empirically minded economists. So something is bound to be done. It thus is well worth knowing how strong the academic case for some type of wealth transfer taxation, especially an inheritance tax, now appears to be.

I myself would combine inheritance taxation in some form with a progressive consumption tax in lieu of the current income tax, but this is a topic for another day (actually for a past not a future day as I have written about income and consumption taxation quite a lot in recent years).

1 comment:

Ian said...

Your preference for a progressive consumption tax would agree with a view recently expressed by Warren Buffet. Research work on the FairTax bill (HR 25) - pet tax reform preference of these two presidential candidates of opposing parties, Mike Gravel (D) and Mike Huckabee - would seem to support tax equity. Witness:

The effective tax rate percentages, that different income groups would pay under the FairTax, are calculated by crediting the monthly "prebate" (advance rebate of projected tax on necessities) against total monthly spending of citizen families (1 member and greater, Dept. of HHS poverty-level data; a single person receiving ~$200/mo, a family of four, ~$500/mo, in addition to working earners receiving paychecks with no Federal deductions) Prof.'s Kotlikoff and Rapson (10/06) concluded,

"...the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.

"Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax."

Further, per Jokischa and Kotlikoff (circa 2006?) ...

"...once one moves to generations postdating the baby boomers there are positive welfare gains for all income groups in each cohort. Under a 23 percent FairTax policy, the poorest members of the generation born in 1990 enjoy a 13.5 percent welfare gain. Their middle-class and rich contemporaries experience 5 and 2 percent welfare gains, respectively. The welfare gains are largest for future generations. Take the cohort born in 2030. The poorest members of this cohort enjoy a huge 26 percent improvement in their well-being. For middle class members of this birth group, there's a 12 percent welfare gain. And for the richest members of the group, the gain is 5 percent."

More on the Act and scrapping the tax code which would purport to pay for government the way that America's workers are paid - when something is sold.