In Defense of High Estate Taxes

A few days ago I had a post in which I argued that a progressive tax structure is the one that makes the most sense in the context of capitalism. I even threw in a quote from Adam Smith’s Wealth of Nations saying the same thing. Of course, many of those who call themselves capitalists would disagree.

Another thing on which those who call themselves Capitalists – the Steve Forbes and Steven Moores and the various think tanks like the Cato Institute, and even something calling itself the Adam Smith Institute would disagree with Adam Smith on the inheritance tax.

One big argument that those in favor of eliminating the inheritance tax typically have is that an inheritance tax reduces people’s motivation to work; many people, once they achieve financial security, would stop doing productive work if they couldn’t pass on their wealth to their families. A second big point is that inheritance often allows family enterprises to continue on; put a big enough tax on inheritance, and a person’s heirs would be unable to continue on the family business or family farm.

Now, consider (and I’m not advocating this – we’ll discuss what I’m advocating later) these two positions in the extreme opposite position: a 100% inheritance tax. Would those without heirs choose to stop working earlier? We all know the anecdotes that say yes. But… for all essential purposes, there are many people today that have no heirs they care about, and thus, on whose estate the tax is essentially 100% today. They are either estranged from their family, or childless, or whatever. Do these people stop working sooner than those who have heirs today? If I was arguing that the inheritance tax should be eliminated, this would be the first thing I’d look for to bolster to my argument. Perhaps they have, but I don’t recall seeing the Tax Foundation or Heritage putting out any data about this.

Similarly, here’s a thought experiment. What happens if the gift tax is essentially zero, but the estate tax is confiscatory, or at least higher than the estate tax? (This may be more than a thought experiment – I’m sure its happened before and would be interested in reader’s comments about when and what happened.) Well, the bequest argument indicates that a wealthy person would seek to transfer as much wealth as possible to the next generation prior to their death. And one might argue that you do see some transfer of wealth going on now. But there is a difference between “as much as possible” and “some.” I don’t think very many people would willingly give up their entire net worth to their heirs prior to their death, at least not voluntarily.

Put another way, people want to retain control of their wealth, both while alive and while dead. Disposing of assets is one of the few rights we as a society give the dead. We don’t allow people to specify who they will vote for in the first election after they pass away, nor do we allow them to drive or even check out library books after they’re dead.

The second point is more interesting. What would happen to assets if the inheritance tax was 100%? Well, presumably they’d be sold off to raise government revenues. (Presumably this would allow the government to reduce taxes on another constituency, namely the living.) So who would run a business better, someone who scrimped and saved in order to buy the business from the government because he/she thought he/she could do it, or someone whose great-grandfather started the business and who would never sell it because its been in the family for generations?

The argument for a confiscatory inheritance tax is simple. The beauty of capitalism as described by Adam Smith is that the magic of the free market, guided by the Invisible Hand, moves resources in the direction of their highest marginal product use to society. (Of course, there are market failures that can move the market away from this happy point: externalities, crime, market power, etc.) This works through everyone’s personal greed – I will use resources as efficiently as possible because I benefit most when I do so, and I benefit a lot less when I am wasteful. In other words, there are costs and benefits to every action.

Well, the costs and benefits go away with inheritance. From the point of view the estate passer on, there are no costs associated to passing on an asset to one potential heir as opposed to another potential heir; after all, the estate leaver is already dead. Contrast that with what happens if the person passes on those assets while alive – the decision has to be made much more carefully. Of course, there aren’t exactly benefits to passing on an asset to one potential heir as opposed to another potential heir, as, once again, the estate leaver is already dead.

What about the recipient of the inheritance? Well, there is a big benefit, but no cost associated with it. No action was needed or taken in order to receive the estate. Which may be many things, but it is also a market failure as it lies outside the realm of the Invisible Hand. It also encourages indolence among recipients of large estates, and such indolence can extend for generations.

So what Adam Smith suggest? Well, he seems to have been something of a realist. It seems he felt people should be able to pass on a small estate – enough to keep the widow (this was the 18th century, after all) and young children afloat. But otherwise, Adam Smith, of course, was a capitalist. He felt that each person should earn his or her own way.

I like to think of myself as both a realist and a capitalist. I would agree. I think an inheritance equal to zero for anything up to the median wealth for the country, and rising rapidly to 100% at twice the median wealth for the country would make sense. Some exceptions could be provided for small children, the elderly, or the handicapped, and there should be no tax on assets passed from one spouse to another. I think Mr. Smith would approve of such a plan.