Pearls of Wisdom Why Taxing Fairly Does Mean Taxing Inheritance

Pearls of Wisdom Why Taxing Fairly Does Mean Taxing Inheritance

On Sunday, Professor Mankiw wrote in the New York Times that the estate tax is inherently unfair. The 100th anniversary of the enactment of the estate tax passed last Thursday, so the piece was timely. Beyond that however, the piece holds little truth. Professor Mankiw writes the story of two families who create businesses and earn a lot of money - the Frugal family who save their money and the Profligate family who spend most of their money - and says it is unfair that after their demise the Frugal family has to pay some of it as an estate tax, but that the Profligate family does not.

Professor Mankiw seems to be advocating for a system under which taxes are paid by people who work for a living, but not by people who get rich owning businesses that their parents and grandparents created.

Professor Mankiw is not correct that the Frugal parents are being treated unfairly. The tax payments which Professor Mankiw is complaining about are not being paid by the business people who earned the money. The payments are made after they are dead. Their children are signing the estate tax returns (and checks) after their parents’ death. Let’s look at the situations of those children who are sitting in their lawyers’ offices a year or so after their parents die.

Imagine that in each family the older generation retires from their businesses having saved twenty million dollars:

  • The Frugal family lives off of just investment income, and the older generation dies with twenty million dollars in the bank.
  • The Profligate family spends all of their investment income, plus half of the principal, and the parents die with only ten million dollars in the bank.

For the next generation, that means:

  • The children of the Profligate family can keep the entire ten million dollars, tax free. (There is no federal estate tax on estates of less than around 10.9 million dollars for a couple).
  • The children of the Frugal family need to pay a tax of a little less than four million dollars - and they get to keep just over sixteen million dollars.

Either sixteen or twenty million dollars is a lot of money. Those children each inherit enough money so as to never have to work for a living, ever. Professor Mankiw believes that those children should never need to pay any tax on the money they receive.

Keep in mind: none of the children, from either family, did anything to “earn” their wealth. The principle of fairness would tell us that these next generations should pay a tax on their income (their inheritances) the same way our tax system mandates that people who actually worked to earn their money.

The point of our tax rate system is that the richer people should pay more taxes than the poorer people. If that was not the case, inequality would be growing even more than it actually is. There is no good reason why people who inherit money should be taxed at lower rates than people who earn their own money.

Professor Mankiw’s analysis is incorrect as it attributes the incidence of the tax to the dead people. Dead people do not sign checks.

The other argument made against the estate tax is that the deceased have already paid taxes on their money. That is also factually false for people who create business.

  • The entrepreneur who dies owning his business never pays any income tax on the increase in the value of his business from zero when he starts to (in our example) twenty million dollars (because he never realizes the gain; the tax on the gain from owning a business or other investment which increases in value is paid only when it is sold).
  • The next generation never pays taxes on that either, even if they do sell the business. They are taxed only the increase in value from the time their parents die until the time they sell the business; this is called “stepped up basis.” The rationale for that rule is that it is too much work for the heirs to figure out how much the increase in value before their parents died was, so it is made to be tax free.

Right now, eight of the twenty wealthiest people in America did absolutely nothing to earn their billions, other than being born as heirs to either Sam Walton (Walmart) or Forrest Mars (Mars Candy). There is no logical policy reason why these people (and their children, and grandchildren) should never be taxed.