Confused About Taxes

By James Kwak

In the Times a couple of days ago, Gregory Mankiw made a half-hearted case for eliminating the estate tax that was so weak I’m not even sure he convinced himself. The core of his argument is that the estate tax violates the principle of horizontal equity, according to which “similar people should face similar burdens.” The problem, on his view, is that between two rich couples that each amass $20 million, the Profligates who consume their wealth before death end up paying lower taxes than the Frugals who maintain a modest lifestyle. “To me, this does not seem right,” Mankiw concludes.

First of all, it’s not even clear why this example violates horizontal equity. The Profligates and the Frugals are not “similar people”—Mankiw specifically constructed the example that way. They may have each earned the same amount of money, but they have vastly different consumption habits.

Second, it’s not clear that the Frugals are paying more tax than the Profligates. Their estate will pay higher taxes, but by then they are dead; the estate tax does not directly limit their personal consumption in the slightest. In fact, the ones whose estate will pay the tax are the ones who apparently are not interested in consumption in the first place. Now, the defense of Mankiw is that the Frugals do care about how much money they can pass on to their children, so the estate tax does affect their utility. But that brings up the third, and most important point . . .

Only an economist, and an economist of a certain type, could evaluate the fairness of the estate tax by comparing two wealthy families. Mankiw’s point is that the estate tax is unfair to the Frugals—as compared to whom, exactly? Remember, Mr. and Mrs. Profligate spent most of their money before they died; their children get next to nothing. The Frugals’ kids end up with about $16 million ($20 million less the 40% federal estate tax on the amount above the exemption), but they’re still the richest people in the story. The Profligates’ kids get the remaining crumbs of the parents’ once-impressive fortune—yet we’re supposed to feel sorry for the Frugals.

But the people we should really be thinking about are everyone else’s children. It’s a little peculiar to profess to care about equal treatment and then proceed to talk solely about rich people. What about Mr. and Mrs. Poor and their children, who far outnumber the Profligates and the Frugals? The Poors’ children inherit nothing because their parents died with nothing; the Frugals’ kids inherit $16 million although their parents died with $20 million. There’s no reason to think the second generation of Frugals is any more deserving than the second generation of Poors—yet they are born into comfort and security, while the Poors face hardship and anxiety. From this perspective, the only fair estate tax would be one with a rate of 100%. And even then, the Frugals’ kids would be better off than those of the Poors, since they would have the most productivity-enhancing childhood that money can buy.

The bottom line is this: You can’t argue against the estate tax on fairness grounds, unless your powers of abstraction are so awesome that you can some how overlook the fact that most people wish their parents had to pay the estate tax.

As I said, I’m not sure that Mankiw bought his own argument, because he then concedes that “not all economists share my judgments about the estate tax.” So he pivots into a different point that he thinks “everyone can agree on”: that “we need more stability in the tax code than we have had in the past.” And we can only have stability, he claims, if opposing sides can compromise on outcomes that both find tolerable.

This argument about tax code stability is just a special case of the more general claim you often hear that businesses need regulatory “predictability” so that they can make long-term plans. And in both cases, this position is either naive or disingenuous. The United States is still a democracy. And in our democracy, a party that controls both the White House and Congress can do more or less what it wants, at least when it comes to economic policy. For an example, look no further than the George W. Bush administration, which eliminated the estate tax (for only one year, because it had 51 but not 60 votes) back in 2001. Even if some nonexistent master statesmen were able to come to sort of grand bargain on the estate tax, nothing would prevent Paul Ryan, Mitch McConnell, and (say) President Ted Cruz  from eliminating it in 2021. Complaining about “uncertainty” is just a sophisticated way of complaining about the fact that your side might lose.

The big misdirection in Mankiw’s column, however, goes unstated: talking about the estate tax in isolation from the rest of the tax code and, for that matter, the economy. At the end of the day, the estate tax is about the inter-generational transmission of wealth. From that standpoint, the rest of the tax code effectively imposes a negative estate tax.

The main reason is step-up of basis at death. Ordinarily, when you sell an asset, you have to pay capital gains tax on your profits (sale price minus purchase price). But when you die, your heirs get to increase their cost basis to the value of the asset at the time of your death—so no one ever pays tax on the appreciation during your lifetime. This is very clearly a negative estate tax, since it makes assets worth more to your heirs than they were to you. In addition, you don’t pay capital gains tax until you sell an asset—so the longer you hold onto an asset, the lower your effective tax rate. This obviously benefits the wealthiest families the most, since they have the least need to sell assets. And if you do ever sell an asset, you get to pay capital gains tax at a preferential rate.

In short, most of the tax code benefits families with more wealth than they can consume in one lifetime. In this context, the estate tax is really just an imperfect, partial, insufficient way to slightly mitigate the inter-generational transmission of wealth and the development of an aristocracy of hedge fund managers and their children. The big question isn’t whether we should have an estate tax or not. It’s whether we should take much more aggressive measures to give all children a fair shot at a comfortable and prosperous future. Eliminating the estate tax, without addressing the sources of inter-generational inequality, would only accelerate the transformation of American into a new feudal society.