The Case for Flexible Inheritance Tax

January 30, 2018 | When engaging the topic of inequality, it is important to distinguish between unequal distribution of wealth and social mobility. Simply put, social mobility takes place when individuals move between income brackets, e.g. when someone is born poor but dies rich. The fact that a society experiences inequality does not necessarily have to mean that rich families remain rich and poor folks remain poor. In other words, growing inequality need not signal a decrease in social mobility. Although inequality has increased over the last several decades, some of the best research suggests that the odds of moving in the income ladder in the United States have not changed much in the last twenty years.

The Gini index measures income inequality (2014).

By M Tracy Hunter (Own work) [CC BY-SA 3.0 (https://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

Distinguishing between inequality and social mobility is critical because stagnation in the latter phenomenon is much more damaging to social peace than the former. The fact that some are quite rich ought not to be a problem. A genuine problem is faced when the rich are the same people, generation after generation. As Adam Smith noted a few centuries ago, “a power to dispose of estates forever is manifestly absurd.” This is because the all-important link between personal effort and success that lies at the heart of capitalism is substituted by one between birth and riches. Likewise, Alexis de Tocqueville observed that “what is most important for democracy is not that great wealth fortunes should not exist, but that great fortunes should not remain in the same hands. In that way there are rich men, but they do not form a class.” While certain inequality will remain a characteristic of free societies, lack of social mobility need not. In fact, nothing endangers the survival of a free social order more than the perception of many that they cannot, regardless of their effort, reach any and all echelons of society.

It is thus striking that many proposals that hope to ensure general social mobility focus first and foremost on inequality. Hiking income taxes is such a solution. These taxes may succeed at reducing various indices of inequality, but they also weaken the incentive to innovate more and work harder. The chief benefit of allowing people to retain a greater share of their income is that it constitutes a link between one’s effort and the results that follow. It only makes sense to work hard if we can be sure that the fruits of our labor will belong to us.

Besides weakening incentives to work hard, high income taxes do little to address the possibility that birth, not personal initiative, will ultimately decide how much wealth an individual can amass. This is because inheritance of fortunes, not their creation during one’s lifetime, is the force that can lead to the outcome Tocqueville warned against, i.e. that rich men will form a class.   

An appropriate policy would thus seek to strengthen, not weaken, the link between one’s effort and the results that follow to advance social mobility. One such solution could come in the form of a flexible inheritance tax that would be, to the extent possible, accompanied by lower income taxes. A flexible inheritance tax would tax the wealth of rich individuals upon death, limiting the degree to which the fortune of birth trumps hard work when it comes to amassing wealth. It would be flexible because those subject to the tax could avoid it by voluntarily donating to charitable causes that benefit all of society. In other words, a flexible inheritance tax would not automatically empower the government to decide who gets the money. All it would mandate is that a cause that benefits the society at large be supported.

Inheritance and estate taxes, both of which are levied when wealth is transferred from one generation to another, used to be an important part of tax codes around the world. In the 1960s, over one percent of government revenue in OECD countries originated in inheritance and estate taxes. Today, less than half a percent of government revenue is raised from these levies. This is in stark contrast with other types of taxes. While the overall tax burden that countries impose on their citizens has risen, inheritance taxes have either diminished in importance or left the tax code altogether. In 1997, the top U.S. estate tax rate was 55 percent and the associated exemption was $600,000. This means that the estate tax was levied on what was left after the $600,000 exemption was applied. Since 2013, the estate tax has been kept at 40 percent. The latest reform of the U.S. tax code has increased the exemption that a couple can enjoy to $22.4 million. As a result, very few estates in the U.S. will pay the tax. This is a move in the wrong direction.

Although the current U.S. estate tax does allow for deductions for charitable bequests, charitable giving—and the tax’s flexibility—could be further encouraged by allowing to deduct two dollars from the taxable amount for each dollar that is donated to a charitable cause.

There are several good reasons why inheritance taxes are preferable to other kinds of levies. Crucially, taxing inheritance is less distortive. Unlike taxes imposed on income, inheritance levies leave the incentives to work hard intact. Unlike capital gains taxes, taxing inheritance does not discourage savings or investment. In fact, by forcing each generation to begin somewhat anew, inheritance duties encourage entrepreneurial initiative and the necessary risk taking that underlies progress in capitalist societies.

Vladimir Chlouba is a PhD student of political science at Ohio State University.

The views expressed in this piece do not necessarily reflect the views of other Arbitror contributors or of Arbitror itself. 

Photo by NASA/GSFC/METI/ERSDAC/JAROS, and U.S./Japan ASTER Science Team for NASA