Higher Estate Taxes Can Prevent a Nation of Dynasties

(Bloomberg Opinion) -- It makes sense that President Donald Trump would change tax law to favor inherited wealth. The real-estate-entrepreneur-turned-television-host got his own start thanks to a super-wealthy father, and ended up inheriting hundreds of millions of dollars (much of it sheltered from taxes). Trump’s tax reform, passed in late 2017, makes it easier for people to follow in his footsteps. It increases the amount of money a married couple can pass to their heirs free of tax, to $22.36 million. It also raises the amount that rich people can leave directly to later family generations without paying the generation-skipping tax. Though the higher limits are set to expire in 2025, it leaves a window for rich people to avoid taxes permanently by placing their assets in dynasty trusts.

This is exactly the opposite of the direction the nation needs to be going. Since the late 1980s, the U.S. has seen the fraction of wealth owned by its richest people more than double:

Higher Estate Taxes Can Prevent a Nation of Dynasties

More than one-ninth of the entire country’s wealth is now controlled by just 1 in 10,000 Americans.

Numbers like these would be less disturbing if the set of people occupying these top spots changed more often. If super-rich people frequently tended to lose their fortunes, or if wealth didn’t persist from generation to generation, then this vast inequality would look more like a game, where sometimes you win and sometimes you lose.

But inherited wealth means that wins and losses aren’t so temporary. Unlike income, wealth is easy to pass on to your descendants -- you just sign it over in your will. Even if heirs make bad financial decisions and spend down their fortunes over time, inheritances can lead to inequality that persists for generations. And if heirs squirrel away the money in well-diversified portfolios of stocks and real estate, wealth inequality may actually be self-reinforcing.

This probably strikes many Americans as unfair -- after all, heirs didn’t do anything to earn their fortunes other than be born to the right parents. The phrase “dynasty trust” itself sounds a little disturbing to the democratic, individualistic American ideal - - who wants to live in a country ruled by dynasties?

Opponents of estate taxes argue that if inheritances are taxed, it will be an incentive for rich people not to save their money, lowering the national pool of funds available for investing. But in fact, many inheritances are largely accidental. Economist Jens Kvaerner has found that changes in life expectancy don’t change how much couples tend to save (though being widowed does induce a change). That suggests that although some rich people do want to create a dynasty, many simply make as much money as they can, and leave it to their kids by accident when they die.

Raising taxes on inheritances is unlikely to change these people’s saving behavior, making estate levies a fairly efficient form of taxation. As for rich people who do strongly desire to leave their children a fortune, high estate taxes may actually make them save more money, in order to ensure that their heirs remain rich even after the tax.

Additionally, if estate taxes are used in lieu of business taxes, they can help shift the allocation of capital from heirs to entrepreneurs, which will probably increase the effectiveness of investment.

So by changing the law to favor rich heirs, Trump has taken the U.S. economy and tax structure in the wrong direction. The estate tax exemption should be lowered significantly, and the top tax rate -- now 40 percent for estates of more than $1 million -- should be raised.

But as the popularity of schemes like dynasty trusts demonstrates, estate taxes alone don’t do a great job of preventing rich people from leaving money to their kids. Beyond simply lowering exemptions and raising tax rates, the U.S. should switch to a more comprehensive method of taxing inheritances. Lily Batchelder, a professor of law and public policy at New York University School of Law, has some suggestions for how to do this.

The most important shift would be to change the estate tax and gift tax to a unified inheritance tax. This means that instead of taxing the person who gives away the money, the person who receives it would be taxed, based on the total amount they get. Batchelder suggests a 15 percent surcharge on income tax, applied only to income from inheritances.

Another important technical change -- which can be implemented even without shifting to the inheritance tax that Batchelder suggests -- is to charge capital gains taxes across generations. Currently, when someone dies and leaves assets to heirs who then sell the assets, the capital gain is only taxed relative to the time of transfer. For example, if I buy a stock at $100 and it goes up to $200 and I leave it to my daughter who sells it at $250, she would currently only have to pay taxes on $50 of capital gains income rather than $150. Batchelder recommends changing this so that the entire capital gain, from when the benefactor bought the asset, gets taxed.

These, plus a number of more minor adjustments Batchelder lists, are all good ideas. Whatever the mechanism, though, the U.S. needs to act decisively to head off a future in which wealthy dynasties maintain their pole position for generation after generation. Such a society of aristocrats and peasants isn't be in keeping with traditional American values of opportunity and individualism.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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