Tuesday, August 5, 2008

Income Inequality Effects of Estate Tax

The controversy surrounding the estate tax has emphasized moralistic arguments. The first is that proponents claim that eliminating the estate tax will increase wealth inequality. The second is that opponents argue that the estate tax is coercive and deprives earners of their right to property. A corollary of the first is that the estate tax enhances government revenue. A corollary of the second is that the estate tax taxes wealth that already has been taxed via capital gains and income tax.

But what if the estate tax increases wealth inequality?

The claim that the estate tax reduces wealth inequality overlooks a critical point: not all estates are taxed. In particular, wealth placed in family trusts is not taxed. Since the ultra-wealthy tend to place their wealth in family trusts, the wealth-equalizing effects of the estate are uncertain.

There is surely a statistical argument that if you eliminate wealth of the top 2-0.5 percentiles of wealth earners, then there is more wealth equality. But wealth in the top 2-0.5% of wage earners is not what might be called deviant levels of wealth. The top 0.5% of wealth is in the 3-4 million dollar range, which is not enough to escape at least the threat of having to earn a living. Someone who aims to live a luxurious lifestyle would need to have much more than that. Thus, the variance of wealth distribution is a deceptive measure. It is only with respect to the top .1% and above that income inequality has significant effects on one's prospects, and it is precisely this group that establishes family trusts.

As I have previously blogged, a prime example is the Ochs Sulzbergers, owners of the New York Times, who have repeatedly advocated estate taxes for everyone else, but have dodged them for themselves for the past four or five generations via a family trust. To be fair, an estate tax would tax family trusts first, say 70% of a pro-rata share of each beneficiary who dies, before lesser wealth is taxed. I have never heard of a Congressional proposal to tax family trusts. Hence, Congress has never really cared about wealth inequality where it really counts. Just the opposite.

That is, there is a more subtle question. The onerous taxation of families in the top 2 - 0.5% percentile while exemption of families above that level from estate tax via family trusts may actually increase wealth inequality. This cannot be proven nor disproven empirically.

It takes some firms several generations to grow into Fortune-level concerns. Examples include Johnson and Johnson and IBM. If there are fewer very large firms than there would be without an estate tax, shares of the very large firms trade at higher prices than they would under conditions without the estate tax because there is less competition. The estate tax may accentuate the wealth of the very wealthy by nipping competition in the bud. If there would be a greater number of large firms in a free and fair market than there are today, then profit levels of the large firms would be lower. Stock prices of the large firms will also be lower. There will be more firms, more economic diversity, and as a result, more equality.

There would be more equality without an estate tax because the wealthiest, like the Ochs Sulzbergers, would not be as wealthy, and because the ranks of the very wealthy would be increased by a greater number of competitors. The larger number of competitors would reduce the wealth of the very wealthy and would increase their number. Thus, wealth inequality would be reduced. Moreover, the incentive to invest long term would increase, stimulating more Americans to achieve high degrees of wealth. The end result would be that income equality would be increased. This could have large effects on wages if increased competition increases demand for workers.

In other words, the estate tax may be increasing inequality by reducing the number of firms that become large over several generations and increasing the wealth of the Ochs Sulzbergers and other ultra-wealthy families. This freezing of American capitalism leads to a more permanent form of income inequality than would a competitive economy where families are struggling to compete with large firms.

As a result, not only can one not say with certainty that the estate tax reduces wealth inequality, but one can be fairly sure that the estate tax INCREASES the MOST IMPORTANT forms of social stratification whereby an ultra-elite that includes the Ochs Sulzbergers differentiates itself from the rest of society not because of merit but because of government and law.

One response might be to tax family trusts, and if there is to be an estate tax at all it should be applied to family trusts first because the oldest, least innovative firms are held by the oldest money that is most likely to be in trusts.

The most innovative firms that are most likely to create new technologies are held by families in the top 2-.5 percentiles. Thus, the estate tax may create wealth inequality in yet another way. By freezing out innovation and supporting the upper echelons in outmoded technologies, new business ideas that create new sources of wealth have been inhibited by the estate tax. The result is a country that is poorer because there is less innovation and economic growth and more wealth inequality. The effects of the estate tax likely exceed any mere statistical variance or Gini coefficient and may be unobservable because no one knows how badly the estate tax has harmed innovation.

Do not look for these ideas in the New York Times.

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