Do estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. es make people work and save less? It’s commonly argued that they do not. After all, the argument goes, estate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es are levied on the dead. How can they affect economic behavior among the living, especially young workers?
This seems plausible. But simple economics shows it’s wrong. Let me show you why.
Estate taxes are essentially one-time excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. es on savings. As people save and invest throughout life, they do so knowing that some day their nest egg will be taxed.
However, savings are really just set-asides from income. When people save, they set aside part of their income. And when they die, that saved income is taxed through the estate tax. When viewed this way, we can think of estate taxes as delayed, one-time income taxes.
Once we realize estate taxes are fundamentally income taxes, it’s clear that they affect economic behavior just like other income taxes. The only real difference is that the payment due-date is delayed.
Economists use this line of reasoning to measure the effect of estate taxes on work and savings decisions in the economy. By converting the estate tax into an equivalent income tax, we can get a better sense of its economic importance.
Here’s the logic: People shouldn’t care whether their saved income is taxed each year though life, or once at the end of life. Using some algebra, we can figure out how big of an income tax is needed to replace the estate tax.
With an estate tax rate “k,” an equivalent income tax rate “t,” return on savings “r,” and a remaining life expectancy (that is, years of saving) “n,” the following equation should hold:
(1 + r)n(1 – k) = (1 + r(1 – t))n
The left side is the value of your lifetime savings with an estate tax. The right is what it’d be with an income tax paid each period instead. If we re-arrange and solve for “t,” we get this:
t = [(1 + r) – (1 + r)(1 – k)1/n]/r
Here’s what that equation says: “What income tax rate ‘t’ today would we have to pay if we wanted to replace the estate tax with an income tax, given life expectancies and expected returns on savings?”
From a new paper from the Treasury Department’s Office of Tax Analysis, here’s a chart of those equivalent income tax rates, by age and rate of return on savings, using life expectancy data from the CDC (click to enlarge):
Even for young workers, those rates are substantial. And they skyrocket for older workers. So how much do they affect work and savings decisions overall? From the study:
…the findings suggest that estate taxes have a dampening effect on the reported size of taxable estates. Estate taxation seems to depress taxable bequests by some 14 percent.