Ed Prescott on the Federal Estate Tax

June 1, 2006

From this morning’s Wall Street Journal, Nobel Laureate Edward Prescott makes the case for repeal of the federal estate tax:

From what I can tell, there are two main arguments in favor of an estate tax: the increased revenue that government receives to go about the people’s business; and the desire to somehow balance life’s unfairness by limiting the amount of capital assets that “the rich” can leave their kids.

On the second point, there is little to say except that what’s fair for one is often penalty for another. What is fair, for example, about telling someone that he will be unable to distribute his hard-earned money, which has already been taxed once, to his heirs as he sees fit? Such a person has zero incentive to accept an estate tax for which he sees no justification. He will do his best to try to avoid this tax through every legal means necessary, after which he may be inclined to consume more than he otherwise would, or just quit working sooner than otherwise. And while there’s nothing wrong with consuming one’s assets, if such consumption comes at the expense of capital that would otherwise be put to better use, such consumption is suboptimal. Recent empirical work on the disincentive effects of estate taxes has proven these phenomena true.

And that gets to our first point about the supposed budgetary benefits of such a tax. Since an estate tax is really just another name for a tax on capital income, then there is certainly no justification for such a tax. I, and others, have written before in these pages about the inefficiency of capital income taxes, and there’s no need to revive those arguments here, except to say that we can only grip the neck of our vibrant economic goose so tightly before it eventually dies and quits laying those golden eggs. And many of those golden eggs come in the form of capital that allows descendents to keep family businesses intact, or to begin new businesses that fuel our economy.

Besides, even if estate taxes were not inefficient and could be construed as fair, they would still do little to address the budget deficit. In 2003, net estate taxes accounted for $20.7 billion, a drop in the bucket of an $11 trillion economy. Clearly, we are not going to balance the budget by grave robbing. (Read the full piece here.)

Aside from its indirect effects on charitable giving—which in our view isn’t a compelling justification for policy—the estate tax is typically defended in two ways.

First, because estate taxes are assumed to be borne by wealthy taxpayers, it is argued that they are an efficient mechanism to redistribute income within society. Second, it is commonly argued that estate taxes are an important federal revenue source.

However, once the tax-shifting behavior of estate holders is taken into account, the economic incidence of the estate tax may be much less progressive than is commonly assumed, making it a blunt instrument for income and wealth redistribution.

Also, the history of the federal estate tax makes clear that the tax has never been an important federal revenue source, typically accounting for 1 to 2 percent of federal collections. A growing body of economic research suggests the tax may raise zero or even negative net tax revenue once widespread estate-tax avoidance is accounted for.


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