The Estate Tax is Double Taxation
November 2, 2016
This week, Professor Lily Batchelder of New York University published a paper titled “The Silver Spoon Tax,” which argues that the United States should strengthen its wealth transfer taxes, such as the federal estate tax. She argues that wealth transfer taxes are relatively efficient and that the next president should increase the estate tax rate, broaden the estate tax base, and eliminate stepped-up basis at death.
In making her case for expanded wealth taxes, Batchelder also argues against some common concerns about wealth taxes. One concern she addresses is the argument that the estate tax is a form of double-taxation:
“Some argue that any income or payroll tax previously paid by a wealthy individual on gifts and bequests they make should count as tax paid by the heir. But they are two separate people. When a wealthy individual pays his assistant’s wages out of after-tax funds, we don’t think the assistant has thereby paid tax on their own wages. In short, today the income and payroll taxes effectively tax unearned income in the form of inheritances at a zero rate.”
This is a weak argument. Simply because two people are involved in a transaction should not make their exchange of money a taxable event. Batchelder ignores an important distinction that the tax code makes between two types of transactions in the economy: an exchange of money for a final good or service that generates additional income, and a transfer of money between two people that does not.
Generally, the income tax attempts to tax the creation of new income once, as it happens. Take the example of a business that produces a good and sells it to a customer, who buys that good with after-tax income. The business then pays tax on the income generated from that sale. We do not consider the taxation of that business income to be a double-tax of the customer’s income simply because the customer paid tax when they earned it. Rather, this transaction is due to the generation of new income attributable to the business, from a new good or service. This new income should be taxed.
However, a transaction that is the result of a new good or service is distinct from transactions in which no good or service is produced. Money changes hands in the economy all the time without the creation of a new good or service. Alimony is a good example of this. Under current law, the receipt of an alimony payment is considered taxable. However, alimony does not result in new income, because it is simply the transfer of money from one person to another. So to prevent double taxation, the payer of alimony is able to deduct it from their taxable income. Transfers like these are generally exempt from additional taxation, in order not to tax the same income twice. The tax code makes a similar adjustment – allowing deduction for payment, but taxing receipt of income – for several other transfers between parties: business interest expenses, payroll expenses, costs of goods sold, and home mortgage interest, to name a few.
Batchelder’s example of the wealthy individual who pays an assistant in after-tax income is a transaction that results in new income. To make her example comparable to a wealth transfer, it would be more appropriate to compare it to the payment of alimony, which is taxed on receipt, but is paid in pre-tax income. With this more accurate comparison, one can see why a wealth transfer tax is clearly double taxation.
Wealth transfer taxes are progressive and some of the proposals that Batchelder argues for, such as eliminating the step-up in basis, are worth considering. However, her paper does not sufficiently rebut the argument that they are a form of double taxation. If the goal is to raise more revenue from high-income taxpayers, there are much more efficient ways to do so. In fact, a 2% increase in the top marginal ordinary income tax rate could completely replace estate tax revenue while reducing the overall tax compliance burden. I still think there are many good reasons to remain skeptical of wealth transfer taxes such as estate taxes.