Rosen on the Estate Tax

June 8, 2006

One of the leading public finance economists, Princeton Professor Harvey Rosen, has a commentary today on regarding the estate tax. He addresses an issue that has is often overlooked in tax policy debates: who bears the economic incidence of the estate tax?

Here’s an excerpt in which he explains three key economic arguments on the negative impacts of the estate tax:

First, a high estate tax rate has a detrimental effect on the behavior of individuals in their roles as entrepreneurs. People with large estates are disproportionately owners of small businesses — Douglas Holtz-Eakin, former director of the Congressional Budget Office and Donald Marples (GAO) estimate that entrepreneurs are three times more likely to be subject to the estate tax than portfolio investors. The estate tax in effect reduces the returns to entrepreneurs’ investments. Thus, the estate tax increases the “user cost of capital” — the rate of return that an investment must make in order to be profitable. The higher the user cost of capital, the lower the number of profitable investments available to the entrepreneur…

Second, an increase in the estate tax rate would have a negative effect on individual saving rates and wealth accumulation. Research by academic economists suggests that an increase in the estate tax rate of 10% leads to a roughly 14% decrease in net worth. Other serious studies conclude that there would be a substantial increase in saving if the estate tax were eliminated altogether…

Third, arguments that high estate tax rates make the U.S. tax code more progressive are problematic. The basic assumption is that the burden of the estate tax falls entirely on the decedent — the rich dead guy takes the entire tax hit. This assumption is natural because, by law, the decedent’s estate is responsible for paying the tax. However, it reflects an approach that the economics profession has rejected for at least a century. Who bears the burden of a tax depends on the underlying economic fundamentals, not on who writes the check to the IRS. When the government levied a special tax on yachts, for example, the burden fell not only on the owners of yachts, but also on the individuals who produced and serviced them. Applying the same kind of logic in this case, the most likely scenario is that the decedent will not bear the burden of the tax. Rather, he or she will simply leave a smaller bequest, because the estate tax makes wealth accumulation (saving) less attractive. (Full Story)

For more on the estate tax, have a look at our most recent Special Report on the topic.

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