Megan McArdle writes about why we tax estates rather than taxing inheritances. Taxing estates has a major double-taxation problem (generally, the wealth composing the estate was taxed as income as it was accumulated), a progressivity problem when a large estate is distributed in the form of many small bequests, a disincentive to long-term savings, and a very large deadweight loss in that it often forces a large portion of the estate (with large subjective value to both the deceased and the heirs) to be liquidated to pay the tax.
The last problem is well-illustrated by the recent death of George Steinbrenner. Restoring the New York Yankees to greatness was his life’s work. Sure, he made money in the process, but he never hesitated to pour that money back into the team, to spend whatever it took to give the team the best chance it could have for another championship. Since he died this year, he was able to pass it on intact to his sons, who presumably share his vision and values. But had he died next year instead, majority ownership of the team would have had to be sold to pay the death tax.
McArdle’s post concentrates on the second objection to taxing estates, by noting that an inheritence tax would address that problem but only at the cost of imposing other problems. Of the three problems she highlights, the third is actually the same as the Steinbrenner problem with taxing estates, but more severe. But the first of her three problems with an inheritence tax points to a better alternative to either, one that addresses the problems with either an estate tax or an inheritence tax.
When property is inherited, the capital gains basis is “stepped up”, or reset to the market value at the time of death, rather than the normal capital gains basis of the purchase price of the asset. This is done for two reasons. First, to partially compensate for the steeply progressive estate tax that is typically levied. Second, to save the heir the extreme difficulty of deducing what their ancestors paid for a piece of property when it was orginially acquired.
I’d deal with the issue the other way around. Rather than taxing at time of death and stepping up the capital gains basis, I would instead levy no special tax on estates or inheritences and step the capital gains basis down to zero. After all, the heir paid nothing for the property he inherited. That way, nothing needs be sold to pay the tax, but when the heir does sell the inherited property, he pays capital gains tax on the entire proceeds. Cash and cash equivilents would simply be taxed as capital gains the year the inheritence takes place.
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Sweet. I love policy suggestions! And this one makes sense.
Yours,
Wince
By stepping the capital gains basis down to zero you provide an incentive never to sell the asset — the tax consequences would simply be devastating. This ends up leaving a lot of heirs holding onto a lot of assets that, under normal circumstances, they never would, and maybe never should, but they have so much more to lose by selling in a lump sum that it still “pays” for them to milk them for their income until they’re essentially destroyed.
I am sure estate planning guys could do a workaround on this anyway.
Als0, doesn’t this approach leave cash untaxed? That would probably have some pretty distortive effects too…
Ron,
That argument doesn’t make a lot of sense. They’re in the same position as anyone who built a company up from scratch. And not selling the asset is the whole point.
You don’t have to leave cash untaxed. Cash can have a basis other than its value. Cash would be taxed immediately or upon use, other assets when they’re sold or exchanged.
I like this idea a lot. I tried to find a reason not to like it, but it’s actually fairly elegant.
Of course, Tom, Dave, and Eric see nothing wrong with this plan.
You guys aren’t redistributionists!!!
Ron hit one the one “flaw” in this scheme. As long as it is never sold, the property could be handed down from generation to generation and the government would never get a cut.
Stepping the basis down to zero does provide an incentive to never sell the asset, but against that we have to weight the natural incentive to sell (i.e. getting money for the asset). Of course, it depends what the tax rate is, but at a 15% capital gains tax rate, the disincentive doesn’t seem very strong to me relative to keeping the asset and getting no money out of it.
Just about every way of getting money out of a financial asset is taxed. Sell it — capital gains tax. Take a dividend — capital gains tax. Take an interest payment — income tax. Take a salaried position at a company you own — income tax.
The only assets that heirs will be made reluctant to sell are assets that have inherent usefulness apart from their investment value (houses, cars, jewelry, etc), or a high subjective value (the aforementioned New York Yankees likely have a high subjective value to Hal and Hank Steinbrenner).
The real fix to the “problem” of the government never getting its cut should be part of a broader fix of how we tax financial assets. I’ve long thought that if we must tax richness, it’s much better that we tax being rich (wealth taxes, which work like property taxes but assessed on financial assets as well) rather than getting rich (progressive personal income tax, capital gains tax, corporate income tax, etc).
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