The Estate Tax's Perverse Incentives

If you do not think it’s a good idea for someone to have to accelerate or delay his or her death due to changing tax laws, then you cannot be very pleased about the back-and-forthing on the estate-tax law in the U.S.

Here’s how we laid it out in SuperFreakonomics:

In the United States, the rate in recent years was 45 percent, with an exemption for the first $2 million. In 2009, however, the exemption jumped to $3.5 million – which meant that the heirs of a rich, dying parent had about 1.5 million reasons to console themselves if said parent died on the first day of 2009 rather than the last day of 2008. With this incentive, it’s not hard to imagine such heirs giving their parent the best medical care money could buy, at least through the end of the year. Indeed, two Australian scholars found that when their nation abolished its inheritance tax in 1979, a disproportionately high number of people died in the week after the abolition as compared with the week before.

For a time, it looked as if the U.S. estate tax would be temporarily abolished for one year, in 2010. (This was the product of a bipartisan?hissy fit in Washington, which, as of this writing, appears to have been resolved.) If the tax had been suspended, a parent worth $100 million who died in 2010 could have passed along all $100 million to his or her heirs. But, with a scheduled resumption of the tax in 2011, such heirs would have surrendered more than $40 million if their parent had the temerity to die even one day too late. Perhaps the bickering politicians decided to smooth out the tax law when they realized how many assisted suicides they might have been responsible for during the waning weeks of 2010.

Well, as it turns out, the bickering politicians haven’t smoothed things out. The estate tax was abolished for 2010 and, as this excellent Wall Street Journal article makes clear, there’s a good chance the law will return next year at an even higher rate and with a lower cap. Highlights:

If Congress doesn’t change the law soon – and many experts think it won’t – the estate tax will come roaring back in 2011. Not only will the top rate jump to 55%, but the exemption will shrink from $3.5 million per individual in 2009 to just $1 million in 2011, potentially affecting eight times as many taxpayers. The math is ugly: On a $5 million estate, the tax consequence of dying a minute after midnight on Jan. 1, 2011 rather than two minutes earlier could be more than $2 million; on a $15 million estate, the difference could be about $8 million. …

Advisers say the estate-tax dilemma is especially awkward for heirs. “At least in December 2009, people wanted to keep their relatives alive,” says Ronald Aucutt, an estate-tax attorney with McGuire Woods in the Washington area. Now he and others are worried that heirs may be tempted to pull plugs on Dec. 31. Economists might call the taking of a life to reap a tax advantage a “perverse incentive.” District attorneys might call it homicide.


malinfriess

A bad policy..causing a sick incentive indeed.

Malin

charlie

boy, sure wish my kids had to worry how much of $5 million they'd inherit because that would mean I have $5 million now.

Fortunately for my kids, we're normal, so all they'll have to worry about is whether I go all drooly and incontinent on them.

in short -- this is a problem the rich have that normal people don't. Their goal of becoming a permanent rich class, a veritable American royalty, will just have to wait.

Or maybe they could go out and get real jobs like the rest of us.

FredInRVA

Pardon me while I play the world's smallest violin for the heirs of the top 5% of the richest people in the country. Of course their needs are far more important than any other. This problem wouldn't exist if the Bush tax cuts weren't forced through Congress under reconciliation process. Excuse me if I don't cry for the failure of this accounting gimmick.

E Olson

Dubner providing an easy assist:

In related news, George Steinbrenner's family saved about $600 million this week in not paying Estate Tax.

Brett

If you dare to have a job and make money, the government will take some of your money.

If you're foolish enough to start a business, the government will take more of your money.

If you have the audacity to die rich, the government will take some of your heirs' money.

If you decide you'd rather not get a job and provide for yourself, the government will give you money.

Matt

Interesting points - I especially like the attempt to link lowering taxes with an increase in murderous behavior of children towards their parents - those evil minded rich people!

Although the concept of an estate tax is ridiculous to begin with. How do you owe the federal government money for dying? After a lifetime of sticking its hand in your pocket the governments sticks its hand in your grave.

It would be interesting to note to all you liberal Yankees fans that had Steinbrenner died in 2009 or 2011 the family would most likely have been forced to sell their majority share in the team to pay the nearly $500 Million estate tax - lucky for the fans he died a "timely" death here in 2010!

I wonder - will Steinbrenner's children will be accused of homicide???

not a baseball fan

The Steinbrenners win...again.

Katy

True, but there was a huge incentive to keep a wealthy person on life support in December 2009 in order to avoid the tax altogether this year, and we haven't heard of anyone doing that. (I realize it's tough to track this behavior.) I would think people would be far more likely to artificially prolong life than take one in order to save money, but it doesn't appear to have happened. Just a couple of terribly wealthy families (Steinbrenner's and Dan Duncan's families) have had fortunate (in the literal sense) timing for their otherwise terrible losses. I take 2009-2010 results to mean to foretell that morally rational behavior will prevail over economic rationality. We'll see.

Spork in the Road

Andy O.

It is depressing to constantly get reminders of how incompetent our elected officials truly are.

The tax code, in all its glory, not just the estate portion, has to be one of the biggest signposts of our governments' inability to do the right thing.

Tris

The real incentive is not to hope (or cause) a more timely death, but to spend yourself into debt prior to your death.

As usual, the people who live beyond their means and have no intention of leaving anything to their children win. While those that carefully plan, save & invest for the future are penalized for doing so.

Comments #2 & 3: You realize that with some property, investments & cash that it's not really that hard to save more than $1 million throughout your lifetime. It means making sacrifices, working hard and being frugal. All virtues discarded in these modern times.

If you had worked & saved like this, how you feel if the government swooped in and taxed away half of that lifetime of effort?

I can assure you that the Congress-critters that are letting this happen have some built-in protection against having to pay the tax themselves. Most of them are millionaires. Or will be prior to their deaths.

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DonBoy

It would be useful to remember that dead people do not pay estate taxes. Living heirs pay them. In the Steinbrenner example, the living heirs have just been handed hundreds of millions of dollars for having been lucky enough to have a billionaire be their father, so economically I'm not worrying about the injustice to them.

Ari

People don't understand the negative effects this have, based on the comments. Someone may have a business worth $5 Million, but when he dies, the heirs are responsible to pay up to 40% and going higher of the majority of that value. TO get that cash often they need to sell the business. This is a negative thing no matter how you look at it. If someone is worth $5M he doesn't have that much cash lying around. Enough with this rich vs. poor crap. I have no where near a $1M but I can appreciate that someone who does has the right to keep it in his family.

Mike B

This tax anomaly is an artifact of the Republican hubris of the early 2000's where they figured their unique style of klepto-government would give them permanent majorities. The idea was that in 2010 when the tax cut would expire they would be able to eliminate it for good, but two disastrous wars later that plan didn't work out so well.

The estate tax is a critical tool is prevent a permanent aristocracy from developing in the United States. The easiest way to make money is to have money to begin with. By having a large pool of capitol one is able to put themselves on the winning side of the boom-bust cycle, selling their assets to the commoners as markets rise, then buying them back after the markets crash. Extreme wealth concentration not only leads to social instability and serious inequity, but also a net reduction in economic output as the vast majority of consumers will be unable to consume.

The truth is that there are more than enough mechanisms to allow small businesses to stay within the family so to speak. All that is required is for the principle owner to slowly divest themselves of ownership over the course of their lives to various members of their family. Granted this would prevent them from acting like autocrats by controlling their kin through wealth up until the moment of death.

Of course the easiest way to avoid the tax is to simply to give one's wealth to charitable causes. The whole policy behind taxing estates is to make it clear that an individual has an obligation to use some portion of their wealth to benefit the community, not subvert the community by transferring said large amounts of wealth to people that earned it through nothing more than being born. In America people are expected to earn their place in life through hard work. A strong estate tax serves to mitigate the most egregious subversions of this idea.

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Nosybear

I find it amusing in a perverse way: The Right will rail against people getting what they haven't worked for from the Government, i.e. unemployment, assistance, even Social Security, then fight vehemently for the children of the rich, who haven't worked for theirs either, to get the self-perpetuating handout called inheritance. Many countries use the inheritance tax as a way to level the playing field, as a means to prevent the perversity that is self-perpetuating wealth. We seem to think that all that dead capital is somehow going to magically work itself out of the hands of the Trust Funders and into our economies. Through encouraging the development of self-perpetuating wealth, we produce generations of rich incompetents through simple application of regression to a mean: A capitalist grandfather may have created the wealth (and I do not begrudge him one cent) but the idiot grandchild, who benefited from the wealth in the form of education, training and contacts a much more skilled poor child would never have, can't make any more out of it (and so goes into politics, very well funded, by the way). The Inheritance Tax plays an important role in getting the capital out of the hands of the idiot grandchild and into the hands of the next capitalist and so plays a very important societal function, one so often forgotten by those who would have no handouts, except to their own children.

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keith

Ari, there are several solutions to your issue: founding parents transitioning control of the business to the next generation within their lifetimes, or using a life insurance policy to cover the gap. Yes, one requries money, but the other simply requires trust and a formal agreement between generations. Family-owned Yuengling Brewery currently runs a radio commercial where current boss Dick Yuengling describes how he bought the business from his family in the early 1980's. A failure to properly plan ahead is really not a problem for people outside the family.

I understand there is a catch to the current no-estate-tax regime that could be very interesting in the years to come: there is no "step up in basis" on estates this year. If the estate doesn't get taxed at market value, each of those asset's basis flows to the heir. Example: the parents bought a $40K house (or a $40K wad of stock) in the 1970's worth $1MM today. If the parent's estate gets taxed, the kids get the asset with a basis of $1MM. Sell it next year for 1.1, have cap gains income of $100K.

If the estate does not get taxed, the heirs get an asset with a basis of $40K (and a need for good records that go back decades). Sell it next year for 1.1, have a cap gains income of $1.06MM.

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Otter

If there HAS to be an inheritance tax, it should be based on cash transfers only. If property, stocks or a business is handed down, it can be taxed if and when it is sold...and on the entire sale value. This way, property and businesses can be handed down for generations

Colin

"Extreme wealth concentration not only leads to social instability and serious inequity, but also a net reduction in economic output as the vast majority of consumers will be unable to consume."

This is nonsensical. How does someone possessing a lot of money prevent me from consuming? This is only true if one somehow thinks that either wealth is fixed or that the rich person's money is stuffed under their mattress rather than, much more like, invested in productive investments so they can get even richer (mwahahaha!!!).

Also, "nosybear", if the grandchild really is an idiot, then he/she will be soon parted with the money and you will have nothing to worry about. If they are like some of the trust funders in Brooklyn they'll be spending the money on sustainable local beet farms and indulging in similar idiocies.

But then again, that's their right. They family made the money and can spend the money as they see fit.

The greed of the left and their desire to use the government to take other people's money to spend on their own favored programs never ceases to amaze me. If you want the money, go make it yourselves.

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Clancy

A lot of this discussion overlooks the fact that there are lots of ways to avoid the estate tax (trust funds: have your accountant look it up) I think what we'l end up seeing is a surge in creative accountancy rather than something so crude as murder.
It's the accountants and lawyers who will come out ahead, not the hitmen.

Samantha

After reading these comments I have seen many good points.

I think the best by far was otter who mentioned the idea that only cash transfers be taxed or business shares/property at point of sale.

If you are middle class and you think that the rich don't deserve their inheritance it is only because you are not rich. (I am in college so I am probably worse off then you by the way)

Oprah and countless other have proven that you can become crazy rich no matter where you begin, so I suggest Americans stop complaining and start building their own futures.

Perhaps more motivation would reignite the innovators inside of us so we can keep on pace with those overseas.

Rajiv

The advocates of estate tax forget an age-old device exists for transferring inherited wealth back to society: Stupidity.