REASSESSING THE ROLE FOR WEALTH TRANSFER ......No. 21 WEALTH TRANSFER TAXES 121 (Graetz 1983 and...

REASSESSING THE ROLE FOR WEALTH TRANSFER TAXES***

HENRY J. AARON* AND ALICIA H. MUNNELL**

ABSTRACT theory to develop the justification for taxes

This article brings together severalon wealth transfers. The second part dis-

strands in the literature to provide acusses alternative definitions of wealth and

framework for assessing the role of wealthpresents data on the distribution of wealth

transfer taxes. It examines the theoreticalin the United States and other countries.The patterns reported for the industrial-

rationale for these taxes, discusses data on ized countries surveyed are quite similar.the distribution and accumulation of The third part is devoted to a summarywealth, and reviews the experience of the of the current debate in the United StatesUnited States and other countries under over how much of the stock of wealth rep-their existing systems. Although wealth is resents wealth the current generation in-highly concentrated in industrial coun- herited, as opposed to wealth it accumu-tries and the life-cycle framework indi- lated during its life cycle. The resolutioncates that wealth transfers should be taxed, of this debate bears on the potential ofthis paper finds that countries do little wealth transfer taxes to alter the concen-through their tax systems to affect wealth tration of wealth holdings. The fourth partconcentration. Because a substantial por- examines the use of wealth transfer taxestion of the existing stock of wealth is in- in the United States and Selected otherherited, these taxes could have significant countries and reviews the relative meritsequalizing effects. Thus, a serious reas- of bequest and inheritance taxes.sessment of wealth transfer taxes is war- The conclusion, which is summarized inranted. the final part, consists of five points. First,

ownership of wealth in all industrializedcountries is highly concentrated. Second,

ALL developed countries rely exten- neither the United States nor the othersively on progressive personal in- countries we survey do much through their

come taxes. None derives significant rev- tax systems to reduce that concentration.enue from taxes on the transfer of wealth. Third, the life-cycle framework suggests,In one sense, this situation is not sur- on equity grounds, that wealth transfersprising, since taxes on wealth transfers should be taxed. This conclusion would beare exceedingly difficult to administer and reinforced if wealth were to provide util-many view any taxes on wealth as a form ity above and beyond the ability to con-of double taxation. In another sense, the sume or if it were shown that wealth con-situation is surprising, since the life-cycle centrations produced adverse social orframework suggests that wealth trans- political effects. Fourth, the evidence sug-fers-by bequest or inheritance-belong gests that bequests and inheritances playin the tax base as much as annual flows a significant role in the accumulation and

of earnings or consumption. Moreover, to distribution of wealth, so that effective

the extent that wealth conveys benefits wealth transfer taxes could reduce the

above its ability to support consumption, concentration of wealth holdings. Fifth,

wealth transfer taxes could prevent un- the excess burdens associated with cur-

due concentrations of economic, social, or rent wealth taxes are very large relative

political power. to revenue generated. In short, wealth

This article explores the role of wealth transfer taxes deserve a serious reassess-

transfer taxes in a modern industrial ment.

economy. The article is divided into fiveparts. The first part reviews basic utility The Rationale for Wealth Transfer

Taxation*The Brookings Institution, Washington, DC 20036**Federal Reserve Bank of Boston, Boston, MA' If people can borrow and lend freely at

02106. a given interest rate, total lifetime eco-

119

120 NATIONAL TAX JOURNAL [Vol. XLV

nomic resources are equal to either of two One could ask, however, how the pre-sums: the discounted present value of scriptions of the life-cycle model for wealthearnings plus inheritances, or the dis- transfer taxes fit into a tax system basedcounted present value of consumption plus on comprehensive income as the optimalbequests.' For those who can borrow and personal tax base. Including wealth (or itslend freely, this life-cycle perspective leads surrogate, capital income) makes sense onon equity grounds to either of two pre- equity grounds within a utility-basedscriptions: that personal taxes should be framework only if one holds that plan-levied on earnings plus inheritances, or ning horizons are no longer than the tax-that personal taxes should be levied on able period and that capital markets pre-consumption plus bequests (with suitable clude the transfer of resources acrossaveraging to allow for variations in tax taxable periods.5 In effect, a taxable unitrates). Which of these quantities should would "inherit" each period a stock ofbe subject to tax and the extent to which wealth bequeathed from itself in the pre-they should be taxed hinge on a number ceding period. Adopting these (unrealis-of other considerations: the efficiency ef- tic) assumptions and applying the logicfects of taxing alternative bases, the re- used above would suggest an annual taxalism of the assumption of perfect capital on net worth. The tax on capital incomemarkets and the importance of violations could be seen as an alternative means ofof this assumption, and variations in the achieving that objective, although the im-need for revenues over time. plied tax rate on capital income should

This line of argument is based on the then exceed that on earnings.'concept of wealth as potential consump- In practice, of course, the effective ratetion. If wealth is deemed to provide util- of tax on capital income falls well shortity above and beyond financing consump- of that on labor income in most countriestion-for example, as a source of economic in most situations, because of shelteredpower and control-then standard abil- pension savings, the failure to fully taxity-to-pay theory would call for a separate capital gains, and evasion of taxes on in-tax on the holding or transmission of terest and dividend income. One partic-wealth apart from any tax on earnings plus ularly glaring loophole, at least in theinheritances or on consumption plus be- United States, is the ability of individuals

2quests. to completely escape tax on appreciatedThe "dynastic" theory of consumption, assets by passing them from one genera-

espoused by Barro (1974) and others, pro- tion to another as bequests, since the ba-vides less clear guidelines for wealth sis for determining capital gains on in-transfer taxation.' Under this theory, herited property is the fair market valuehousehold saving, consumption, and labor on the date of the decedent's death. As asupply are determined by the wealth result of this and other provisions, actual,available not to a single generation but to as opposed to theoretical, income taxes lookmany generations of a family or house- more like taxes on earnings than compre-hold. This theory provides no basis for hensive levies on all sources of income.adding inheritances or bequests to earn- The failure of the income tax to reachings or consumption in a personal tax base, most capital income and gains means that,but would allow for the taxation of wealth in the absence of wealth transfer taxes,or wealth transfers in some fashion if an important portion of the tax base sug-wealth provides utility apart from its use gested by the life-cycle model escapes tax-to finance consumption or if wealth-re- ation altogether. While this portion av-lated social, political, or economic power erages roughly 8 percent for the populationwere deemed appropriate to tax. For con- as a whole, it is significant for the moststructing a national tax system, we be- affluent members of society, since wealthlieve that the life-cycle framework is a holdings are highly concentrated.' In fact,more useful model than one that assumes in the United States, proponents ofvirtually infinite time horizons on the part strengthening the estate tax cite failuresof individuals.' of the income tax as a major justification

No. 21 WEALTH TRANSFER TAXES 121

(Graetz 1983 and Gutman 1983). though they may be regarded as rich.In short, the life-cycle model provides a For the remainder of this article, we

strong intellectual case on equity grounds shall follow the conventional route offor taxing wealth transfers as well as measuring wealth excluding human cap-earnings or consumption. This goal is met ital. In reviewing data from the Unitedinequitably and incompletely through at- States, we shall use three definitions oftempts to include capital income in the wealth that vary according to the controlpersonal income tax base. The compre- the household has over particular assetshensive income tax reaches some income (Table 1). All three definitions include thefrom life-cycle accumulations, which un- replacement value of tangible assets, theder a life-cycle income tax should be wholly market value of equities, and the bookexempt. And it falls at a negligible rate value of bonds. To these basic ingredi-on inherited wealth, which should be taxed ents, the narrowest wealth concept, W,,more heavily. The analytically correct levy adds the cash surrender value of trusts andis one on either bequests or inheritances. pension funds-typically small amountsThe justification for such a levy is rein- that a household could realize if it triedforced by the notion that wealth may well to sell its holdings. This narrow measureprovide utility above and beyond the abil- could be useful for analyzing the behaviority to consume, or the potential that great of persons with limited capacity to borrowconcentration of wealth holdings can pro- against other assets, or of myopic con-duce adverse social or political outcomes. sumers. It also provides the best index of

economic power.

Defining and Measuring Wealth A broader wealth concept, W2, includesthe full value of both trusts and pension

8It is one thing to decide that wealth funds. To the extent that pensions aretransfers should be taxed; it is another to fully funded, pension assets reflect futuredetermine what constitutes wealth. Within pension benefits-a factor that, accordingthe life-cycle theory, wealth is the sum of to the life-cycle model, would be expectedresources available to people over their to influence a household's saving and cap-lives and is simply the discounted present ital accumulation.value of inheritances, earnings, and re- If future pension benefits influenceturns on saving that differ from the rate household decisions, as implied by the useof discount. This means that the life-cycle Of W2, then so should the present dis-definition includes "human capital," as counted value of social insurance pensionrepresented by the value of future earn- benefits, which are included in the thirdings, as well as physical and financial wealth measure, W3- If households fore-capital. see future social insurance entitlements,

If wealth enters the utility function of they should also recognize the taxes thatpeople because it is a source of power or will be necessary to pay for these bene-social standing, independent of the con- fits; hence, W3 includes net rather thansumption it can finance, a more limited gross social security wealth. This compre-concept is appropriate. In that event, the hensive concept would be appropriate forrelevant measure is the stock of financial most life-cycle consumption models.or real assets under control of the taxable All three measures are valuable, sinceunit. Empirical studies of the distribution the appropriate definition of wealth forof wealth generally have focussed on this policy deliberations varies with the issuenarrower measure, suggesting a view that under consideration. Those concerned thatwealth conveys power and influence in- an undue concentration of wealth puts toodependent of consumption. To put it in the much power in the hands of a few shouldboldest terms, traditional empirical stud- probably look at the distribution of WI, aies on the distribution of wealth suggest measure of assets directly controlled bythat people who earn enormous incomes households. On the other hand, W2 (or evenand have enormous life-cycle wealth, but W3) is a superior measure if the issue iswho save little, are not wealthy, even the role played by wealth in supporting


TABLE 1DEFINITIONS OF WEALTH CONCEPTS

Concept Definition

wi W, is defined as the cash surrender value of total assetsless liabilities and is a measure of the wealth currentlyavailable to the household or individual. The assetsinclude owner-occupied housing, other real estate, allconsumer durables, demand deposits and currency, time andsavings deposits, bonds and other financial securities,corporate stock, unincorporated business equity, trust fundequity, the cash surrender value of insurance, and the cashsurrender value of pensions. Liabilities include mortgagedebt, consumer debt, and other debt. Trusts are measured attheir actuarial value, which represents roughly 50 percentof the total reserves of trusts. Pensions are measured attheir cash surrender value, which represents a very smallpercentage, around 5 percent, of their total reserves. Allother tangible and financial assets and liabilities aremeasured at full value.

W2 W2 is a broader measure of wealth than W, and is defined asW, plus the full reserves of trust funds and the fullreserves of private pension funds less their actuarialvalues included in Wi.

W3 An even broader measure of wealth, W3 equals W2 Plus thepresent discounted value of expected social securitybenefits.

consumption, because these measures in- The balance sheet data contain hintsclude public and private pensions. about shifts in the distribution of wealth

ownership. Assets can be divided into "life-

The Amount and Composition of Wealthcycle wealth" and "capital wealth." Life-

in the United States: 1900-1990cycle wealth includes owner-occupiedhousing, consumer durables, cash and de-

The three measures of net worth are mand deposits, and pensions, less mort-shown in Figure 1.9 These estimates are gage and consumer debt-assets and li-an updated and slightly modified version abilities whose accumulation depends onof data originally compiled by Wolff (1989). the age of household members as pre-

Wl, W2, and W3 are virtually identical dicted by the life-cycle model. Capitalin the United States until 1922, at which wealth includes tenant-occupied housing,time W2 begins to exceed W, because of time deposits, financial securities, corpo-the emergence of private pensions. By 1990 rate stock, trust fund equity, and unin-pensions grew to 14 percent of total assets corporated business equity less other li-and 18 percent of net worth. W3 began to abilities-wealth that appears to be builtdiverge from W2 in the late 1930s after up primarily to create estates for suc-the enactment of the social security pro- ceeding generations." These classifica-gram. By 1990 the present value of ac- tions are interesting, crude as they maycumulated social security entitlements be, because life-cycle wealth consists ofequalled roughly 40 percent of market- assets that are distributed broadly amongable net worth of households. both the middle and upper classes, while


FIGURE 1REAL NET WORTH PER CAPITA

(1990 DOLLARS)Dollars

12D.000

W3(W2plus SocialSecurity Wealth)

ioo,wo I

80.000

W2 (Full Valueof Pensions

OD.000and Trusts)

40.DW Wl (Actuarial Value ofPensions and Trusts)

2D.WD

01900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990

Year

capital wealth is concentrated among those sponsored pensions is included in the cal-with the highest incomes. Hence, a sig- culation. Expanding the wealth conceptnificant shift in the share of one or the even further to include the present dis-other compared to the total could signal counted value of net social security ben-a major shift in the distribution of asset efits, W3, the ratio of life-cycle to totalholdings. wealth depicts a steady trend toward de-

As it turns out, the extent to which a concentration in household asset hold-shift appears to have taken place depends ings.critically on the definition of wealth The following section pursues evidenceadopted (Figure 2). According to the nar- on the distribution of W, by looking at es-rowest wealth concept, WI, the ratio of life- tate tax returns. The data from these re-cycle wealth to total wealth increased from turns seem to confirm the trend toward18 percent to 30 percent between 1930 and deconcentration in the prewar period, the1950, and fluctuated around 30 percent absence of any trend toward deconcentra-after 1950. Life-cycle wealth as a share of tion since 1950, and an uptick of concen-the total declined sharply in the 1980s, tration in the 1980s.suggesting an increase in the concentra-tion of wealth holdings. W2 presents a

d-a'ial VaI... ad T

W,p

somewhat different picture; the increaseConcentration of Wealth Implied by U.S.

in life-cycle wealth as a share of the totalEstate Tax Returns: 1922 to 1986

continued through 1980 and then leveled Although estate tax returns contain dataoff. In other words, the apparent decrease on the wealth only of the deceased, theyin life-cycle wealth, with its implication can provide wealth information about theof increasing wealth concentration, dis- living population through the "estateappears once the full value of employer- multiplier method." By multiplying the


FIGURE 2"LIFE-CYCLE" WEALTH AS A PERCENT OF NET WORTH

Percent70

4

60 W3(W2 plusSocialSecurity W"Ith)

50

40 W2 (FullValueofPensions and Trusts).:

30 ........ Wl (ActuarialValueofPensions and Trusts)

20 1,,,, 1.... I .... I .... I I19W 1905 1910 1915 19M 1925 1930 1935 1940 W5 1950 1955 19W 1965 1970 1975 1980 1985 1990

YearNote:'Ufo-CyclelWealthIsdefinedasowner-occupiedhousing,land,consumerdurables,demanddepositsandcurrency,

pensionfundreserves,and,Inthecaseof W3,SocialSecuritywealth,minusmortgagedebtandconsumerdebt.

wealth of the deceased in various age-sex occurred in the distribution of wealthcategories by weights equal to the recip- among households.rocal of the mortality rate for each group, Despite these limitations, the estateone can infer total wealth holdings among multiplier method yields informative es-these same categories. timates. An early study by Lampman

The estate multiplier technique has one (1962) calculated the share of wealth heldimportant strength-all questions on es- by the top 0.5 percent of wealth holderstate tax returns are answered fully and for selected years from 1922 to 1953.the returns contain very detailed finan- Lampman's work was subsequentl@ up-

cial information. It suffers from four main dated to 1976 by other researchers.

drawbacks, however. First, since few peo- We have updated the series that cor-

ple are required to file estate tax returns, responds to W, to include data for 1982

wealth estimates can be calculated only and 1986 and have re-estimated the 1976

for the wealthiest portion of the popula- figure, which showed an inexplicable diR

tion. Second, the proportion of decedents in the concentration of wealth holdings.

subject to tax is not constant, because i -Figure 3 reports the results. It shows a

ing thresholds change significantly overmarked decline in the concentration ofasset holdings between 1922 and 1947. The

time. Third, small errors in mortality start of this drop precedes the increase in

W2'FullVa

Valueof,us0",

7*W True,

Wl (ActuarialP.and T..t.)

rates, and hence in the multiplier, trans- the ratio of "life-cycle wealth" to "totallate into large errors in the wealth esti- wealth," but the end of the decline roughlymates. Fourth, because estate returns are coincides with the postwar stabilizationbased on individuals, any changes in the in this ratio. The estate tax estimates in.distribution of wealth within the house- dicate no systematic trend in the share ofhold can alter concentrations based on in- wealth held by the top 0.5 percent and 1dividual wealth holdings, even if no change percent from 1947 through 1982, but sug-


FIGURE 3ESTIMATED SHARE OF NET WORTH HELD BY THE TOP 0.5 PERCENT AND THE

TOP I PERCENT OF THE POPULATIONPwwnt40

35

30 1.0 PareeM ofPopulation

.............

25 ........0.5 Pefftnt Of

Population

20

151 l,ll.i ... I I .... 1. 1 .... I I ....1922 1927 1932 1937 1942 1947 1952 1957 1962 1967 1972 1977 1982 1986

Year

gestan abruptand sizableincrease there- of the participants were reinterviewed inafter. Broader definitions of wealth would 1986 and again in 1989, when new par-show less concentration and more of a ticipants were added. Because wealthtrend toward deconcentration. holdings are highly concentrated, these

Perhaps the most important fact to be surveys over-sample households with highgleaned from the estate tax data is that incomes.they provide no evidence of deconcentra- Wealth estimates generated from thetion in the holdings of W, during the survey data correspond most closely, al-postwar period and hint that concentra- though not perfectly, to Wl. One differ-tion may even have begun to increase af- ence is that the surveys do not include in-ter 1982. The next section explores formation on the ownership of consumerwhether this picture is consistent with the durables other than vehicles. Further-results of the Federal Reserve Board's more, because most people know littlecross-sectional surveys. about their expected pension or social se-

curity benefits, surveys typically include

Concentration of Wealth from Surveyno pension information. The 1983 SCF is

Data: 1962 to 1986an exception, as the Federal Reserve Boardcombined answers from respondents and

Household surveys with reliable data their employers on pension plans to gen-on wealth holdings are available for onA erate estimates of the present value of ex-four years-1962, 1983, 1986, and 1989. pected benefits. Expected social securityThe Federal Reserve Board initiated the benefits were also calculated based on age,process with the 1962 Survey of Financial sex, earnings, and other data.Characteristics of Consumers (SFCC), Like the estate tax data, the surveyswhich gathered detailed data on asset show that the concentration of wealth hasholdings and liabilities. Two decades later, remained quite stable from the 19608 tothe Fed conducted the 1983 Survey of the mid 1980s, but has increased duringConsumer Finances (SCF), as the first in the last half of that decade (Table 2). Thean ongoing series of wealth surveys. Many wealthiest 1 percent of the U.S. popula-


TABLE 2SHARES OF NET WORTH HELD BY TOP WEALTHHOLDERS, ESTIMATED FROM SURVEY DATA,

1962 TO 1989

Percent ofPopulation 1962 1983 1986 1989

Share of Net Worth (Wl)

.5 24.8 24.3 23.9 28.81.0 32.2 31.5 31.7 37.1

Share of Net Worth (W3)'

1.0 20.6 to 23.8 17.8 to 20.6 -- --

'The estimates for the share of net worth, defined as W held by the top Ipercent are taken from Wolff and Marley (1989), Tables Y3 and 15.

Source: Authors' calculations based on the 1962 Survey of FinancialCharacteristics of Consumers and the 1983 and 1986 Surveys of ConsumerFinances, Machine Readable Data; Arthur Kennickell and R. Louise Woodburn,1992, "Estimation of Household Net Worth Using Model-Based and Design-BasedWeights: Evidence from the 1989 Survey of Consumer Finances," Table 1.

tion owned roughly 32 percent of W, in percent Of W2, and 21 percent of W3. Sec-1962, 1983, and 1986. 14 The 1989 survey, ond, while it is true by definition that thehowever, showed that their share of wealth concentration of wealth is greater ifhad increased to 37 percent. With regard households are classified by wealth thanto the broader measure of wealth, W3, the if they are classified by income (or anyholdings of the top 1 percent declined from other characteristic), the difference in21 to 24 percent in 1962 to 18 to 21 per- concentration is remarkably small, a factcent in 1983. The ranges reflect different that demonstrates the high correlationassumed growth rates for average pen- between annual income and wealth. Third,sion benefits; the higher the growth rate, the 60 percent of the population with thethe larger the pension and social security least wealth hold very little net worth, 7.4wealth and the lower the concentration of percent of WI, 9.2 percent Of W2, and 12.8wealth, since pensions and social security percent Of W3- 15

claims are distributed more widely than Finally, Table 4 shows the distributionare other forms of wealth. of W, for the entire population for 1962,

Table 3 presents the shares of wealth in 1983, and 1986. Here, developments de-1983 held not only by the very rich but pend crucially on whether households arealso by the rest of the population under grouped by wealth or by income. Wheneach of the three wealth measures. The households are grouped by net worth, theshares are calculated for households data indicate that inequality in the dis-ranked first by income and then by wealth. tribution of wealth holdings has re-Table 3 prompts three observations. First, mained constant not only for the verythe concentration of wealth is higher, the wealthy but also for the entire incomenarrower the definition of wealth. For ex- distribution. When households are groupedample, the wealthiest I percent of the U.S. by income, however, conflicting trendspopulation held 31.5 percent of Wi, 27 emerge. Concentration in wealth hold-


TABLE 3DISTRIBUTION OF NET WORTH BY INCOME CLASS AND NET WORTH CLASS, 1983

Percent of Net WorthClass wi W2 W3

Income:Highest .5% 18.1 15.6 12.1Highest 1% 25.8 22.3 17.6

Highest 20% 64.9 61.1 53.9Fourth 20% 14.5 15.5 16.7Middle 20% 9.2 10.2 12.2Second 20% 7.4 8.4 10.7Lowest 20% 4.0 4.7 6.5

Net Worth:Highest .5% 24.3 20.7 16.0Highest 1% 31.5 27.0 21.0

Highest 20% 79.6 75.2 67.5Fourth 20% 13.1 15.5 19.6Middle 20% 5.8 7.0 9.4Second 20% 1.6 2.2 3.2Lowest 20% 0 0 .2

Source: Federal Reserve Board of Governors, 1983 Survey of Consumer Finances,Machine Readable Data.

ings among the richest 0.5 percent or 1 while the top quintile held 65 percent topercent of the population declined slightly, 85 percent (Table 5). Although cross-but concentration of wealth holdings in country comparisons are always difficultthe top quintile increased perceptibly, from and wealth data scarce, the consistency of57 percent of total wealth in 1962 to these results is remarkable. One set of re-roughly 65 percent in 1983 and 1986. searchers (Kessler and Masson) specu-

lated that perhaps these similarities stemfrom underlying forces common to indus-

Relationship of U.S. to European trialized countries: similar labor and cap-Experience ital markets that determine the income

distribution, analogous institutional ar-Several researchers have examined the rangements aimed at supporting the lower

wealth distribution in European coun- end of the income distribution, or com-tries. 16 They generally use a wealth mea- parable family structures that affect thesure approximating WI, with concentra- patterns of consumption and wealth ac-tions estimated either from estate data or cumulation.household surveys. The most striking fea- Data for two countries, Sweden andture emerging from these studies is the Great Britain, allowed an examination ofhigh level of concentration across coun- the trend in wealth concentration overtries, a pattern very similar to that re- time. These estimates showed a markedvealed by the U.S. data. Among eight in- decline in concentration from the 1940s todustrialized nations, the wealthiest 1 the 1980s, perhaps reflecting efforts overpercent of the population held between 19 this period in both countries to equalizepercent and 32 percent of total wealth, the wealth distribution through progres-


TABLE 4DISTRIBUTION OF NET WORTH BY INCOME CLASS AND NET WORTH CLASS,

1962, 1983, AND 1986

Percent of Net WorthClass 1962 1983 1986

Income:Highest .5% 18.6 18.1 16.1Highest 1% 25.2 25.8 22.1

Highest 20% 57.1 64.9 63.6Fourth 20% 15.9 14.5 14.0Middle 20% 11.0 9.2 9.5Second 20% 8.9 7.4 8.1Lowest 20% 7.0 4.0 4.8

Net Worth:Highest .5% 24.8 24.3 23.9Highest 1% 32.2 31.5 31.7

Highest 20% 78.1 79.6 78.1Fourth 20% 14.5 13.1 13.6Middle 20% 6.3 5.8 6.0Second 20% 1.5 1.6 2.1Lowest 20% -.3 0 .1

Source: Federal Reserve Board of Governors, 1962 Survey of FinancialCharacteristics of Consumers, 1983 Survey of Consumer Finances, and 1986Survey of Consumer Finances, Machine Readable Data.

sive tax policies. This evidence is consis- serve Board all indicate that holdings oftent with, although much more dramatic wealth in the United States are highlythan, the slight decline in U.S. wealth concentrated. Using the narrow defini-concentration evident in the life-cycle to tion, the top 1 percent of wealth holderstotal wealth ratio. Interestingly, the control about 30 percent of net worth.Swedish study that extended into the Broader definitions reduce this value, but1980s found the same uptick in concen- the holdings of the top of the distributiontration as that registered in the U.S. es- remain significant.tate tax data. Thus, overall it appears that Although the estate tax data suggest athe experience of the United States, in major deconcentration of wealth in the firstterms of the distribution of wealth, is con- half of the century, some researchers havesistent with that of other industrialized suggested that this apparent trend to-countries. ward equalization might simply reflect

intrahousehold equalization in wealth

Overall Assessment of U.S. Wealthholdings between spouses, rather than re-

Distribution Dataduction in the interhousehold concentra-tion of wealth. More importantly, no trend

Crude manipulations with the national toward deconcentration is evident in thebalance sheets, estimates from estate tax postwar era. Rather, data on income in-data, and solid evidence from cross-sec- equality during the 1980s suggested thattion surveys conducted by the Federal Re- the concentration of wealth holdings would

TABLE5WEALTH DISTRIBUTION IN EIGHT INDUSTRIALIZED COUNTRIE

Percentage of Wealth HeldUnited Republic of

Top Percent of France Belgium Kingdom Germany Denmark sWealth Holders (1977) (1969) (1974) (1973) (1973)

1.0 19 28 32 28 255.0 45 47 57 n.a. 47

10.0 61 57 72 n.a. 6020.0 81 71 85 n.a. 75

Note: n.a. indicates not available.

Source: Denis Kessler and Andre Masson, 1987, "Personal Wealth DistributioEvidence and Extensions," in Edward Wolff, ed., International Comparisons oTable 7.7, p. 153; Federal Reserve Board of Governors, 1983, Survey of ConsData.


be likely to increase (U.S. House of Rep- sumers and age-specific mortality rates toresentatives 1991). Indeed, preliminary estimate annual intergenerational trans-results from the 1989 Survey of Con- fers. They transformed the flow of be-sumer Finances indicate that a signifi- quests into a stock of wealth by assumingcant increase has occurred in the wealth that beneficiaries, on average, receive aholdings of the top 1 percent. The next constant fraction 'of their lifetime laborsection explores the role played by be- income in bequests and that the averagequests in the accumulation and distribu- age gap between bequeathers and inher-tion of national wealth. itors is unvarying. These assumptions

mean that the relationship between be-

The Role of Bequests in Wealth quests and the stock of inherited wealth

Accumulationdepends on the size of the age gap, the rateof growth of the economy, and the real rate

According to the traditional life-cycle of return. Using this approach, Kotlikofftheory, people choose a consumption path and Summers concluded that inheritedbased on the relationship between their wealth accounted for 46 percent of the to.personal rate of time preference and the tal wealth.rate of return they can earn on savings. The direct calculation of life-cycle wealthIf the former exceeds the latter, people produced the even more startling resultchoose to consume more when young than that inherited wealth accounted for nearlywhen old, and conversely. When the two 80 percent of the stock,' and that life-cyclerates are equal, people seek unchanging wealth was only 22 percent of the total.consumption over their lifetimes. Under In calculating these figures, Kotlikoff andthe assumed hump-shaped earnings pro- Summers defined life-cycle wealth as thefile, people save during their working accumulated difference between the pastyears and draw down accumulated assets streams of labor income and past streamsin retirement. Although the life-cycle of consumption. Procedurally, this meanttheory can accommodate a bequest mo- distributing total labor income and totaltive, bequests have been accorded slight consumption in each year by age and sexweight, and Modigliani has argued that groups (based on cross-section informa-they probably account for a small portion tion), calculating the difference betweenof asset holdings. Members of each cohort these values for each group, capitalizingare assumed to consume most of what they and cumulating these values to arrive athave saved before they die, and to trans- life-cycle wealth for each age and sexmit wealth to the next generation only group, and finally aggregating acrossbecause the exact date of death is uncer- groups to arrive at total life-cycle wealthtain or because annuity markets are im- in a given year.perfect." If this theory accurately char- Modigliani (1984 and 1988) counteredacterized wealth accumulation in the that the preponderance of evidence, in-United States, it would leave a small role cluding his own research, places life-for wealth transfer taxes to affect the dis- cycle-not inherited-wealth at 80 per-tribution of the nation's wealth. cent of total wealth .2' He identified two

In 1981 Kotlikoff and Summers chal- key issues that accounted for most of thelenged the conventional wisdom, claim- difference between his results and thoseing that intergenerational transfer rather of Kotlikoff and Summers-namely, thethan life-cycle saving explained most definition of life-cycle wealth and the def-wealth accumulation in the United inition of an intergenerational transfer.States." They based their conclusion on Kotlikoff and Summers calculated life-two calculations-one derived from the cycle wealth as the difference between theflow of bequests and one from cumulating past streams of labor income only andlife-cycle saving." Under the former, Ko- consumption; Modigliani argued that ittlikoff and Summers used wealth data should be the difference between total in-from the Federal Reserve's 1962 Survey come and consumption. Thus, Modiglianiof Financial Characteristics of Con- would include as life-cycle saving any in-


come earned on previously received inter- balance as transfers to dependent chil-generational transfers. He argued that, by dren.adding income on inheritances to inheri- Adjusting the estimates to eliminatetances, Kotlikoff and Summers grossly educational expenditures and making twooverstated the role of intergenerational other technical adjustments suggested bytransfers. Modigliani" bring the Kotlikoff-Sum-

With respect to the definition of inter- mers ratio of bequests to total wealth togenerational transfers, Kotlikoff and 32 percent using the flow-of-bequest ap-Summers included as bequests payments proach and to 52 percent using the cu-

21received by financially dependent indi- mulation of life-cycle saving approach.viduals after age 18. The largest such These numbers are consistent with thetransfer in the United States is college results of a recent detailed study of estatetuition. The issue of how to treat college tax returns, which concluded that be-tuitions and other such payments arose tween 25 and 40 percent of the U.S. cap-because Kotlikoff and Summers used a ital stock results from intergenerationalspecific age, rather than the formation of transfers (Barthold and Ito 1991). The ad-the household, as the point from which to justed Kotlikoff-Summers figures are alsodate accumulation. Under their proce- consistent with the share of total wealthdure, college students over 18 who have represented by assets characterized as life-no income but consume tuition provided cycle assets by Wolff, depicted in Figureby their parents are treated implicitly as 2: roughly 35 percent of W, and 44 per-if they were life-cycle dissavers. This cent Of W2 in the 1980s.means that the value of college tuitions The most persuasive piece of evidence,is subtracted from life-cycle saving and from our perspective, is a simple calcu-added to inherited wealth. lation based on data from the 1986 SCF

Our assessment of the controversy at and 1986 estate tax returns. The distri-

this stage is that the Kotlikoff-Summers bution of wealth from the 1986 SCF com-

treatment of earnings on previously in- bined with total wealth from the 1986

herited assets is preferable to Modigli- household balance sheets and age-specific

ani's, but that on balance their treatment death rates indicate that $215 billion was

of college tuition payments is not. The in- in the hands of decedents in 1986 (Table

clusion of earnings on previous inheri- 6). Through the decedents' instructions,

tances simply standardizes in present some of this wealth went to spouses, some

value terms inheritances received at var- to charity, and the remainder to members

ious times in the past. The standard def-of succeeding generations. Since estate tax

inition of life-cycle income, as noted ear-returns for 1986 decedents reported 45

lier, is simply the discounted present valuepercent of net worth being transferredacross generations (Johnson 1990), an-

of earnings plus inheritances. nual intergenerational bequests for theThe issue of whether to treat parental population as a whole were assumed to

payments for college tuition as bequests equal $97 billion (45 percent of $215 bil-or as parental consumption is more dif- lion). This amount can be transformed intoricult. At some point, parental gifts to adult a stock of inherited wealth, S, by adopt-children clearly should be treated as being Kotlikoff and Summers' simplifyingquests. Cash gifts made by elderly par- assumptions, which produce the followingents to middle-aged offspring are an ef- formula:fective means of avoiding estate taxes, forexample. On the other hand, parental le (r-n)g - 1]

support of dependent children normally is s B.treated as parental consumption. A con- r - ntinuum of circumstances exists betweenthese extremes. If one is forced to put tu- Following Kotlikoff and Summers, we setition payments in one category or the the real after-tax portfolio-adjusted rateother, they probably should be treated on of return, r, at 4.5 percent, the real rate


TABLE6 ESTIMATEOFTOTALNETWORTHINHANDSOFDECEDENTB,1986

Age Group

Net Net Worth in Percent of Worthb Death Hands of Decedentsd

Total Net Worth' (S Billions) RateC (S Billions)

Under 25 25-34 35-44 45-54 55-64 65-74 75+

All Groups

.5 :x:

.0007

.0013 s: 1!*3 21:9

1,604 .0021 3 2,455 .0050

24.3 2,729 .0126 :: 23.1 2,598 .0280 9.6 1,079 .0846 ;:

100.0 11,229 215

'The distribution of wealth by age calculated from the “1986 Survey of Consumer Finances," household head.

using household net worth excluding pensions by age of

bDistribution of wealth by age applied to the total 1986 net worth of the household sector (W,) as calculated for this paper. 'Deaths in each age group divided by the total U.S. population in the same age group. Excludes infant deaths. Net worth multiplied by the death rate.

'Less than $500,000.

Source: Federal Reserve Board of Governors, 1986, Survey of Consumer Finances, Machine Readable Data; National Center for Health Statistics, 1989, Vital Statistics of the United States. 1986, vol. 2, Mortality, Tables l-3, 8- 3; and authors' calculations.

of growth of the economy, n, at 3.5 percent, and the average gap between bequeathers and beneficiaries, g, at 30 years. These values imply that inherited wealth in 1986 totalled $3.4 trillion, 30 percent of national net worth. This estimate is a lower limit, as it excludes intergenerational transfers other than by bequest.

Despite the appearance of some consistency among the estimates, the role of bequests in wealth accumulation is clearly controversial and unresolved. Part of the controversy reflects a genuine ambiguity regarding when an expenditure should be regarded as consumption and when as a transfer. Beyond such conceptual issues, current estimates are just not very pre- cise. For the purpose of this article, however, the central finding is that intergenerational wealth transfers are of sufficient size to establish a potential role for wealth

transfer taxes to affect the distribution of wealth.

Wealth Transfer Taxes

Most developed nations impose some kind of tax on the transfer of wealth by gift or bequest. Without exception, the taxes yield little revenue and the trend in collections has been down, if any trend can be detected. Moreover, the costs of avoidance, at least in the United States, are formidable. This combination of circumstances -low yield and high collection (or noncollection) costs-suggests the need for reform of wealth transfers taxes.

Wealth Transfer Taxation in Selected Countries

United States Experience. The United States has built a legally elaborate sys-


tem for taxing wealth transfers that yields yields are meager. No developed indus-little revenue. The federal government trial country derives significant revenuestaxes gifts and estate transfers and im- from wealth transfer taxes. This shouldposes a separate tax on generation-skip- not be surprising, however, given that theping trusts. In addition, all states but one wealth of decedents in any one year is nottax estates, 19 states tax inheritances, and a large percentage of GDP (5 percent inseven states tax gifts. 1986 in the United States). Wealth trans-

At the federal level, Congress experi- fer taxes yield between 0.2 and 0.3 per-mented with rudimentary inheritance and cent of gross domestic product in France,gift taxes in the late nineteenth century, the United Kingdom, and the Unitedbut enacted an estate tax in 1916 when States, even less in Germany, Japan, andfaced with the revenue needs of World War Sweden, and virtually nothing in Can-1. An estate tax was chosen over the in- ada, which repealed national wealth

24heritance tax because it was viewed as transfer taxes in 1972 (Table 8).easier to administer and was thought to This pattern of high nominal rates thatproduce more revenue. Net estates in ex- few actually pay raises the question of howcess of $50,000 were subject to a progres- taxpayers escape these taxes. If the mech-sive levy that ranged from 1 percent to 10 anisms are inexpensive, the result maypercent. Wealthy individuals promptly only be disrespect for the taxing author-discovered that they could avoid the es- ity. If the mechanisms are costly, then thetate tax by giving away their property be- ratio of excess burdens to revenues gen-fore death. To close this loophole, Con- erated may be quite large, a circumstancegress enacted the gift tax in 1924. that heightens the need for reform.

After remaining relatively untouchedfor its first 60 years of existence, except

Tax Avoidance in the United Statesfor changes in rates and exemptions (Ta-ble 7) and adjustments in the treatment One U.S. expert writing on the wealthof married couples, the wealth transfer tax transfer tax system in the United Statessystem was overhauled substantially in entitled his 1979 book for The Brookings1976. The three most important changes Institution A Voluntary Tax? The authorwere: (1) unifying the gift and estate taxes concluded:into one system that applies a single progressive rate schedule to combined life- In sum, because estate tax avoidance is such a suc-

cessful and yet wasteful process, one suspects that thetime and death transfers, (2) introducing present estate and gift tax serves no purpose othera comprehensive levy on generation-skip- than to give reassurance to the millions of unwealthyping transfers, and (3) expanding the that entrenched wealth is being attacked. The attackmarital deduction. These positive devel- is, however, more cosmetic than real and the economy

is paying the price in fettered capital and distortedopments, from the perspective of tax re- property ownership for this cosmetology (Cooper 1979,formers, were offset by a more than three- p. 82).fold increase in the general exemption in

More recent statements in the popular es-1981.tate planning literature echo the sameExperience in Selected Countries. Intheme:contrast to the United States, most in-

dustrialized countries tax wealth trans- With proper planning, practically no family, even thefers under an inheritance rather than an quite wealthy, need pay wealth transfer taxes (Austerestate tax. Typically, small transfers are 1987, p. 116).

exempt. Transfers among close relations, Fortunately, the federal tax code contains an assort-especially spouses, are taxed at lower rates ment of opportunities for you to protect your estatethan transfers to others in France, Swe- from the government's grasp (Anrig 1985, p. 60).

den, and Germany. The tax schedules are As long as you are not caught by surprise, almostprogressive in every country, with nomi- everyonecan pass along their estate to heirs withoutnal rates rising to levels as high as 70 losing anything to the IRS [Internal Revenue Service]

percent.(Anrig 1985, p. 66).

Despite the high marginal rates, the Estate tax statistics confirm these sen-


TABLE 7RATES AND EXEMPTIONS UNDER THE ESTATE AND GIFT TAXES, 1916 TO THE PRESENT

Esto@t. TaxedExomtion (Dollars) at Minimum Rat* at M"i-

Re onusGft

!ts. Rate. t r below Rate above

Act Estate (Per Year) t. Gift (Dollar.) ($MLIlLms)

1916 1.0-10.0 0 0 5.00 50

1917 50:'.'.'0 1.5-15. 50:0000 5.0

1917' 50,000 2.0-25.0

1918 50,000 a 1.0-25.0 'S 'o : .0 0. 11.0-001924 50,000 500 1.0-25.0 1.00-25.00 50,000 10.0

1926 100,000 a 1.0-20.0a

50,000 10.0

1932 50,000 5,000 1.0-45.0 .75-33.50 10,000 10.0

1934 50 00 50

1.0-60.0 .75-45.00 10,000 10.0,935 40:0000 5:0.000 2.

0

-

700 1

'55-52.50 10

50.0-7 .55-52

.

10 10 01938 40 000 1 000 2.0 0 0 1 :0000 1. 0

1940

40'...

4'000

2.2-77.0- 1.65-57.75- io:o

3.0-77.0* 2.25-57.75- 0:0,0*1941 40,000 4 000 , oo 10.01942 60,000 3

,000 3.0-77.0-

2.25-57.75- 5,000 10.0

1976 175 625 3,000 18.0-70.0 18.00-70.00 10,000 5.01981: 600:000 10,000 18.0-50.0 18.00-50.00 10,000 2.5

-No gi ft tax.44a" Revenue Act of 1917.*In ludes defense tax equal to 10 percent of tax liability.

'rh: figures in the table show the ultimate affect of the Tax Reform Act of 1976, which unified the estate md sift

tax and provided a credit in lieu of exemptions. The credit increased an follows: 1977, $30,000; 1978, $34,000;1979, $38,000; 1980, $42,500; 1981, $47,000. These credits are equivalent to the following oxe"tions: 1977,

$120,667; 1976, $134,000; 1979, $147,333; 1980, $161,563; 1981, $175,625.-Then* figures represent the ultimate impact of the Economic Recovery Tax Act of 1981 (ERTA), which had several

provisions affecting *state and gift taxes. First, it increased the amount of the unified credit as follows: 1982,

$62,800; 1983. $79,300; 1984, $96,300; 1985, $121,$00; 1986, $155,800; 1987 and later years, $192,800. The credits

areequivalent to the following oxmptions: 1962, $225,000; 1983, $275,000; 1984, $325,000; 1985, $400,000; 1986.

3500,000; 1987 and later, $600,000. Second. ERTA lworod the maximum rate and level as follows : 1982, 65 percent

above $4 million: 1983, 60 percent above $3.5 million; 1984, 55 percent above $3 million; 1985, 50 percent above$2.5 million. The Deficit Reduction Act of 1984 postponed the final phase until 1908, and the Omnibus Budget

Reconciliation Act of 1987 again postponed the 55 percent to 50 percent drop, this time until 1993. Additionally,

wi th the enactment of the Rev*nua Act of 1987 the bonsfits of graduated rates and the unified credit are phased out

for estates over $10 million.

Source: Joseph A. Pechman, 1987, Federal Tax Policy, 5th ad. Washington, D.C.: The Brookings Institution, Tables

A-14 and A-15; U.S. Congress, 1984, United States Code Congressional and Administrati a Nwo. val. 1, 98 Can&., 2

Sass., St. Paul, MM: West Publishing Co., 98 STAT, p, 506: U.S. Congress, 1987, United States Cad* Congressional an

AdministrAtive New3, vol. 2, 100 Cong., I Sass., St. Paul, MN: West Publishing Co., 101 STAT, pp. 1330-430 to

1330-431.

timents (Table 9). Of the $123 billion of planning techniques that fall into threewealth slated to be transferred across major categories: freezing the estate, cre-

21generations in 1986, only $36 billion ating tax-exempt wealth, and disposing ofshowed up on estate tax returns. Total wealth already accumulated. Placing a lowfederal taxes paid amounted to only $6 value on wealth already accumulated maybillion. Thus, despite high, progressive be the primary method of tax avoidance.rates, the effective rate of tax on trans- "Freezing" the size of the wealthy per-ferred wealth was about 5 percent .26 In- son's current estate and diverting futureformed observers think that decedents growth to the intended heirs is much eas-could have avoided even this modest toll ier, in estate planning terms, than dis-if they had taken the time to do so. posing of substantial wealth after it has

accumulated. The most straightforward

Mechanisms of Avoidanceoption is simply to give away large por-tions of the estate as gifts as early as pos-

Even with the generous exemption, the sible. The problem is that gift taxes cansteeply progressive rates of the U.S. es- become burdensome and the originaltate and gift tax could reduce the concen- owner loses control over the property. Totration of wealth if avoidance were not so avoid these difficulties, estate plannersprevalent. Wealthy people avoid estate have developed several procedures thattaxes by employing an array of estate allow the donor to retain control over the

No. 21 WEALTHTRANSFERTAXES 135

TABLE 8ESTATE/INHERITANCE AND GIFT TAX AS A PERCENT OF GROSS DOMESTIC PRODUCT

United UnitedYear Gemany France Sweden Canada Japan Kingdom States

1965 .07 .20 .14 .39 .13 .80 .491970 .08 .25 .14 .31 .19 .73 .461975 .05 .27 .11 .09 .21 .29 .381980 .07 .23 .10 .02 .19 .20 .311985 .08 .27 .13 .01 .34 .24 .221986 .10 .30 .12 .42 .25 .231987 .11 .34 .11 .52 .25 .241988 .11 .38 .09 .50 .23 .231989 .09 .38 .10 .52 .23 .24

"Less than .01 percent.

Source: Organisation for Economic Cooperation and Development, 1991, RevenueEstimates of OECDMember Countries: 1965-1990 (Paris, France: OECD).

property, reduce or avoid the need to pay stock and its subsequent appreciation beimmediate gift tax on the transfer, or included in the transferor's estate. Thetransfer more property than is apparent. rules, however, changed again in 1990, so

"Preferred stock recapitalization" used that the transferor now pays gift tax onto be an ideal solution, but it has been the value of the common stock at the timereined in recently by new restrictions. The of the transfer, but subsequent apprecia-way it used to work is as follows: an owner tion once again goes untaxed under theof a closely held business who wanted to estate levy. Although the current provi-transfer future growth in the business to sions are significantly more lenient thanan heir would cancel the company's out- those resulting from the 1987 reforms, thestanding common stock and issue in its transferor can no longer set the value ofplace a combination of preferred stock, the common stock at zero. Additionally,which would receive most of the compa- the preferred stock retained by the parentny'i; current net profits and perhaps ef- must earn market rates of return.fective voting control over the company, Estate "freezing" is but one approach to

and common stock, which would be enti- estate planning and applies particularlytled to the fruits of future growth but to wealthy business owners, entrepre-would receive little current income and neurs, investors, and others whose activ-enjoy little control. The owner would re- ities generate capital growth. While thisceive the preferred stock, and heirs would group accounts for the majority of wealthyget the common stock. The terms and con- individuals, high-salaried executives con-ditions on the preferred would be set in stitute another significant segment. Thesuch a way as to minimize the value of major estate planning opportunity forthe common stock. This procedure would these persons is to take advantage of pos-allow the owner to transfer all future sibilities for creating tax-exempt wealth.growth to the heirs, without excessive gift The most important item in this cate-tax and without sacrificing control." gory is life insurance. Corporations com-

The Omnibus Budget Reconciliation Act monly provide their high-paid executivesof 1987 placed severe limits on the use of with large amounts of employer-fundedestate freezing. Most importantly, it re- group term insurance. Such policies fre-quired that the value of the transferred quently exceed $1 million, yet proceeds

TABLE 9FEDERAL ESTATE TAX RETURNS FILED, SELECTED YEAI

DOLLAR AMOUNTS IN MILLIONS

Gross Returns Taxable ReturnsPercent Percentof all of all Gross Taxable

Year Number Decedents Number Decedents Estate Estate

1925 14,013 1.1 10,642 .8 $2,958 $1,6211930 8,798 .6 7,028 .5 4,109 2,3771935 11,110 .8 8,655 .6 2,435 1,3171940 15,435 1.1 12,907 .9 2,633 1,4791945 15,898 1.1 13,869 1.0 3,437 1,9001950 25,858 1.8 17,411 1.2 4,918 1,9171955 36.595 2.4 25,143 1.6 7,467 2,9911961 64,538 3.8 45,439 2.7 14,622 6,0141963 78,393 4.3 55,207 3.0 17,007 7,0711966 97,339 5.2 67,404 3.6 21,936 9,1601970 133,944 7.0 93,424 4.9 29,671 11,6621977 200,747 10.6 139,115 7.3 48,202 20,9041983 b 63,251 3.1 35,148 1.7 50,390 26,4831986 42,125 2.0 23,731 1.1 59,805 31,6351987 45,113 2.1 21,335 1.0 66,564 35,9141988 43,683 2.0 18,948 .9 70,625 37,2501989 45,695 2.1 20,695 1.0 77,997 42,1611990 50,367 2.3 23,104 1.1 87,117 48,566

gthese data are not entirely comparable with those discussed in the text becreturns filed in a given year, while the data discussed in the text represenUnfortunately, a consistent series of data on estates by year of death ratheavailable.bl983 figures are for returns with gross estates in excess of $300,000. Howfiled in 1983 were for 1982 decedents. Consequently, to the extent that gro$300,000 had net taxable estates greater than $225,000, these 1983 figures u

Source: U.S. Congress, Joint Committee on Taxation, 1981, Background and De404, S. 574. and S. 858) Belating to Estate and Gift Taxes, Washington, D.C.April 30, Table 4; U.S. Bureau of the Census, 1987, Statistical Abstract ofWashington, D.C.: Government Printing Office, Table 112; National Center forStatistics of the United States, 1986, vol. 2, Mortality, part A; DHHS Pub.D.C.: Government Printing Office, Table 1-1; Mary F. Bentz, 1984, "Estate TaIncome Bulletin, Table 1; Barry Johnson, 1990, "Estate Tax Returns, 1986-198Tables 1, IB, and 1C; U.S. Department of the Treasury, Internal Revenue Servfor 1989 and 1990," Statistics of Income Bulletin, Tables I and 2.

No. 21 WEALTHTRANSFERTAXES 137

easily are excluded from the executive's sale would depress the market price. Al-estate. All that is required is to transfer ternatively, the value of a small block ofownership either directly to the prospec- stock may be reduced because it does nottive heirs or to a trust on their behalf.28 confer voting control. The value of a rel-

Disposing of accumulated wealth is the atively unknown company may be dis-most difficult estate planning task. "A counted because the lack of reputationdollar in the hand is worse than two in would depress the value of its stock on thethe bush from an estate planning per- open market.spective" (Cooper 1979, p. 38). Neverthe- Several options also exist for real es-less, numerous options are available to tate. Alternative valuation procedures forreduce or to eliminate transfer tax liabil- real estate used in farming or closely heldities. For example, a couple with numer- businesses can lower values significantlyous beneficiaries and foresight can easily below what the market would bring. Thegive away several million dollars tax free conservation easement is sometimes anunder the current exemption of $20,000 attractive option for suppressing propertyper year per recipient; and, of course, gifts values for tax purposes. The primary ex-also transfer future appreciation without ample of this is the creation of open-spacetax. easements that are donated to charitable

While planned giving is ideal for those conservation organizations. If the ease-with foresight, the private annuity can ment is created during life, the wealthysave the estates of those who realize sud- individual gets the benefit of a currentdenly and belatedly that death is nigh and charitable income tax deduction as wellthe estate tax collector not far behind. as the reduction in value of the propertyUnder this arrangement, a parent could for gift and estate tax purposes." Val-transfer all property to the children in re- uation is a delicate art that can reduceturn for an annuity. As long as the an- dramatically the value of an estate andnuity fairly reflects the value of the prop- whose skillful practice is compensatederty and actuarial probabilities-but not generously by satisfied clients.necessarily the specific illnesses facing the The wealthy can always reduce theirpotential decedent-the transaction is not estate by donating an undivided or splitsubject to gift tax or estate tax, even if interest in property to charity. Split in-the parent dies the day after the transfer terest gifts can take the form either of atakes place." charitable "remainder trust," which in-

Placing a low estimate on the value of volves a life interest to an individual andthe estate is perhaps the most popular way the remainder to charity, or a charitableto avoid taxes. This technique is partic- "lead trust," which provides income to aularly useful in the case of closely held charity for a term of years followed by acorporations where a low value can some- remainder to an individual .

31

times be assigned to the outstanding stock.Stock values are usually calculated in two Overall Assessment of Wealth Transfersteps. The first consists of the valuation Taxesof the company based on the book valueof underlying assets, current and pro- Subjecting wealth transfer taxes to thejected earnings and dividends, values of conventional tools of economic analysis issimilar publicly-traded companies, and particularly difficult. Estate and gift taxesother objective factors. Expert appraisers cause taxpayers to structure financialusually prepare such estimates according transactions in ways that reduce tax lia-to conventional rules and methods. bility. To some degree such tax avoidance

At the second stage, a series of special affects real economic behavior, such as thefactors are considered that can cause fair nature of investment or property use. Formarket value to diverge from the step-1 the most part, however, tax avoidanceestimates. For example, the estimated consists of hiring skilled legal talent tovalue of a large block of stock may be re- arrange property rights in appropriateduced because of the possibility that abrupt ways.


The economic cost of arranging such the bequest tax base, which they probablyavoidance is not trivial. The American Bar cannot, the estate tax is the wrong levyAssociation reports that over 16,000 law- to link to what is essentially a tax on la-yers, roughly 5 percent of its total mem- bor income.bership, cite trust, probate, and estate law The life-cycle framework suggests thatas their area of concentration. Accoun- an earnings tax, which personal incometants engage in estate planning as well, taxes in most countries approximate, beand are trying eagerly to increase their paired with an inheritance tax. A com-share of the estate planning market. To prehensive tax on accessions through in-the compensation of these professionals heritance or gift would permit countriesmust be added the efforts of those who are to tax lifetime income in full. Moreover,trying to avoid the taxes. In total, the most experts agree that a wealth transfercompliance costs of the transfer tax sys- tax system with graduated rates based ontem must amount to a sizable fraction of the circumstances of the inheritor is morethe total yield of $6 billion. equitable than one based on the wealth of

If wealth transfer taxes are indeed the decedent, since most assume that thettvoluntary taxes," as Cooper alleged, they recipient ultimately bears the burden ofare hardly related to ability-to-pay in the the tax regardless (Surrey, McDaniel, andusual sense. Rather, they are penalties Gutman 1987). Furthermore, an inheri-imposed on those who neglect to plan tance tax should encourage the dispersionahead or who retain unskilled estate of large estates, since the tax would beplanners. These are not the customary in- much greater for a single inheritor thandices of economic capacity. In short, tfie if the estate were divided among severalestate and gift taxes in the United States beneficiaries."have failed to achieve their intended pur- An inheritance or accessions tax hasposes. They raise little revenue. They im- several potential drawbacks, three minor,pose large excess burdens. They are un- but two more serious. First, the admin-fair. And they should be restructured or istrative burden of enforcing such a taxreplaced. would most likely increase, simply be-

Two broad options are available within cause it would involve collecting fromthe framework of the life-cycle identity; several inheritors rather than one estate.the choice is between taxing earnings plus This issue is more complex under aninheritances or consumption plus be- accessions tax, since the tax would bequests. This framework might seem in- based on the amount received from all do-appropriate, because most countries claim nors. This difficulty could be mitigatedto apply comprehensive income taxes. In somewhat by deducting the duty at thefact, none does. Capital income is incom- source, rather than from the individual.pletely, and in some cases negatively, The second minor problem is that yieldstaxed." As a result, the actual personal may decrease if the estate is split amongincome tax bases in most countries more several beneficiaries, but this decreasenearly resemble labor income taxes. These could be offset by raising rates or lower-are linked to a combination of ad rem ing exemptions. Third, a shift from an es-consumption taxes on value added, sales, tate to an inheritance tax would requireand various individual commodities. a significant transition period to allow

Starting from a consumption tax norm people to adjust to the n*ew rules, The fi-would lead one to try to perfect the tax- nal problems are more serious. Tax avoid-ation of estates and gifts. A variety of re- ance through the use of trusts is morestrictions could be added to limit avoid- complicated under an inheritance tax thanance of estate and gift taxes. For example, under an estate tax."' Additionally, thethe U.S. Treasury has put forward new valuation problems that plague the estateregulations concerning estate freezing that tax would still arise under an inheritanceare intended to narrow opportunities for tax.tax avoidance. Even if additional such Although the inheritance tax has sev-amendments could expand significantly eral technical problems, most could be


mitigated by structuring the system care- wealth transfer taxes, the trends in in-fully. Moreover, the theoretical appeal of come and wealth distributions, and thean inheritance tax given our reliance on need for wealth transfer taxes for thelabor income taxes-namely its inherent proper definition of income add up to afairness compared to the estate tax and strong case for reform of this tax.its greater ability to break up large es-tates-argues for giving serious consid-

ENDNOTESeration to exploring the adoption of sucha levy. ***This paper was originally prepared as the Jo-

seph A. Pechman Memorial Lecture for the 47th Con-gress of the International Institute of Public Finance.

Conclusion The opinions expressed in this paper do not necessar-ily reflect the views of the trustees, officers, or staff

Wealth transfer taxation persists, but of The Brookings institution, or the official positionjust barely, in developed industrial coun- of the Federal Reserve Bank of Boston or the Federaltries. Administrative problems partly ex- Reserve System. The authors would like to thank Leah

plain its light use. In the United States,Cook and Karan Singh for their extensive support inpreparing this paper, and two anonymous referees of

resources spent on avoiding wealth trans- this journal.fer taxes are of the same general magni- 'Gifts received should be regarded as inheritances.tude as the yield, suggesting that the ra- Gifts given should be regarded as bequests. See At-

tio of excess burden to revenue of wealth kinson and Stiglitz (1980).'Economists seldom include power or control in the

transfer taxes is among the highest of all utility functions they use in analysis. Psychologists,taxes. sociologists, and many others would find its omission

Whatever the administrative problems, a bit peculiar. We suggest that the explicit inclusion

a good intellectual case exists for inof wealth in the utility function and an explorationof the implications for tax policy of doing so, although

creased reliance on wealth transfer taxes, rather trivial in one sense, might be instructive.Within the life-cycle framework a tax on 3Musgrave (1985) notes that in a model with an in-wealth transfers -bequests or inheri- finite number of periods, any wealth transfer tax would

tances-is essential to the definition ofviolate equity considerations, and a pure income orconsumption tax eventually would tax all resources.

lifetime income. Outside the normal util- This paper assumes, however, that the life-cycleity-based framework employed by econo- framework with a finite horizon is the, more appro-mists, an additional basis for taxing both priate model.

wealth and wealth transfers exists ifInterestingly, the life-cycle theory may provide a

superior description of the behavior of most families,wealth independently confers economic, while the dynastic theory may provide a better de-social, or political power. To the extent that scription of the accumulation and transmission of most8uch economic power produces utility, it wealth. The explanation for this anomaly is that most

can be incorporated within the tradi'

people inherit and bequeath very little, but a fewhouseholds accumulate large estates, hold them, and

tional framework of welfare economics and pass them on to their heirs. For an empirical and the-ability to pay. To the extent that large and oretical critique of the infinite -horizon theory ofdurable concentrations of economic power household behavior, see Bernheim (1987).

are regarded as antithetical to economic'It makes sense on efficiency grounds if the effi-

ciency gains from a lower tax on earnings more thanand social mobility, taxes can be used to offset the efficiency losses from the disturbance of in-hinder the transfer of such advantages tertemporal consumption neutrality caused by taxingacross generations. capital income. More generally, the optimal tax lit-

erature has shown that uniform tax rates on differentEvidence from the United States sug- consumption goods (where differences include the

gests that wealth remains highly concen- timing as well as the type of consumption) minimizetrated, although less so than it was early utility loss only under rather strong assumptions.in the twentieth century. Other countries 'Under the life-cycle theory, the tax rate on the stock

have displayed similar trends- In the of capital inherited at the start of life is the same asthat on labor income. Application of this principle an-

United States, increasing inequality in the nually would imply a tax rate on the stock of capitaldistribution of income over the 1980s SUg- equal to that on labor income. The tax rate impliedgested that wealth concentration might for capital income, tK, would be tL/r, where tL is the

follow the same trend. Recent evidence has tax rite on labor income and r is the ratio of capitalincome to capital value. Typically, tK would exceed

borne this out. 100 percent.The unsatisfactory current state of 'In 1986, assets in the hands of decedents amounted


to $215 billion (see Table 6). Total earnings in that of wealth in 1984, based on a definition of wealth thatyear amounted to $2,483 billion ($2,095 billion of wages is close to Wl.and salaries, $199 billion of other labor income, and '6See, for example, Atkinson (1972), Kessler andassume two-thirds of $282 billion of proprietors' in- Masson (1987), Shorrocks (1987), Spent (1987), andcome). Hence, wealth transfers amounted to 8 percent more generally, Wolff (1987).of the recommended earnings-plus-inheritance tax "An early study by Tobin (1967) provided some em.base. pirical support for the notion that life-cycle saving

arven though trusts are a small portion of total could explain most of the capital stock.wealth, their treatment is one of the most compli- "Kotlikoff and Summers acknowledged that theircated aspects of the various definitions. In the case of methodological approach was similar to that of Darbytrusts over which individuals have complete control, (1979) and Brittain (1978). Darby used cross-sectiontheir cash surrender value of W, and their full mar- data on wealth, earnings, and consumption to divideket value of W2 are identical. Where the beneficiary current wealth into that portion that would be con-and owner are different, however, as in the case of sumed and that portion that would be transferred tosecond or third party trusts, the trust has no cash sur- succeeding generations. He inferred longitudinal age-render value to the beneficiary; the beneficiary can- consumption and age-earninp pr-ofiles from the crownot liquidate the trust, since the beneficiary does not section data and concluded that no more than 29 per-control the assets. In this case, W, includes the ac- cent of U.S. private net worth was used for life-cycletuarial value of the trust, which is the full value of consumption. Brittain also concluded that inheri-trust assets discounted over the expected lifetime of tance played a major role in wealth accumulation andthe second and/or third parties. W2, on the other hand, inequality.includes the full market value of trust assets. 19'ro bolster the case that life-cycle saving plays a

'Few data on the size and distribution of wealth were minor role in wealth accumulation, Kotlikoff (1988)available in the United States before the 1980s, when cited several other developments that he believed castthe Federal Reserve Board began publishing national doubt on the life-cycle theory itself. These includedbalance sheets with both tangible and financial as- the slow rate of asset decumulation among the el-sets. Earlier information consisted largely of pioneer- derly, the apparent lack of demand for annuities, anding research by Goldsmith on national aggregates since the steady saving rate despite the substantial exten-1900 (Goldsmith 1962). A 1962 survey by the Federal sion of the retirement period. These items must beReserve Board provided the first glimpse of the dis- interpreted cautiously, however. First, asset decu-

tribution of wealth among households, but the Fed did mulation appears much more rapid if one also in-not undertake another comprehensive survey until cludes the drawing down of pension and social sftu-

1983 Follow-up surveys in 1986 and 1989 and a de- rity wealth. Second, private and public retirement

tailed set of longitudinal surveys by the Census Bu- systems provide most of retirement income as annu-

reau beginning in 1983 have provided policymakers ities and may well satisfy retirees' demand for this

with access to fairly good information about the mag- form of financial arrangement. Finally, the introduc-tion of the social security program probably satisfiednitude and composition of national wealth and who the need for additional saving to finance the "tended

owns it. See the original paper for a full discussion of period of retirement. Social security, however, tradi-sources and methods used in compiling all of the data tionally has been financed, more or less, on a pay-as-in this section, and for detailed tables. you-go basis, and therefore would not raise the saving

lothis categorization was suggested by Wolff (1981). rate."Smith and Franklin (1974) and Smith (1984) pro- 'A referee informed us that Kotlikoff recently has

vided updated estimates for selected years from 1953 revised this figure downward to 55 percent, after ac-to 1976. Smith (1984) noted that although his series counting for the effect of inheritances on labor supplyand LampmaWs are not completely comparable, they and earnings.are sufficiently similar to warrant comparison. "Other evidence cited by Modigliani (1988) in-

"Descriptions of the estate tax data and the meth. cluded survey results, where participants reported thatods used to update the series are available from the they had received only a small share of their totalauthors. wealth from gifts and inheritances (Morgan et al. 1962,

"At the time of publication, only preliminary es- Projector and Weiss 1964, and Barlow, Brazer, andtimates were available from the 1989 Survey of Con- Morgan 1966), evidence based on probate statisticssumer Finances (Kennickell and Shack-Marquez 1992, (David and Menchik 1982, Menchik and David 1983),and Kennickell and Woodburn 1992). a direct estimate of life-cycle wealth (Ando and Ken-

"Wolff and Marley (1989) have extensively ad- nickel] 1985), and an estimate from the United King-justed the 1962 and 1983 W, data, imputing values dom (Royal Commission on the Distribution of In-for consumer durables and scaling asset and liability come and Wealth 1977).values to correspond to the aggregate household bal- 'The largest of these adjustments deals with theance sheet figures. The adjusted data show a pattern treatment of durable goods and affects the cumula-of concentration in the holdings of W, almost iden- tion of life-cycle saving estimate. Originally, Kotli-tical to that portrayed by the unadjusted data. koff-Summers (1981) included expenditures on dura-

"Comparable findings from a survey that does not ble goods in consumption, as the National Income andover-weight high-income households illustrate the Product Accounts do. Modigliani (1984) countered thatimportance of sampling methods. According to the this treatment is incorrect; durables should be treatedSurvey of Income and Program Participation (SIPP), like other investments and included in life-cycle sav-the 60 percent of the population with lowest income ing. Using Kotlikoff-Summers data, he included de-held 37.1 percent of wealth in 1988 and 36.6 percent preciation of durables in consumption and net pur-


cham of durables in saving. This correction was not any development of most of the surrounding land. Thisentirely consistent, since it added durables to life-cycle will preserve the property as a natural sanctuary andwealth but not to total wealth. Kotlikoff-Summers re- not alter the owner's use, while drastically reducingsponded (1986) with an alternative correction that the value of the property for tax purposes.omitted the accumulation of durables from both life- 3'For example, under a charitable remainder trust,cycle wealth and total wealth. This procedure is trou- a 60-year-old person might transfer $1 million of ap-blesome for two reasons: it completely ignores a piece preciated securities to an annuity trust for his almaof wealth, and the excluded item exhibits a strong life- mater, retaining an annuity of $80,000 (8 percent) forcycle pattern of accumulation. It seems that the ap- life. The IRS, using a 10 percent discount rate, valuespropriate correction has now been made by Modigli- a life annuity for a 60-year-old at $592,928. An im-ani (1988), who includes the accumulation of durables mediate income tax deduction is allowed for the re-in both life-cycle wealth and total wealth. This cor- mainder of $1 million less $592,928, or $407,072. Whenrection reduces the initial Kotlikoff-Summers share the person dies, the value of the trust is included inof bequests in total wealth by 14 percentage points. his estate but is offset immediately by a charitable

The other adjustment affects the flow-of-bequest es- deduction for the same amount.timate by altering the assumption of timing of be- 3Capital income is taxed negatively when pay-quests. Kotlikoff-Summers assume that, on average, ments are deductible at higher average rates than ap-bequests occur 10 years before death, at age 65. Mo- ply to receipts. This outcome is widespread in the casedigliani instead assumes that bequests occur at the of interest expense and interest income, since fullytime of death, which reduces the ratio of bequest wealth taxable interest typically is deducted by fully taxableto total wealth by roughly 5 percentage points. payers and received by partially or fully exempt re-

231f these same acbustments were applied to Kotli- cipients.kofrs revised estimate under the cumulation of life- 33The wealth-dispersing feature of the tax could becycle saving approach, they would reduce the new es- limited if the estate is bequeathed only to the im-timate from 55 percent to 27 percent. mediate family, since close relations are taxed at lower

"Four of the seven countries shown in Table 8 also rates under the inheritance tax. This drawback couldimpose net wealth taxes-Germany, France, Sweden, be alleviated through careful design of the system,and Canada. In each case, the yield of the net wealth however.taxes exceeds that of the corresponding wealth trans- '@4Theuse of trusts basically presents two difficul-fer taxes. ties. Under an inheritance tax, the distribution of trust

'This $123 billion of transferred wealth differs from property, not the contribution or creation of the trust,the $97 billion reported at the end of the section en- is the taxable event. Since trusts can be structured totided "The Role of Bequests in Wealth Accumula- indefinitely postpone the distribution of the property,tion" because it represents the pre-tax value of es- this can result in virtually unlimited tax deferral. Thistates, whereas the $97 billion is a post-tax figure. difficulty can be addressed by including a provision

*This figure excludes state and local estate and in- on property left in trust that would operate largely asheritance tax paid. Including these taxes brings the a mechanism for prepayment of inheritance taxes oneffective tax rate up to 6 percent. the ultimate distribution of this property. The second

27Theonly negatives to a preferred stock recapiw- problem arises because most accessions tax proposalsitation are that the corporation becomes loaded with involve graduated rates that vary with the benefici-a heavy preferred dividend requirement and the owner ary's relationship to the decedent. This creates a dif-becomes the recipient of additional ordinary income ficulty in the case of remainderman trusts. Consider,that has already been taxed at the corporate level. for example, a woman who sets up property in a trustThe latter problem is reduced to the extent that pay- that will pay income to her sister for life with thement of profits is shifted to payments of interest, which remainder passing to her sister's son The questionare deductible at the corporate level in the United becomes whether the son should be treated as if heStates. inherited the property from his mother or from his

'In view of the unlimited marital deduction, the aunt. Hence, one needs to decide whether the finalmost common procedure is to assign ownership to the inheritors should be taxed asif they received propertychildren with the spouse having access to both inter- from the original testator or the previous trustee.est and principal during his or her lifetime. Moreover,this approach is as effective for whole life as it is forterm insurance. Since the amount of insurance is un- REFERENCESlimited by law and can be offered by any corporation,the possibilities for tax avoidance through life insur- Aaron, Henry J. and Harvey Galper. 1985. Assessingmm are staggering. The data, however, show that this Tax Reform. Washington, D.C.: The Brookings In-pmibility is not being exploited fully. stitution.

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