Three Wrongs Don't Make a Right: Thaler on Estate Taxes
"First, it is incorrect to say the estate tax amounts to double taxation. The wealth in many large estates has never been taxed because it is largely in the form of unrealized — therefore untaxed — capital gains. A 2000 study found that for estates worth more than $10 million, unrealized capital gains represented 56 percent of assets."The problem with this is that capital gains are calculated on nominal, not real, values. To see why that matters, consider someone who bought an asset in 1981 for $100 and sold it in 1998, the year the study's figures are based on, for $200. On paper, he has a capital gain of $100. But over those seventeen years, prices doubled; $200 in 1998 was worth the same amount as $100 in 1981. His real capital gain is zero. If instead he sold the asset for $300, the capital gain reported on his schedule D will be $200, his real capital gain only $100.
As you can check by downloading the study Thaler cites (his link only gives you the abstract), its figure of 56 percent of assets was calculated using the conventional definition, hence consists largely of imaginary capital gains. One cannot tell how large the overestimate is without additional information on when and for how much the assets were bought. If we assume that my imaginary asset bought for $100 in 1981 and worth $300 in 1998 is typical, Thaler's figure is off by a factor of two—real capital gains represent 28% of those estates, not 56%, which makes his dismissal of the double taxation argument substantially less persuasive.
Why does all of this matter? It matters because what Thaler is implicitly arguing for in this part of his piece is balancing one error in the tax code with another, while ignoring a third.
What are the three errors, seen from the standpoint of measuring and taxing the real gains from buying and selling assets?
1. The failure to index capital gains, to measure them in real rather than in nominal terms. At a zero inflation rate this wouldn't matter, but if inflation is substantial it taxes investors on imaginary profits, heavily discouraging any form of investment activity that will eventually show up on a schedule D.
2. The failure to retain the basis for capital gains when an asset is inherited. Under current law, when my imaginary investor dies in 1998 and his son inherits his $300 asset, the basis for the asset shifts up, so neither the real $100 gain nor the imaginary $100 gain ever pays capital gains tax.
3. The estate tax. Instead of paying capital gains tax on either the real or the imaginary capital gains, the son is taxed on the amount of the estate, some unknown fraction of which consists of actual capital gains. This is double taxation on part of the estate, single taxation on another part, and, given the exemptions in the estate tax law, zero taxation on a third part.
Richard Thaler's piece is offering advice to Congress on how to deal with the changes in the estate tax currently scheduled for the end of this year. I will accordingly end this post with my alternative. Index capital gains. Base capital gains on the original basis for an asset, whether or not it has been inherited in the meantime. Abolish the estate tax.
The result would still transfer money from private individuals to the government, which I regard as a bad thing although I presume Thaler does not. But it would at least do so in a consistent and coherent way.
Three wrongs don't make a right.