## Sunday, November 07, 2010

### Three Wrongs Don't Make a Right: Thaler on Estate Taxes

In a recent New York Times piece, Richard Thaler discusses alternative ways in which the estate tax might be revised. I have no strong opinions on optimal taxation, other than wanting it to be as low a possible, but it struck me that one part of his argument was wrong in an interesting way. Thaler writes:
"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.

Gordon said...

Perhaps Thaler expects support from Lipsey & Lancaster here. ;-)

What I find strange is his statement that, "If no estate tax is imposed, capital gains taxes can be avoided indefinitely." What is the problem with that? If, to use one of Thaler's own examples, Paris Hilton wants to buy clothes for her next trip to St. Tropez, she is going to have to pay from dividends - which are taxed - or from the sale of a capital asset - which will then be taxed. I suppose Thaler could argue that she could borrow against such assets "indefinitely", but the likelihood is that she will have to transfer a capital asset at some point, thus subjecting it to capital gains tax.

Dick White said...

We may be missing another tax here. In Professor Friedman's #3 scenario the original income that produced the savings that grew, nominally or actually, itself was taxed. Thus the notional cap gains portion of the estate tax is the second tax on this asset, albeit limited to the growth increment, be it nominal or real.

Doc Merlin said...

This is also why no private currency can compete with the USD within the United States. Any depreciation of the dollar will cause you to have to pay taxes on it.

Anonymous said...

Actually, capital gains usually have already been taxed. The federal corporate tax rate of 35% applies to corporate profits. Since corporate profits belong to the shareholders, they are paying approximately a 35% federal tax rate on their business earnings. It is these earnings that give rise to capital gains. (If the government taxed business earnings at 100%, companies would have a terrible time growing at all and there would be no real capital gains.) It's a big fraud to ignore corporate taxes and claim that capital gains are untaxed -- what Thaler is doing.

If the government taxed your bank account at 35%, and then again taxed you personally on income from your account, it would be obvious what was happening. The corporate tax is exactly the same thing, with the shareholders collectively owning the "account". Yet, guys like Thaler seem to largely succeed in befuddling people on this issue. Don't fall for this government sleight-of-hand.

Anonymous said...

This argument has a flaw. I see no reason why deferred capital gains should be sheltered from inflation when other forms of income over a comparable period weren't.

Inflation amounts to a variable premium over fixed nominal tax rates. Looking back, during years of high inflation, the effective capital gains tax rate was higher.

If you calculate the total tax deferred taking into account the *effective* rates (inflation adjusted) it will come out closer to the original estimate.

You might argue that we shouldn't be taxed on inflation in the first place, but try not to give capital gains a special exemption when putting the argument forward.

Anonymous said...

Re: "This argument has a flaw. I see no reason why deferred capital gains should be sheltered from inflation when other forms of income over a comparable period weren't."

Because deferred capital gains are not income. You don't have any income until you realize the gain.

And if the capital gain was the result of inflation only you don't have any real income.

If I buy \$10,000 worth of stock, and sell it for \$20k after prices have doubled, I never had any income at all, but I will be taxed as if I did.

If over the same time span, I have \$10k of ordinary income, its real income for me. I can use it to buy things or to invest. Even if I get it in cash at the beginning of the period and put it under my mattress until prices have doubled, its still worth the same as \$5k was at the older prices. I still have gained an asset, not converted one asset (cash) in to another (stock) and then back to cash, without ever realizing any benefit.

- Tim