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International Tax and Public Finance

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01-08-2014

The optimal inheritance tax in the presence of investment in education

Author: Michel Strawczynski

Published in: International Tax and Public Finance | Issue 4/2014

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Abstract

This paper provides an example aimed at calculating the optimal inheritance tax in a model in which inheritances are used to finance investment in education. Two results are obtained: (1) The optimal inheritance tax schedule includes a threshold, estimated between 2.5 and 5.5 times per-capita GDP. This result holds for a Rawlsian social planner that maximizes the welfare of the poorest individual, who does not leave bequests. (2) Contrary to the result of a 100 % tax on pure accidental bequests, the optimal simulated tax rates are between 28 %, for the case of educational bequests, and 57 %, for the case where educational and accidental bequests interact. This range is in line with existing schedules in developed economies.

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Gales et al. (2001) and Graetz and Shapiro (2005) shed light on different aspects of the inheritance tax.

Note that both developed and developing economies will accept a certain degree of tax avoidance. Tax avoidance is a natural reaction to taxes in general, and to inheritance taxes in particular. According to Erard (1998), the avoidance of the inheritance tax in the U.S. is estimated at 13 % of the potential tax base.

It should be mentioned, however, that the model presented in my example is solved for a linear schedule.

A long, ongoing discussion is documented in the literature on the causes of bequests, which in practice change during the life cycle and are related to many different aspects covered in the literature. Kopczuk and Lupton (2007) and Kopczuk (2009) have documented the different bequest motives. Abel (1985) is a pioneer paper, analyzing accidental bequests.

Galor and Zeira (1993) show that the imperfection in financial markets, together with the indivisibility of the investment in education, constitutes a market failure that causes inequality to be transmitted among generations.

I assume that the demand for skilled workers is constant.

This function was used by Sheshinski in his graduate Public Economics course, and by (Laffont (1994), p. 220).

In my model, the dynasties act in a stationary, steady state (that is presented as a two-period model). This would be equivalent to a middle run scenario within the framework of Galor and Zeira (1993), since in their case the model arrives in the long-run at a two-dynasty economy.

A further feature that supports the assumption of a three-dynasties economy, in the context of the present model, is presented in footnote 18.

This assumption is similar to Galor and Zeira (1993). Introducing disutility of labor for the child would not affect the main results.

For simplicity’s sake, I assume that government intervention concentrates on income redistribution. I assume implicitly an exogenous level of public goods (not including education).

Note that the combined budget constraint of dynasty i is given by: \(c_{pi} +c_{ki} =(1-\tau )w_{pi} l_{pi} +A+[n_\mathrm{s} (1-\tau )-1]X_i -g(X_i )\), where the term in the right parenthesis is the net return of investing one dollar in education from the dynasty’s point of view.

Dahan and Tsiddon (1998) ponder endogenous fertility and find that poor dynasties will have more children. This result is related to the cost of acquiring human capital and that of foregone earnings.

See Strawczynski (1993).

Note that in Abel’s model there is intra-generational inequality, that is related to the number of generations in which the parent died young. In that case, an inequality averse social planner would choose a positive redistributive inheritance tax even for small levels of bequest. In order to solve a tractable analytical solution, I consider the case in which the number of previous generations with an early parent’s demise is equal to m for all dynasties.

Kopczuk (2003) explains that, compared to the first best policy (i.e., in the presence of annuities), a 100 hundred percent tax is not optimal since it implies a welfare loss. He shows that, with a lack of annuities, the inheritance tax can act as an annuitizing device.

Abolishing this assumption would change the results for the optimal income tax schedule, but would not affect my conclusions on the optimal inheritance tax.

Since I show in Table 2 that all countries imposing an inheritance tax adopt a threshold, this paper is focused on the case of three dynasties. An example in which a small bequest tax is desirable from the first dollar is presented by Grossman and Poutvaara (2009), in a model that combines both wage and bequest taxes.

The coexistence of two types of taxation differs from the well-known result of Atkinson and Stiglitz (1976) regarding the redundancy of indirect taxation. The difference arises from the fact that, in my model, wages and inheritances are separate sources of inequality, and both can be used for redistribution.

This point is shown by Blumkin and Sadka (2003).

Note that the model assumes that education is a private good, while in reality most countries have a public education system. The discussion on the optimal provision of education is beyond the scope of the present paper.

For simplicity’s sake, we assume that taxes relate to inheritance. However, the same argument works for an estate tax as long as grandparents are willing to reduce their estates in order to invest in their grandchildren’s education.

Abel, A. (1985). Precautionary savings and accidental bequests. American Economic Review, 75(4), 777–791.

Atkinson, A. B., & Stiglitz, J. E. (1976). The design of tax structure: Direct versus indirect taxation. Journal of Public Economics, 6, 55–75.CrossRef

Blumkin, T., & Sadka, E. (2003). Estate taxation with intended and unintended bequests. Journal of Public Economics, 88, 1–21.CrossRef

Dahan, M., & Tsiddon, D. (1998). Demographic transition, income distribution and economic growth. Journal of Economic Growth, 3, 29–52.CrossRef

Ernst and Young. (2011). The 2011 Global Executive—individual tax, social security and immigration. London.

Erard, B. (1998). Estate tax under-reporting gap study: A report prepared for the internal revenue service economic analysis and modeling group. Order Tirno 98-P-00406. Washington, DC: Internal Revenue Service.

Farhi, E., & Werning, I. (2010). Progressive estate taxation. Quarterly Journal of Economics, 125(2), 635–673.CrossRef

Gales, W., Hines, J. R, Jr, & Slemrod, J. (2001). Rethinking estate and gift taxation. Washington, DC: The Brookings Institution.

Galor, O., & Zeira, J. (1993). Income distribution and macroeconomics. Journal of Economic Studies, 60(1), 35–52.

Graetz, M., & Shapiro, I. (2005). Death by a thousand cuts: The fight over taxing inherited wealth. Princeton: Princeton University Press.

Grossman, V., & Poutvaara, P. (2009). Pareto-improving bequest taxation. International Tax and Public Finance, 16(5), 647–669.CrossRef

Kopczuk, W. (2003). The trick is to live: Is the estate tax social security for the rich? Journal of Political Economy, 111(6), 1318–1341.CrossRef

Kopczuk, W. (2009). Economics of estate taxation: Review of theory and evidence. Tax Law Review, 63(1), 139–157.

Kopczuk, W. (2013). Taxation of intergenerational transfers and wealth. In A. Auerbach, R. Chetty, M. Feldstein, & E. Saez (Eds.), Handbook of Public Economics (Vol. 5, pp. 329–390). New York: Elsevier.CrossRef

Kopczuk, W., & Lupton, J. (2007). To leave or not to leave: The distribution of bequest motives. Review of Economic Studies, 74(1), 207–235.CrossRef

Laffont, J.-J. (1994). Fundamentals of public economics (4th ed.). Cambridge, MA: MIT Press.

Loayza, N., Rigolinu, J., & Llorente, G. (2012). Do middle classes bring about institutional reforms? Economics Letters, 116(3), 440–444.CrossRef

Loury, G. C. (1981). Intergenerational transfers and the distribution of earnings. Econometrica, 49, 843–867.

Milanovic, B., & Yitzhaki, S. (2002). Decomposing world income distribution: Does the world have a middle class? Review of Income and Wealth, 48(2), 155–178.CrossRef

Piketty, T. (2011). On the long-run evolution of inheritance: France 1820–2050. The Quarterly Journal of Economics, CXXVI(3), 1071–1131.CrossRef

Piketty, T. & Saez, E. (2012). A theory of optimal capital taxation. CEPR Discussion Paper no. 8946.

Strawczynski, M. (1993). Income uncertainty, bequests and annuities. Economics Letters, 42(2–3), 155–158.CrossRef

Title: The optimal inheritance tax in the presence of investment in education
Author: Michel Strawczynski
Publication date: 01-08-2014
Publisher: Springer US
Published in: International Tax and Public Finance / Issue 4/2014
Print ISSN: 0927-5940
Electronic ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-014-9324-1

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