Wealth, Inheritance and the Estate Tax

Policy Reports | Taxes

No. 289
Thursday, September 21, 2006
by Jagadeesh Gokhale and Pamela Villarreal

Executive Summary

It is commonly assumed that inheritances are a major source of wealth inequality and that the offspring of wealthy families tend to be as rich as their parents due to bequests.  This perception is one reason why many people support taxing estates at death.  But an individual's skills and personal choices are far more important in determining household wealth than inheritances.  In fact, the contribution of inheritance is surprisingly small.

More importantly, skills acquired through education, entrepreneurship and hard work determine whether individuals move from one wealth level to another.  To understand the reasons for wealth inequalities, this paper relies on a model of wealth accumulation that spans individual lifetimes.  It focuses on that point in the life cycle when wealth accumulation tends to peak, as married households reach retirement age (60 to 69) and have accumulated all the wealth they will during their lifetimes.  The model shows the distribution of wealth is highly unequal: 

  • The top 1 percent of households (with wealth of $13.8 million or more) holds about 23 percent of all wealth.
  • The top 5 percent ($4.02 million or more) holds 51 percent of all wealth.

However, according to the model, inherited wealth is a very small portion of total wealth even for the richest households.  For example:  

  • If we could somehow tax away every single dollar of wealth due to inheritances, it would reduce the top 1 percent's share of the nation's total wealth by only 4 percentage points.
  • If all the wealth due to inheritance of the top 5 percent were taxed away, it would reduce their share of the wealth by only 7 percentage points.

The principal argument for the estate tax is the notion that without it wealth would become more concentrated in the hands of financial dynasties.  However, wealth is highly mobile - being raised in a rich family does not guarantee that these children will be rich themselves when they retire:

  • Only one in five children of the rich will themselves be rich when they reach retirement age.
  • On the other hand, more than half of the children whose parents are in the bottom half will end up in the top half by the time they retire.

Interestingly, Social Security has a significant effect on the distribution of wealth.   Without Social Security, bequests would actually reduce wealth inequality.  Specifically, if Social Security did not exist, the top 5 percent of households would hold only 46 percent of all wealth, instead of the current 51 percent.

The reason?  Social Security - a pay-as-you-go program that does not save and invest - tends to replace savings that lower- and middle-income households otherwise would have accumulated.  This is because for these households, expected Social Security benefits replace retirement savings.  As a result, they have little or nothing to leave to their children since these benefits are not transferable.  By contrast, the savings habits of higher-income households are not affected very much by Social Security.

The estate tax is ostensibly designed to reduce wealth disparities, but it has proven to be ineffective for several reasons:

  • Estate tax revenues account for only 3 percent of federal tax revenues, yielding very little money to redistribute.
  • For most estates larger than $5 million, the effective tax burden is only 13.5 percent to 17 percent of estates; in fact, the burden tends to fall primarily on smaller estates.
  • Additionally, the estate tax lowers the capital stock while raising the return on existing capital, making the rich richer.

Economists have called the estate tax a voluntary tax, since people can avoid it if they make a large enough effort.  There are social costs of tax avoidance, however.  In return for trivial effects on wealth distribution, there is likely a large misallocation of resources caused when people allocate large amounts of capital based on tax law rather than on the basis of economics.

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