Wealth, Inheritance and the Estate Tax

Policy Reports | Taxes

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

Factors That Contribute to Wealth

Wealth in the United States is quite mobile, and many variables account for the fact that some families reach retirement far richer than others.  Aside from inheritances, past empirical work indicates that three other factors determine wealth:11 

  • Acquired skill differences, which are determined by education, entrepreneurship, hard work and other factors that help individuals attain income and wealth;
  • Marital sorting, which reflects the tendency of individuals with similar levels of acquired skills to marry each other; and
  • "Inherited skills" - the innate intelligence passed down from one's parents and habits nurtured in childhood (such as disciplined work habits).

The effect of each of these factors on the distribution of wealth can be estimated through computer modeling, as the following discussion will show.        

“Personal choices, innate intelligence and nurturing families determine wealth.”

Modeling Factors That Determine Wealth.  The significance of inheritance and other factors on wealth can be determined using a model of the distribution of wealth in the U.S. economy based on data from the Survey of Consumer Finances.  Constructed by the authors and other researchers, the model closely reproduces the actual distribution of wealth among married households nearing retirement (ages 60 to 69).12  It includes the factors that influence the distribution of wealth, such as how much parents and their children earned throughout their working lives, how much they saved, what rate of return they received on investments and when they died.  Over time, the model shows the degree to which each factor, including inheritances, contributes to the distribution of wealth among the children of these households when the children reach an assumed retirement age of 66.

Table I - Wealth Distribution When Isolating Single Factors%2C Based on Simulation of Households

“Taxing all inheritances away would reduce the wealth share of the rich by very little.”

Consider the contribution of labor income to bequests.  The findings in this simulation are similar to actual bequest flows in the United States.  In the model:

  • Bequests to spouses comprise about 9 percent of labor income.
  • Bequests to children comprise about 3 percent of labor income.

These labor market earnings have only a small effect on wealth inequality, holding constant skill and mortality differences. 

Next, consider the effect of other factors on wealth inequality.  The effect of these factors are compared to a benchmark, or base, in which wealth is distributed randomly and no other factors are considered.  As Table I shows:13 

  • The top 1 percent of households hold about 23 percent of wealth, the top 5 percent hold 51 percent of wealth and the top 10 percent hold about 64 percent of wealth.
  • If the inheritances of the top 1 percent were completely taxed away, it would only reduce their share of total wealth by 4 percentage points to 19 percent.
  • If the inheritances of the top 5 percent were taxed away, it would reduce their share of the wealth by only 7 percentage points to 44 percent.
  • If the inheritances of the top 10 percent (accumulated lifetime wealth of $2.1 million) were taxed away, it would reduce their share of the wealth by only 8 percentage points to 57 percent.

“Taxing away all wealth derived from individual skills would reduce the wealth share of the rich by more than 80 percent.”

However, inheritances have a small effect on the wealth distribution when compared to other factors.  Other differences have a much greater effect on the uneven distribution of wealth: 

  • If all the wealth that derives from acquired skills (gained through hard work, education, entrepreneurship and so forth) were taxed away, the share of total wealth of the top 1 percent would drop significantly, from 23 percent to only 3 percent.
  • The top 5 percent of households' wealth would fall from 51 percent to 11 percent.
  • The top 10 percent's wealth would fall from 64.3 percent to 19 percent.

The majority of wealth inequality stems from inequality in lifetime earnings, which are highly influenced by skills, education and motivation. In other words, wealth would be more evenly distributed if individuals had the same innate abilities, education levels, motivation and so forth.  But these levels obviously vary in the real world.

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