Wealth, Inheritance and the Estate Tax
Thursday, September 21, 2006
by Jagadeesh Gokhale and Pamela Villarreal
Table of Contents
Social Security and Wealth Distribution
“Wealth would be distributed more evenly without Social Security.”
As noted, inheritances have only a minor effect on wealth inequality. Without Social Security, however, bequests would actually reduce wealth inequality. How can this be? In general, Social Security taxes tend to crowd out personal saving, leaving consumption unchanged. Because expected Social Security benefits are sufficient to maintain their preretirement consumption, lower-income households reach retirement with very little personal savings. If they die prematurely, however, they cannot pass Social Security benefits onto their children. By contrast, higher-income households, having saved to maintain their consumption level after retirement, will transfer substantial wealth to their children if they die prematurely, aside from Social Security.22 Hence, if Social Security were absent, low-earning households would arrive at retirement on a more equal footing with high-earning ones, and their bequests to the next generation would actually reduce wealth inequality.
The model allows the simulation of the wealth distribution: 1) with and without Social Security, 2) with inheritances and 3) hypothetically taxing all inheritances away. Table II shows some of the results:
- Without Social Security, the top 1 percent would hold 20.4 percent of the national wealth, but this would increase to 23.7 percent if all inherited wealth were taxed away.
- In the presence of Social Security, however, the share of national wealth held by the top 1 percent would shrink from 22.7 percent of wealth to 18.7 percent of wealth if all inheritances were taxed away.
“Social Security reduces savings and can’t be passed on to children.”
In other words, in the absence of Social Security, allowing bequests to flow to heirs without taxation would have a wealth-equalizing effect. For example, Table II shows that the top 5 percent of households would own 49.3 percent of all wealth if all inheritances were taxed away, but only 45.6 percent if inheritances were not taxed. As noted earlier, the involuntary bequests of high earners and savers would go to their children who, on average, are likely to earn and save less than their parents.
Introducing Social Security, however, saps the incentive and ability of low- and middle-earners to save for retirement. Higher payroll taxes mean lower ability to save, and expected future retirement benefits weaken the incentive to save. That means the distribution of bequeathable wealth is less equal, assuming inheritances are not eliminated through taxation. For example, the top 5 percent of those just retired would own 51 percent of all wealth if inheritances are not taxed compared to just 43.6 percent if a 100 percent tax is imposed.
Not only does Social Security increase wealth inequality, it is also likely to make it dynastically more persistent. This happens simply because Social Security makes the distribution of bequeathable wealth more unequal. In its presence, the children of the rich receive much more by way of inheritances than do those of poor- and middle-earners. This improves the chance that the children of high-earners will themselves arrive at retirement with more wealth than the children of low- or middle-earners.23
Some supporters of wealth redistribution through estate taxes argue that we should abolish inheritances by taxing them away so that (with Social Security) we will reduce inequality by as much as possible. As shown in the top right panel of Table II, the lowest inequality in the top tail of the wealth distribution would occur if inheritances were fully taxed and Social Security retained. However, abolishing inheritances would be unfair to those who have a bequest motive and would act as a further disincentive to save, acquire education and invest in bequeathable physical or financial assets. In fact, it is Social Security that has made the wealth distribution more unequal; absent Social Security, inheritances would be wealth equalizing.