Fortune issue: September 4, 2000
First Principles
The Estate Tax Is One Death Penalty Too Many
By N. Gregory Mankiw
When the Republican-led Congress recently voted to repeal the estate tax, many Democrats called the move unfair; President Clinton threatened a veto. Without doubt, the heirs of millionaires - not exactly society's neediest group - would benefit most directly from the repeal. But the concept of tax fairness means more than merely soaking the rich and protecting the poor. The more you think about the estate tax, the less fair it looks.
Consider a story of two millionaires - Sam Spendthrift and Frank Frugal. Each starts a dot-com after college and sells the business a few years later, accumulating a $20 million nest egg. Sam then enjoys the high life, buying expensive cars, boats, planes, and vacation homes. When all that gets boring, he blows millions financing his own campaign for Senate, leaving little for his heirs. Frank, meanwhile, chooses a more middle-class lifestyle. He keeps his fortune invested in the economy, where it finances capital accumulation, new technologies, and economic growth. He leaves most of it to his children, grandchildren, nephews, and nieces.
Now, here's the policy question: Which millionaire should pay higher taxes?
It is easy to argue that they should face the same tax burden. They both start life with the same resources. One person's extravagant tastes aren't the government's business. Equalizing their tax burdens would mean taxing their earnings but not their estates.
It is also easy to argue that Sam should face higher taxes. Sam is taking more from the economy than Frank, so shouldn't he pay for the privilege? If the nation's millionaires were less like Sam and more like Frank, the economy would be more prosperous, and the country would be better off. Many economists have advocated encouraging behavior like Frank's by replacing the income tax with a progressive consumption tax; people would pay taxes based on how much they spent rather than how much they earned. Again, an estate tax wouldn't be necessary.
What is hard to argue, however, is that Sam should pay less in taxes than Frank. But that is precisely the tax policy we have now. Under current law, Frank's estate is taxed at a rate of about 50%, while Sam avoids the tax by blowing his wad during his lifetime. This, according to many Democrats, is what fairness requires.
Of course, proponents of the estate tax are moved not by such comparisons between rich guys but by comparisons between the rich and the poor. In their view, the estate tax helps ensure that the rich pay their fair share. But if the rich are the target, the estate tax is the wrong weapon. The right one is a progressive income or consumption tax. If advocates of greater redistribution think that the current top income-tax rate of 39.6% is too low, they should argue for an increase. If they think there are too many loopholes, they should try to close them. But once we have taxed the successful for their success, we shouldn't go further and tax the frugal more than the spendthrift.
Several years ago the book The Millionaire Next Door made bestseller lists with the message that getting rich is more often the result of patience than of good luck. Recent research from the National Bureau of Economic Research by economists Steven Venti and David Wise confirms this conclusion. According to Venti and Wise, whether a person reaches old age wealthy or penniless mostly depends on the percentage of his earnings he saved - not on the total amount he made in his lifetime. This means that most of the burden of the estate tax falls not on those who have been lucky throughout life but rather on those who have been frugal.
When the government levies a tax on what we leave when we die, it is literally taxing our patience. If the nation were suffering from a surfeit of patience, if national saving were too high, if we were doing too much to ensure our children's economic prosperity, the estate tax would make sense. In the real world it doesn't.
It is a good rule of thumb that when you tax an activity, you get less of it. If we stopped taxing estates, estate building would be more attractive, and that would be good for everyone in the economy. Maybe we'd even have fewer multimillionaires trying to buy themselves second careers in Congress. No one would call that change unfair.
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N. GREGORY MANKIW is an economics professor at Harvard and the author of Principles of Economics.