The Impact of Inheritance Taxes on the Labor Supply of Heirs

Yves here. This post reaches a conclusion that might seem obvious: rich heirs tend not to work much. However. all sorts of wealthy people would like you to believe otherwise. The “not working much” matters because they produce less in labor income which would add to output and be taxed. Of course, if you are a currency issuer, you don’t need to tax to spend, but state and local governments, and Eurozone countries that are currency users do need to worry about tax revenues to fund spending.

By Fabian Kindermann, Professor of Economics, University of Regensburg, Lukas Mayr, Lecturer, Economics Department, University of Essex, and Dominik Sachs, Professor (non-tenured) of Economics, University of Munich. Originally published at VoxEU

Although inheritance taxes are of growing importance for Western economies in raising government revenue, little is known about how inheritance taxation affects individuals’ incentives to work. This column explores how much additional labour income tax revenue from heirs the government can expect to obtainfor each euro of revenue raised directly through inheritance taxes. It concludes that additional labour tax payments from heirs, resulting from an increase in bequest taxes, are of sizable magnitude and should be taken into account in fiscal planning and welfare analysis.

Inheritances are of growing importance for Western economies. Using data from France, Piketty (2011) shows that the annual flow of inheritances has been ever increasing since the 1950s, so that in 2010 it amounted to roughly 15% of national income. This development clearly highlights the increasing power of an inheritance tax in raising revenue. Yet to date, inheritance-tax revenue in most Western economies is rather low. In several countries, inheritances are not taxed at all. In others, including the US and Germany, inheritance taxes exist, but very high exemption levels ensure that most inheritances remain untaxed. Nevertheless, the desirability of inheritance taxation is a prevailing topic in the scientific and political discussion, where popular labels such as ‘death tax’ or ‘Paris Hilton tax’ mirror the emotionality of the debate.

In practice, we know very little about how inheritance taxation affects individuals’ incentives to work, to accumulate wealth, or to engage in entrepreneurial activities. Understanding these effects, however, is crucial for a comprehensive welfare assessment of inheritance taxes. Kopczuk (2013) attributes this lack of evidence to the fact that empirical measurement is difficult, because “[wealth transfers] are infrequent (at the extreme, occurring just at death), thereby allowing for a long period of planning, making expectations about future tax policy critical and empirical identification of the effect of incentives particularly hard” (Kopczuk 2013: 330).

An important household decision that reflects the incentive effects of inheritance taxation is labour supply. It is easy to envision at least two channels through which higher inheritance taxes impact on the household’s willingness to generate labour earnings:

  • For testators, higher inheritance taxes make them poorer and make leaving bequests more expensive. Hence, they will experience substitution and income effects (Hines 2013).
  • For heirs, a higher inheritance tax rate leaves them with a lower net inheritance, thus leading to an increase in labour supply if leisure is a normal good.

In our recent paper (Kindermann et al. 2018), we make progress on understanding and quantifying the second effect, namely, the labour supply channel of heirs. From the perspective of public finances, this is a particularly interesting channel, as rising labour earnings of heirs will inevitably lead to an increase in their labour tax bill and, hence, boost government tax revenue.

We therefore tackle the following policy question:for each euro of revenue raised directly through inheritance taxes, how much additional labour income tax revenue from heirs can the government expect to obtain?

Answering such a question purely on empirical grounds is difficult. One fundamental problem is that inheritances could be anticipated and therefore might already shape labour earnings prior to their receipt. Such anticipation effects can get in the way of a clean identification of the effect of inheritance taxes on heirs’ labour. Estimates of labour supply changes upon the arrival of an inheritance would therefore (most likely) be biased.

To overcome such problems, our paper uses an alternative strategy, exploiting the existing clean evidence on the wealth effect of lottery gains on labour income. From a researcher’s perspective, lottery wins have the advantage that they occur with an almost-zero probability. Hence, anticipation effects are unlikely to occur and observed differences in labour earnings between winners and non-winners of lotteries (or winners of different amounts) can be directly attributed to the differential receipt of unearned income. Using this approach, Cesarini et al. (2017) document a significant reduction in labour earnings following the receipt of a lottery win.

Precisely for the reason that inheritances are (to some extent) anticipated, one cannot directly extrapolate this evidence to answer our policy question. Instead, we use a hybrid approach: we calibrate a large-scale life-cycle model — featuring consumption, labour supply and savings decisions, heterogeneous labour productivity profiles, and realistic expectations about the size and timing of bequests — such that the model replicates the quasi-experimental evidence on lottery wins. Specifically, we distribute lottery gains of different sizes among individuals of different ages in our model in the same way as they are distributed in the dataset of Cesarini et al. (2017). We measure the resulting responses in labour earnings and set preference parameters in a way that the model’s predicted response in labour earnings matches the empirical one. Figure 1 compares the average model-simulated response in labour earnings after a lottery win to its data counterpart.

Figure 1 Response in labour earnings in data and model

 

We otherwise set the parameters of our model such that it resembles the German economy, with its progressive tax system, pension payments, as well as labour earnings profiles, and conditional bequest distributions. The only feature of our model, for which neither quasi-experimental evidence nor survey data provide us with clear guidance for calibration, are individual expectations about whether they will receive an inheritance, and of which size this inheritance will be. From a theoretical viewpoint, different assumptions on rational expectations can be consistent with the data on actual inheritance cases.

To deal with this issue, we consider a general class of expectations that captures two special cases as polar outcomes: (i) full information in the sense that individuals know for sure how much they inherit and the only remaining uncertainty is about the date at which their testator dies; and (ii) no information in the sense that heirs only observe the cross-sectional distribution of inheritances and form their expectations accordingly. Besides these two polar cases, we consider convex combinations of the two.

Equipped with this quantitative model, we conduct the following policy experiment: we let the government levy a proportional tax of 1% on all inheritances in the economy and calculate by how much individuals adjust their life-time labour income in response to this policy change. We then evaluate the impact on public finances through increased labour tax payments.

For our benchmark economy, we find that any euro of taxes the government directly raises from the taxation of inheritances is accompanied by an additional nine cents of labour tax payments from heirs (in present value terms). This result is, by and large, insensitive to the assumptions we make about how informed individuals are with respect to their inheritances, as long as expectations are rational. Figure 2 shows the excess labour tax payments as a function of how informed agents are about the size of their inheritance. The number varies between around 8.5 and 10 cents.

Figure 2 Excess labour tax revenue and information of households

We also show that anticipation effects are indeed likely to bias empirical estimates that rely solely on labour supply changes starting from the date inheritances are received. Our model suggests that about 48% of the total effect of bequest taxes on heirs’ labour earnings occur prior to the receipt of an inheritance. This highlights the importance of considering a structural model in which inheritances are rationally anticipated.

We conclude that additional labour tax payments from heirs, resulting from an increase in bequest taxes, are of sizable magnitude and should be taken into account in fiscal planning and welfare analysis.

See original post for references

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31 comments

  1. Watt4Bob

    The rich and powerful have promulgated the myth that all efforts to make wealth distribution more fair are ‘Social Engineering’, and as such are the evil result of the wrong-minded ‘liberal’ delusion that taking money from ‘successful, hard-working job-creators’ and giving it to lazy takers results in a more fair society.

    Comparing our situation at the present, with the situation in the late 1950s, when the top tax bracket was 91% is proof positive that that story is indeed a myth.

    The rich and powerful, in the person of DT have been busy pushing a populist wave by way of nostalgia for exactly that time period when the tax system was earnestly employed to curb their ability to buy our government, and selfishly wreck our social order.

    One could make the argument that the American revolution was ‘Social Engineering’ writ large, the Progressive Era, and the New Deal certainly were.

    It is so sad to see generations of people who were the beneficiaries of ‘Social Engineering’, convinced that it is now an evil, and existential threat.

    Reply
    1. MichaelSF

      the wrong-minded ‘liberal’ delusion that taking money from ‘successful, hard-working job-creators’ and giving it to lazy takers results in a more fair society

      It seems easy to flip that and cast the situation with the working class as the “hard-working job-creators” and the rich as “lazy takers”.

      I’ve appreciated comments in the past wondering about the lack of concern for the moral hazard inheritors have from unearned windfalls. Will no one think of the inheriting children?

      Reply
      1. Watt4Bob

        Like a lot of things that seem easy, but we’re having a pretty hard time getting any traction for an idea that seems obvious, aren’t we?

        Reply
        1. ambrit

          Obvious to those who have discovered that there actually is an “outside of the box.”
          I guess that it is all a function of what is important to the individual. If one were starving, what matter if the world were round or flat? Similarly, if one is intellectually blinkered…..in school, by television, radio, and now the internet.

          Reply
  2. Olivier

    Sorry Yves but this article is appalling. Implicit here is the premise that we exist only as worker bees to be taxed: that’s all there is to us! When even a countercultural site like NC embraces such ideology is it any wonder that we landed (collectively) where we did?

    There is a case to be made for inheritance tax but these laborious computations of how much more the state could have taxed someone over the course of his lifetime had he not inherited (or inherited less) are just ghoulish. I’d rather that Paris Hilton wallow in her unearned riches than that we be governed by people with such a mindset.

    Reply
    1. Wukchumni

      Yeah, second that.

      I wanted to quit working as quick as I could after i’d scooped up enough acorns, as it wasn’t the end all-be all that it’s propped up to be. When I meet somebody new, inevitably they ask: “what do you do?”

      I always them I like to explore, go hiking & observe, and then there’s this pregnant pause followed by “No, what do you do for a living?”.

      Reply
    2. Lee

      We are governed by Paris Hilton’s bankers and money managers. While she is not personally the problem, she is representative of an array of systemic problems. We don’t really need her money or even her head in a basket, however well deserved such a fate might be.

      Reply
    3. Arizona Slim

      Agreed on allowing Paris Hilton to wallow in the unearned riches. Because she’d probably be a nonstop headache in any workplace.

      Reply
    4. ChiGal in Carolina

      To you, Wuk, and John Beech below, I respectfully call bullsh*t. A lot of LUCK goes into this along with whatever is EARNED. Be real with yourselves, please.

      Since I relocated two years ago to take care of my mom I haven’t had a job. Although I have some income from renting out my Chicago condo, there is no way I could do this without dipping into my inheritance from my Dad (no comparison to the Hilton millions there; he was an econ prof at a midwestern public university).

      And while it could be said that it is a good thing to be caring for my mom, wouldn’t it equally be a good thing if the many people I know back in the ‘hood on the south side could take time off from their grueling minimum wage jobs to care for their parents?

      The difference is luck, not virtue. Anyone who is the least bit spiritual ought to be able to humble themselves enough to know that.

      Reply
      1. Wukchumni

        Luck for me was showing up when opportunity made itself apparent, but my best attribute in the remembering game before computers was my ability to beat other brains to a pulp in business-they hardly had a chance against me, oh, and being very near-sided was quite a gift in my field of endeavor, also.

        I can’t speak for those less fortunate, but I made the best of what abilities I had in my quiver.

        Virtue is what politicians claim to have, but seldom do.

        Reply
          1. Wukchumni

            I’m sure my parents read to me, although memories before I was say 4 are really vague. I started reading when I was 5.

            Reply
    5. Yves Smith Post author

      Do not pigeonhole this site. We don’t take positions to cater to your ideological preferences.

      Work is part of the human condition unless you think having personal slaves is a good social order. I don’t and I abhor people who denigrate work because they denigrate everyone who does work, like hospital orderlies, janitors, truck drivers, checkout clerks, fry cooks, and school teachers.

      Reply
      1. Wukchumni

        One of the considerations of retiring from nearly 30 years of working in the midst of the first year of the 2nd term of Bush the younger, was the idea that I was financing wars I didn’t believe in by paying taxes, and it became unconscionable, so I cut them off.

        I also allowed others to fill in the void I created by leaving the workplace.

        Not everybody has the same advantages I had, and many have to work until they can barely do it anymore, or death comes calling. To me, they sometimes resemble slaves unable to break the economic shackles bounding them.

        Reply
        1. Yves Smith Post author

          By “work” I also mean unpaid work, although the US economy has changed so that a lot of formerly unpaid work is now paid. You can hire someone to pick up your order at Whole Foods and deliver it to you or stand in line for you, gah.

          People still have to work even if they are not formally employed. They need to eat. Someone grew that food and delivered it to where they could buy it. It’s cooked either by you or someone else. I presume you do not live in total squalor, which means either you, someone in your household, or a hired person does the cleaning. Etc.

          So you are paying for war (if you believe taxes fund Federal spending, which isn’t true, but the political class belief that thats true does turn that into a practical constraint) by paying for services and the labor content of goods you buy. There’s no way around it.

          Reply
          1. Wukchumni

            Oh, unpaid work is a different kettle of fish altogether, you do it because you want to, with no expectation of remuneration…

            I volunteer to do essentially convict labor, because I don’t enjoy seeing litter on the road, that sort of thing.

            Or in the case of working for yourself-yesterday would be a good example of putting in 5 hours on the job sans pay.

            We had 4 inches of rain-the first decent amount since April, combined with 40-50 mph winds a few days later, and a few foot wide trunks of multi-trunked Live Oaks about 60 feet tall gave up the ghost and came down, along with other limbs that broke off on other trees.

            As far as our vaunted MIC goes, i’m under no illusion that my tax payment means anything, just as financing the ongoing boondoggle makes no sense whatsoever in the overall scheme of things. If it was a business, the MIC would’ve gone Chapter 7 eons ago.

            Reply
            1. Yves Smith Post author

              Oh, come on. Are you telling me that cleaning your toilet and bathtub is because you want to? Narrowly that is correct but you imply it’s voluntary, when it is voluntary only to the extent that the alternative is to have really nasty stuff start growing. People spend something like 19 hours a week on household chores, and most people consider that to be drudgery, witness that men typically fob that off on their wives.

              Now some people do find cleaning a distraction from other work they find stressful, but they are in a minority.

              Reply
              1. Wukchumni

                They call them household chores for a good reason, and it’s something that needs to be done, or your place looks like a pigsty. That sort of work is hardly voluntary, but necessary.

                Not that far removed from trash pickup on the road, the difference being that i’m not only doing it for me, but also the community.

                Reply
  3. John Beech

    I call BS and argue the opposite. Beggaring the heirs and putting them to work for the economic contribution generated by them sullying their hands wouldn’t amount to a hill of beans. There aren’t enough rich people to notice in the grand scheme of things.

    Added to which, don’t the rich in general, have a whole flotilla of hanger-ons obsessively fleecing/pumping/extracting money from them? They’d be put out of work at the same time, right? That alone is a negative contribution to the economy, right?

    Plus a lot of the ‘wealth’ we’re talking about is handed off as a business owner to a daughter, or a landowner like a farmer, passing off his farm assets to his children. The point being most are working enterprises and facing punitive taxation, said farm, hardware store, car dealership, bank, or what not is just sold off to a more wealthy entity.

    Tell me again how this is a happy thing. Me? I find the tenor and tone of the article mean spirited.

    Reply
    1. lyman alpha blob

      You may be correct that the tax revenue generated by the labor of those involuntarily cured of their affluenza would be minimal. It still doesn’t follow that the rich should be allowed to escape inheritance taxes. Inequality is killing our entire society and the overwhelming majority of those who believe they’ll be super rich someday too are spectacularly wrong.

      Also, the idea that inheritance taxes would take away the family farm has been debunked over and over and over again.

      Reply
    2. Todde

      Beggering the heirs

      The heirs will be fine.

      Nobody loses their business from.the estate tax.

      You might have to spin off the Dodgers if youre rich enough but that didnt beggar amybody.

      Reply
    3. Odysseus

      You’re allowed to give $15k/yr to anyone. That anyone includes each of your children. That’s a significant fraction of the median annual personal income in the United States.

      Start now, and that family business will stay a family business for a very long time.

      https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes

      How many annual exclusions are available?
      The annual exclusion applies to gifts to each donee. In other words, if you give each of your children $11,000 in 2002-2005, $12,000 in 2006-2008, $13,000 in 2009-2012 and $14,000 on or after January 1, 2013, the annual exclusion applies to each gift. The annual exclusion for 2014, 2015, 2016 and 2017 is $14,000. For 2018 and 2019, the annual exclusion is $15,000.

      What if my spouse and I want to give away property that we own together?
      You are each entitled to the annual exclusion amount on the gift. Together, you can give $22,000 to each donee (2002-2005) or $24,000 (2006-2008), $26,000 (2009-2012) and $28,000 on or after January 1, 2013 (including 2014, 2015, 2016 and 2017). In 2018 and 2019, the total for you and your spouse is $30,000.

      Reply
    4. Yves Smith Post author

      Help me. Go look at the difference between median wealth and average wealth. That alone is proof of how significant the wealth held by the top cohort is.

      The point is that there isn’t a loss in taxing inheritances. The state gets revenues from that and the heirs also wind up working more than they would otherwise.

      Reply
  4. Watt4Bob

    The point of taxing the rich has more to do with preventing them from having enough money to purchase our government, not the notion that their wealth is ‘immoral’.

    The inevitable result of the present level of wealth inequality is, and has always been the ability to freeze ‘We the People’ out of being able to influence our government.

    Our current situation is that we have no influence with Washington because they’re in the pocket of their donors.

    Does the phrase “taxation without representation” ring a bell?

    Reply
    1. JBird4049

      The inevitable result of the present level of wealth inequality is, and has always been the ability to freeze ‘We the People’ out of being able to influence our government.

      That’s kinda the reason whole reason for and endgame of a very large part of the Earth’s 0.001% and of those who aspire to be their local community’s wealthiest. Too many equate wealth with superiority and superiority with the right to have power over others. It’s whacked and not everyone of any class believes that. Not even all the wealthiest 0.001% but too many do and their money gives them vast resources and very real power.

      Reply
  5. tiebie66

    Taxes are a problem. Nobody likes to have money taken away from them – earned or not. I believe a very small transaction tax on every transfer from one account to another is the best way to go about it. The poor do few transactions/transfers and will pay a negligible amount. The rich that do nothing with their money will also pay very little. But money under the mattress is of little use, its main use arises when its put into circulation and that will excite a tax. Those that are economically most ‘active’ will pay the most in taxes. A transaction tax will also reduce churn, high frequency trading, and plenty of accounting shenanigans.

    Also, why cannot states/provinces and local governments issue currency? Perhaps coordinated by a central authority? Should endogenous money creation not be shifted from banks to governments of all levels?

    Reply
  6. J C Bennett

    US Constitution, Article I, Section 10:

    No State shall . . . make any Thing but gold and silver Coin a Tender in Payment of Debts . . .

    (This was posted in response to a comment that apparently has been removed.)

    Reply

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