It’s obvious: “Estate taxes are really a tax on death; they’re wrong and unfair.”
There are three claims in this statement: 1) estate taxes are a tax on death; 2) estate taxes are a form of double taxation; and 3) estate taxes are unfair. Let’s review these claims in order.
Estate taxes are not a tax on death. This mistake is simply a category mistake: the claimants have categorized “death” improperly. There are two kinds of taxes: taxes on assets and taxes on transactions. Asset taxes consist of real property or real estate taxes. Asset owners pay a tax that is based on the assessed market value of the asset to the taxing authority. Transaction taxes consist of taxes paid on an economic transaction, including monetary and barter transactions.
The death of a person is neither an asset nor a transaction. To speak of “death taxes” in the United States is to talk about nothing. So, what are estate taxes? Estate taxes are not an asset tax; the estate is not taxed on its value. If this claim surprises you, keep reading. Estate taxes are taxes on a transaction—the transfer of ownership assets from one person to another on the death of one of the parties to the transaction. Your heirs won’t be taxed because you died; they’ll be taxed on the incremental value of the assets you gave them (called a “bequest” instead of a “gift” in this special case of giving). To the heir, this bequest constitutes income. This distinction is crucial. To the deceased, the estate is an asset, but, to the heir, the estate is income, whether it’s a gift, a bequest, lottery winnings, other gambling winnings, ill-gotten gains (robbed a bank, for example) or payment for work.
Why is this difference crucial to understanding the nature of inheritance or estate taxes? By the way, the phrase, “inheritance tax” is the only accurate phrase of the three I’ve used so far. A tax on a bequest to an heir is, in fact, a tax on the heir’s inheritance rather than a tax on the deceased’s estate. This fact about the nature of the asset and the nature of the transaction is crucial to understanding the exact nature of its taxation. Heirs inherit the estates of their benefactors. This inheritance has a determinable value to the heir as income to the heir. This inheritance is not income to the deceased. Therefore, the federal government taxes it as income to the heir. Is it capital gains to the heir? No, the heir didn’t buy the asset, then, sell it to another party. Before the transaction, did the heir own it; was it one of his assets? No. Has this income been taxed before? No.
Here is where the case for double taxation is made. The owner of the estate bought the assets of which the estate consists with, presumably, after-tax income. Value accrued to these assets before the owner died. Since the owner paid taxes on a cash basis, he paid taxes on this accrued value increment as he sold assets at a profit during his lifetime; he probably paid them at the reduced capital gains rate rather than as income from productive labor. In addition, the inheritance tax is calculated on the basis of the gain in asset value to the dead guy, not to the total income to the heir. Therefore, the taxes paid on the transfer to the heir are the first taxes paid on this gain, not the second. During the presidency of G. W. Bush, the first $5,000,000 of inheritance income was exempted from any taxation whatsoever. Thus, up to $5,000,000 of asset value accumulation was never taxed originally and will never be taxed during the heir’s life.
This situation is patently unfair to wage and salary earners, if by fair, we mean that a productive worker should be paid most of the value of his labor, then, this notion of fairness doesn’t apply to estate taxes. The earner is dead; the heir has done nothing to earn this money. If by fair, we mean something else, then, what do we mean? Do we mean, “Earned by my ancestor?” Do we mean, “Acquired by my grandfather, value added by some combination of work and good luck and given to me?” Do we mean, “started by my dad, who taught me how to run the business and left it to me?” I doubt that any of these alternative senses of fairness are held by any but those who are or are likely to be heirs of substantial inheritances.
The absence of inheritance taxes is an egregious flaw in our tax code. Whereas, the ability to accumulate wealth and leave it to one’s descendants is an incentive for productive behavior, bequeathing an inheritance doesn’t stimulate productivity in our descendants. I could argue easily that leaving a substantial inheritance to one’s children is, especially for them, counterproductive to their becoming productive in the way that we were. Warren Buffett and Bill Gates understand this point. Why don’t those who want to eliminate the inheritance tax from the tax code? Warren Buffett and Bill Gates understand, too, that there is nothing “fair” about the current inheritance tax code.