Trapped by Taxation: How Inheritance Tax Impedes Economic Mobility
David Zhan Zou // 29 June 2023
Equality of opportunity is a key foundational principle of liberalism. The most widely accepted definition of equality of opportunity among liberals is the absence of systematic barriers, such as legal discrimination, which hinder individuals from achieving their life goals. A pertinent question then arises: does being born into a wealthy family, as opposed to a poor one, constitute a systematic barrier?
Friedman takes a firm stance on this debate. He argues that being born with a large endowment of money and properties is no different from being gifted at birth with a precious voice and talent for singing. If rewarding an individual with a lucrative income for their inherent talent as a singer is deemed acceptable, then inheriting a profitable business from deceased family members should be viewed similarly. However, in mainstream political discourse, inherited wealth is often perceived as a threat to equality of opportunity. From a purely meritocratic perspective, this viewpoint is logical. It is not a secret that having parents with deep pockets can be a boost in many life endeavours, including education and entrepreneurship. Consequently, this serves as a compelling argument in favour of implementing a substantial inheritance tax.
At any rate, both perspectives share the view that society should strive for high wealth mobility. This implies that there should be no arbitrary barriers preventing entrepreneurs starting from a humble garage from becoming self-made billionaires, nor should there be any objection to irresponsible heirs squandering their millionaire fortunes through gambling in casinos. Therefore, if an inheritance tax can enhance a society’s wealth mobility, even Friedman might recognise its beneficial effects despite ethical concerns. Conversely, if such a policy were to unintentionally impede social mobility, proponents of meritocracy should be the first to oppose it. In short, evaluations of a policy should not be based solely on its motivation and intentions, but rather on its effectiveness.
Scientific research on the effects of the inheritance tax is limited due to data and identification issues. However, Spain’s inheritance tax exhibits a unique structure wherein each autonomous community has full discretion to determine its own tax benefits, creating an ideal environment for what researchers refer to as “quasi-experimental evidence”. Essentially, assuming that there are no inherent systemic disparities between autonomous communities that cannot be controlled using measurable data, variations in wealth inequality and mobility across these communities can be attributed to differences in their inheritance tax policies.
A recent study has revealed the striking adverse effects of a succession tax on social mobility among the lower-wealth segment in Spain. The study found that individuals in the bottom half of the wealth distribution are up to 33% less likely to advance in wealth after receiving an inheritance. This effect becomes more pronounced as the heir’s position in the wealth distribution decreases. Specifically, among the bottom 10%, this figure increases up to 76%. Moreover, these effects persist for up to six years following the receipt of the inheritance. Meanwhile, no statistically significant evidence was found to indicate similar trends among the upper echelons of the wealth distribution.
The lower 40% of the wealth ladder, on average, receive successions that are six times their net wealth and 86 times their liquid assets. This significant ratio is typically not a result of large inheritances but rather reflects extremely low asset ownership among heirs. Although this may initially appear beneficial in terms of increasing the wealth of the less privileged, it is important to consider certain factors. Inheritances are generally illiquid, while those in the lower deciles of the wealth ladder typically face liquidity constraints, meaning that they face difficulties raising short term cash. Common inheritance components include dwellings and business ownership, which take time to be sold or generate returns. This presents two main issues for liquidity constrained households. Firstly, many heirs lack the resources to pay the tax upfront, leading to a significant number of them waiving their inheritance altogether. Secondly, those who do inherit often experience additional liquidity shocks in the form of liabilities or a lack of savings after paying taxes. The need to resort to leverage to finance taxes among lower-wealth individuals results in a 9-12% decrease in their overall wealth for each additional percentage increase in the succession tax. The wealthy, on the other hand, have access to a plethora of financial tools to raise cash in the short term. Ultimately, this leads to remarkably disparate costs and benefits from inheriting between the rich and the poor.
While the existing economic literature suggests that estate taxes have had a net positive effect in reducing wealth inequality, policymakers must also take into account new evidence on their impact on mobility, as seen in Spain. One modest proposal could involve reforming the tax to alleviate the burden on households facing liquidity constraints, possibly by considering their net assets. However, the idea of abolishing the inheritance tax is not as radical as it may seem. Norway and Sweden are exceptions in Europe, as they do not levy any estate, inheritance, or gift tax. Moreover, countries such as Australia, New Zealand, and Canada also operate without this tax and still maintain highly functional economies with remarkable wealth mobility. Furthermore, it is worth noting that tax collection from inheritance taxes is largely symbolic in many European countries. For instance, the Erbschaftsteuer accounts for only 0.8% of Germany’s total tax revenue, the Impuesto de Sucesiones finances just 0.24% of Spain’s public spending, and the Italian treasury barely receives a few million euros each year from their inheritance tax.
In light of everything, inheritance taxes appear to be too controversial despite their limited benefits. Instead, alternative policies aimed at reducing wealth inequality, which may enjoy greater public acceptance, can be implemented to replace the inheritance tax without causing such disproportionate burdens on the financially disadvantaged.
EPICENTER publications and contributions from our member think tanks are designed to promote the discussion of economic issues and the role of markets in solving economic and social problems. As with all EPICENTER publications, the views expressed here are those of the author and not EPICENTER or its member think tanks (which have no corporate view).