The vanishing bequest tax

Bequest tax revenues have been constantly declining in all OECD countries for at least seventy years. Recent policy debate and legislative proposals, in countries such as the US, the UK, France, and Italy, are signaling a further acceleration of the decline of this tax. As I have argued in recent editorials in vox and la voce, this fact is at first glance puzzling, since the bequest tax is a highly progressive, perhaps the most progressive, fiscal policy tool, and this comes at a time when data about inequality confirm not only that wealth concentration is much higher than income concentration, but also that intergenerational transmission is a crucial explanation of the persistence of inequality.

So what can explain the long-term decline of the bequest tax? An answer can come from historical evidence, recently assembled on the basis of inheritance tax returns (and collected by Atkinson and Piketty), showing that top wealth shares have decreased dramatically during the twentieth century.

I combine the evidence on wealth equalization with that on bequest tax reduction within a simple politico-economic model where a tax is imposed on bequests in order to finance redistributive transfers. Under majority voting, the tax rate is selected by the median voter and increases with the difference between his wealth and average wealth, since it is this difference that determines the size of his net transfer. I embed this mechanism in a dynamic framework tracking economic development, where labor income plays an equalizing role and induces a decline in wealth concentration. What I obtain is a sequence of declining tax rates that matches the evidence. To be noticed is that even if in practice in most countries only the very wealthy pay the bequest tax, in my model and in the real world alike the median voter still has a stake in determining its level, since he can gain from the redistribution scheme the tax finances.

Figure 1 shows the evolution of bequest tax revenues over total tax revenues for Italy, the UK, and the US over the century starting in 1860. In the UK, the share of bequest tax revenues over total taxes reaches a high point of over 18% in 1910, drops sharply as a consequence of World War I and, following a temporary recovery, continuously decreases after 1930. The US are late-comers in the application of the bequest tax and they never collect more than 5% out of it. The data for Italy indicate a relatively stable, albeit moderate, role of the inheritance tax. The data confirm a descending trend, as previously discussed, but also reveal an initial increase. Despite cross-country differences in the timing of the turning point, the long-term evolution of bequest taxation thus appears to be humped-shaped. image002_400_03.jpg However, the initial expansion of revenues is not inconsistent with the previously outlined story, since it can be explained by the contemporaneous gradual extension of the voting franchise, which allowed the poor to voice their preferences for more redistribution. The universal male franchise was in fact enacted in these countries by 1920, even though in the US South it was not enforced until 1964.

The figure also points to significant cross-country differences in the level and in the speed of adjustment of revenues over time, which cannot be accounted for by wealth inequality alone. A possible explanation rests on differential rates of avoidance and evasion of the tax, combined with an evolution of wealth composition at differential rates. Tax collection is costly, so voters set a lower tax rate whenever larger avoidance is accounted for, since the redistributive impact of a given rate is diluted. Moreover, a country’s wealth can be divided into financial assets and tangible assets, such as land and housing. For the latter, it is notoriously harder to avoid taxes. Industrialization induces a reallocation from agriculture to manufacturing and shifts the tax base from hard-to-avoid tangible assets toward easy-to-avoid financial assets. The larger is inequality in financial assets, the larger is the reduction of the tax due to tax avoidance. At the same time, the fiscal asymmetry delays the reduction of the tax due to wealth equalization, especially when the tax base is disproportionately represented by those components of wealth, such as land, whose distribution tends to be relatively unequal and stable. To sum up, higher avoidance together with fiscal asymmetries makes the tax rate lower, but also makes its reduction more sluggish. These considerations can explain why in the US and in the UK, where tax compliance is over 70%, revenues have reached relatively high levels followed by a sharp decline, while in Italy, with tax compliance below 30%, revenues have always been low but relatively stable throughout.

Landed property is now a marginal component of aggregate wealth. However, the distinction between wealth components and their fiscal asymmetry can still help to explain the crucial role of housing in household portfolios and in the determination of the tax rate. Housing, as a share of wealth, is particularly large for the middle class, since the poor are liquidity constrained and cannot afford to buy a house, while for the rich residential investment only needs to absorb a fraction of total wealth. In other words, for housing wealth the median is much closer to the mean than for total wealth, which implies that the median voter tends to select a lower tax rate, especially when housing is hit harder by the tax. This is one more reason to expect from voters a reduction of bequest taxation.

These considerations have a purely descriptive, as opposed to normative, purpose. The simple conclusion is that in a democracy where the bequest tax level is selected by voters, in the face of continuing wealth equalization and a shift of wealth composition toward even harder-to-trace financial instruments, we can only expect for the tax a further decline.