The Incidental Economist

The first romp was a post on estate tax economics that reviewed an NBER paper by Wojciech Kopczuk. In this post I review one by Louis Kaplow, which begins with the familiar idea that every type of tax imposes some distortion: tax discourages the thing upon which it is levied. With different modes of taxation available–income tax, estate tax, value-added tax, etc.–a goal is to achieve a redistributional end with minimal distortion.

The notion of externalities plays a role in tax theory, as it does in many areas of economics. The overproduction (underproduction) of things with negative (positive) externalities is a welfare loss. Hence Pigovian taxes and subsidies can be welfare improving and the distributive consequences can be remedied through the income tax. The combination is a pure correction of the externality. The welfare gains of the correction can be distributed to make everyone better off. Notice that this combination of tax changes is revenue (and distribution) neutral. From this perspective, the revenue effects of transfer taxation–the very aspect Kopczuk thought most important–are irrelevant. (All this assumes changes to the income tax don’t impose a different set of undesirable externalities and disincentives, which probably isn’t fair to ignore.)

<Press the pause button.> In two short paragraphs I’ve summarized six pages (roughly 25%) of Kaplow’s paper. At this point I thought, “Oh, come on! Such rarefied tinkering with the tax system isn’t really possible is it?!?” Well, to Kaplow’s credit he read my mind (anti-causally!) and writes, “The foregoing discussion is obviously Panglossian, naive, or . . . choose your preferred adjective. No suggestion is made that reality operates so predictably or efficiently.” (I had to look up Panglossian. Plus, note Kaplow’s humor! Also, all quotes © 2010 by Louis Kaplow.) Nevertheless, Kaplow points to the 1986 and 1993 U.S. tax reforms that implemented changes in the spirit of what he sketched out. We’re talking theory here so let’s give Kaplow some slack. <Press play.>

Next Kaplow turns to transfer taxation. As did Kopczuk, he considers the externalities of transfers. He claims that there are positive externalities in the form of donee benefits. That is, the donor is not compensated for the benefits experienced by the donee. This argues for gift subsidization. (I did get a vague sense of double counting and Kaplow points to a paper by Peter Diamond in which that claim is made.)

On the other hand, to the extent that the donee, now wealthier by the amount of the gift, substitutes leisure for work there is a negative externality on the treasury: lost tax revenue. (I guess we are to ignore the fact that the donor will or did substitute leisure for work in order to save the sum that is gifted. So didn’t the treasury “get theirs” already? Hmm…) Kaplow goes on to describe a few other sources of negative externalities that I covered in my review of Kopczuk’s paper.

Given all the above, and particularly since tax changes can be made revenue and distribution neutral, the essential question is how to tax most efficiently (i.e. how to maximally internalize externalities), making use of all available taxation modes. In the specific case of transfers, it is possible that externalities exist at all levels of wealth (e.g. the positive externality on donees and the negative one on the treasury). Should transfers be taxed (or subsidized) at all levels?

In the final part of his paper, Kaplow discusses a few other considerations such as: transfer motives (covered in my review of Kopczuk’s paper); the fact that the most inter-generational transfers are in the form of human capital (how ought that be folded into the analysis?); the inequality of starting points brought about in large part by differences in human capital inheritance; the effect of transfer taxation on savings incentives (which can be augmented by adjusting taxation of capital gains); and charitable contributions (transfers from individuals to charitable entities outside the family are also significant).

As in my reading of Kopczuk’s paper, at the end of Kaplow’s I was left feeling like I’d missed the forest for the trees. There are clearly a lot of important considerations in transfer (or any) taxation. But they can’t be fully understood in isolation. For revenue and distributional neutrality to hold, increasing tax via mode A requires decreasing it via mode B and vice versa (more complicated still, the multiplicity of taxation modes is potentially unlimited). Given this, the absolute value and sign of externalities that arise via tax mode A don’t matter except relative to those that arise via mode B. Neither Kopczuk nor Kaplow provided in their papers a comprehensive theory within which to make a full analysis across all externalities of all modes. (This is not a critique of the papers as that’s not what they were about. I just yearn for more and will keep reading as I find relevant material.)

On the other hand, such a theory seems like it would be almost hopelessly … well … theoretical. There are practical limitations of knowledge and tax collection, not to mention an explosion of heterogeneity, that would seem to reduce the applicability of much of the theory, if it exists. To his credit, Kaplow acknowledges what I yearn for, both on the theoretical and empirical fronts.

In all, a more complete analysis of optimal taxation as a whole (that is, both income taxation and transfer taxation) would be a daunting task—one that, with regard to many of the factors highlighted here, has not really been attempted.

… There is much empirical work to be done if the many open questions are to be resolved. Moreover, the present analysis suggests that the pertinent list of empirical questions is rather different from those that have received the most attention to date.

OK then. Good start. I eagerly await the sequel.

Addendum: I confess to not having read the very long footnotes that accompany the body of Kaplow’s paper. However, I did notice that he references his book on taxation theory. See his website for details.

I’m not the least bit surprised that there are economic theories that specifically address estate taxation. But I was not the least bit aware of them until I read the recent NBER paper by Wojciech Kopczuk that “provides a non-technical overview of the economic arguments related to the desirability of transfer taxation and a summary of empirical evidence surrounding these issues.” (All quotations © 2010 by Wojciech Kopczuk.)

Kopczuk begins with a review and commentary of the literature on the bequest motive. He notes that altruism cannot fully explain inter-generational transfers as tests of that hypothesis are generally rejected.

It should also be pointed out that from the point of view of the optimal policy, altruistic preferences introduce a reason to subsidize rather than tax transfers and hence do not provide an argument for estate taxation that is observed in practice.

Continuing, Kopczuk finds that strategic or exchange-based motivations are also not compelling. Moreover, they do not suggest whether taxation or subsidization is, in general, appropriate. Is the child under-compensated or is the parent over-paying for whatever services are offered in the exchange?

The joy-of-giving perspective in which the donor does not internalize the benefits to the donee has been a “useful way of describing behavior and is often used in practice as a positive model of bequests,” Kopczuk writes. But it argues for subsidizing, not taxing, bequests in order to internalize their positive externality. He concludes that “while it may be a useful way of describing behavior, paradoxical implications of this theory highlight that it is not an appealing approach for thinking about welfare.”

Kopczuk also reviews theories based on the notions of accidental bequests (that the donor over-saved for other purposes, like retirement), wealth accumulation (that the building of family wealth is desirable for its own sake), and that bequests are a function of psychological biases or mistakes. His review of bequest motive theories concludes with the idea that likely more than one motive exists. This heterogeneity makes for difficult ground upon which to obtain a rational policy stance.

The paper pivots on a passage in which Kopczuk rejects a welfare-based approach to estate taxation. Instead, he finds the revenue implications to be paramount.

Yet, as discussed above, interpersonal externalities …  call for subsidizing rather than taxing gifts. … Subsidizing gifts may well make sense for much of the public but this kind of externality should go away when we get to the top of the distribution: the marginal utility of income (or wealth) of both parents and children is low and hence the relevance of correcting bequest externalities is negligible. … [T]he precise nature of a bequest motive is relevant only in so far as its welfare implications are relevant and at the top of the distribution they are not. What is relevant are revenue implications of taxing bequests, but this is an empirical question rather than theoretical one.

Kopczuk then argues that estate taxation has different effects than income taxation because individuals may differ with respect to wealth and income for different reasons. That is, differences in income largely reflect differences in ability to earn wages. Differences in wealth, on the other hand, may reflect heterogeneity in other dimensions, like entrepreneurial skill or even luck. Thus an estate tax exerts different distortionary pressures than income tax. It is not a redundant mode of taxation.

What, then, justifies estate (or, for that matter, income) taxation? Kopczuk attempts to address this question by suggesting there are negative externalities of wealth concentration. He points to three negative externality candidates: (1) Some of the worst governed countries are also home to the highest concentrations of wealth; (2) Excess wealth can permit some individuals to dominate the state, potentially threatening democracy; (3) Retaining family control of a business prevents others possibly better equipped to run it from doing so. However, he admits that, “[d]etermining whether such externalities exist is an ongoing research issue.”

Finally, Kopczuk discusses what is known about the effects of estate taxation.

[I]t appears likely that both wealth accumulation and avoidance are responsive to tax considerations with neither of these effects being very large, but the bulk of response working along avoidance margin. … If indeed wealth accumulation is not too responsive to tax incentives, then arguments related to undesirability of capital taxation do not apply in this context.

In conclusion, Kopczuk has certainly provided an accessible review of estate tax economics, though I cannot judge its accuracy or thoroughness. In general, he is either not impressed with the literature (e.g., he finds welfare economics and the bequest motive irrelevant) or finds it insufficient (e.g., not enough is known about externalities).

It seems to me one cannot reason about estate taxation without simultaneously reasoning about income taxation, or other forms (like value added taxation). As Kopczuk pointed out, the taxation modes are different. For a constant level of desired government revenue, if one advocates more or less of one mode of taxation, it necessarily means commensurately less or more of another. Therefore, an argument about one can’t be sustained without knowing a considerable amount about the other, which I do not. (Educated readers, feel free to suggest papers.)

This is the second post in a two-post series on estate planning. In the first post I nearly covered the entire topic by cheating: I reviewed Plan Your Estate by Denis Clifford (Nolo, 2008). In this post I cover an important problem not addressed by Clifford: How would your survivors know where your assets are held, why they’re organized as they are, and how to handle them? This is a topic about which I’ve given a great deal of thought, as have others (for instance, on the blogs Bible Money Maters and Gather Little by Little). Below I describe my approach, some of which is of my own creation (though, no doubt, contemplated by others too). Some details were suggested to me by contributors to the Bogleheads Investment Forum.

For several years I’ve maintained a financial information list of every account or institution that has anything to do with my household’s finances. There is an entry in the list for all financial benefits associated with my employment (including retirement accounts and pension benefits), our attorneys (real estate and estate planning), all credit cards, utilities (phone, internet, water, gas, and electric), loans (mortgage and auto), all types of insurance, bank and investment accounts, and anything else that has to do with money.

Each entry in the financial information list includes details so my survivors can easily learn more about the institution or investment: institution name, account numbers, phone number, and web site. I also indicate how the organization communicates with me (whether by mail with paper statements or electronically). If the account draws on or deposits into some other account I also indicate the amount (or approximation thereof) and frequency of the transactions. For accounts with online access I list my user ID, but not my password (that’s the only bit of information I communicate only verbally).

Apart from a source of information for my survivors, this list is very handy for me. Every so often I need to look up an account number or contact information. Instead of digging through my files I can just pull out the financial information list.

With such a list, any of my survivors could see the structure of my household’s finances and find our assets. But that alone is not enough. Would my wife or children know what to do with the assets they inherit? Since I’m the only member of my nuclear family interested in personal finance nobody else knows very much how to manage the portfolio. Therefore, the second component of the information I leave for my survivors is a letter.

The letter explains how my survivors might go about educating themselves about our finances. It indicates where to find all important documents. It also explains that the way I manage things may not be suitable for them. I make a few suggestions as to how to simplify the portfolio. I recommend certain people they might talk to. I suggest they ask questions on the Bogleheads Investment Forum. I have not yet gone so far as to line up a financial adviser of some sort but one day I may do that. Without this letter as guidance I am not confident my survivors would know how to begin to deal with our investments. That’s why I wrote it. (Your situation may be different. If your spouse and/or children are investment savvy then you don’t have this problem.)

The final step is to put all this information in a place where my survivors will find it. That’s easy (for me). Our estate planning attorney keeps our original wills in his fire-proof filing cabinet/safe. I’ve given him a sealed envelope that includes the financial information list and the letter. I wrote on the envelop that it is to be opened by the executor of my will. The letter also indicates where else to look for a more recent version, just in case I pass before providing an update to our attorney.

I know first (well, really, second) hand how challenging it is to unwind a deceased family member’s estate. My maternal grandfather had an exceedingly simple estate. Yet it was still quite a headache for my mother to find all the pieces and to dispose of them properly. Had my grandfather made a list and written a letter of the type I just described it would have been simpler for my mother. It is so easy to do and, as I said, the master list of financial information can be of use in life, if not in death.

This is the first of two posts on estate planning. Can I really cover the topic of estate planning in two posts? No, but I can cheat by using this first post to review an estate planning book: Plan Your Estate by Denis Clifford (Nolo, 2008). In the second post I will discuss how to organize information so your survivors can manage your finances, a topic about which I’ve given a great deal of thought.

Plan Your Estate is the second Nolo book I’ve read; the other is Home Business Tax Deductions by Stephen Fishman (Nolo, 2008). Since I found both books well written, insightful, well organized, and helpful, I’m willing to go out on a limb and recommend Nolo books in general. Nolo is clearly doing something right.

Plan Your Estate covers some of the fundamental estate planning goals: leaving property, providing for children, planning for incapacity, avoiding probate, and reducing estate taxes. The book is divided into twelve parts, each of which has several roughly 10-page chapters. Not everyone will be interested in all parts. The first part, “Setting Your Goals” is applicable to all readers since it helps the reader figure out which other parts of the book are relevant. Unless you are a high-net worth individual and/or have complex inheritance issues, it is unlikely you will need to read the entire book. The second part also deals with necessary preliminary issues like assessing your net worth, how to determine ownership within a marriage, and considerations relevant to deciding what to leave to whom.

Part three is relevant to individuals with children. There are special considerations for minors: who will care for them? Who will manage property you leave them until they reach the age at which you wish to give them control?

Parts four through six are likely relevant to everyone. They cover wills, probate, and gift and estate taxes. While it is theoretically possible to transfer most or all of one’s property without a will, it is likely something will be overlooked. A will serves as a backup device that transfers anything not handled by other means. Also, in most states a will is the only way to name a personal guardian for minor children. Unfortunately, property transferred by will must go through probate, which can take more time and cost more money than you would think necessary (since instructions are written in the will, after all).

Discussing probate, and how to avoid it, is where Plan Your Estate really shines. Clifford, an estate planning lawyer, detests the costly and complex probate process. He essentially thinks it still exists in the U.S. because of the income it provides to probate attorneys. Clifford writes

Lawyers’ assurances that probate is necessary sound increasingly hollow. Even the British eliminated tedious, expensive probate proceedings over half a century ago…In most countries in Western Europe probate is even simpler…Upon death, the deceased person’s successor named in the will performs the probate functions without any judicial supervision. If there are disputes…they are handled like any other legal conflict.

Not so in the U.S. That is why Clifford goes to great lengths to describe how to keep one’s assets from going through probate. He carefully explains the various legal methods to implement what most people think a will does (or should do), but actually does not: transfer property as designated without delays, red tape, and unnecessary legal fees.

Clifford also gnashes his teeth over planning to deal with estate taxes, which Congress has turned into a headache: in 2009 the personal exemption is $3.5 million, in 2010 it is infinite, in 2011 and beyond it drops to $1 million (under current law). Congress is likely to revisit the issue so no one really knows what the future exemption values will be. This uncertainty and the fact that the exemption varies by year of death dramatically over the next few years makes estate planning more difficult.

The remainder of the book goes into methods of varying complexity to handle the issues raised in the first six parts, as summarized above. I won’t review them here as they require more space than a blog post allows. Suffice it to say that one or more of these subsequent parts should be read by anyone with young children, or having high net-worth (at or near the estate tax exemption level), or wishing to impose some control over property, or wishing to permit one set of individuals to benefit from property and its income while leaving that property to another set of individuals, or owning a family business, or any other unusual or special desire for disposition of property.

I recommend Plan Your Estate to those who have not yet thoroughly completed an estate plan. Even if you employ a lawyer to implement an estate plan, you will benefit tremendously from reading this book before implementation (best), during the process (second best), or even after establishing a plan (not ideal but still worthwhile). It will help you understand your lawyer’s recommendations and how the various legal instruments work. Most of us will be revising our estate plan as we age and Plan Your Estate can help us see what’s ahead and decide when to make adjustments. For instance, an estate plan for a young, low-net worth couple with no children should differ from one for a couple with young children or from one for a high-net worth couple with grown children.

What Plan Your Estate does not cover is how one might communicate to one’s survivors the state and structure of family finances. If you are the sole financial planner and manager for your family (as I am), think for a moment what your spouse, partner, or children will encounter upon your death. Do they have any map or guidance to figure out where assets are held, how they relate, and what should be done with them? The next post on estate planning will address this issue.