Memo to Donald Trump: Here's how to make the 'death tax' fair for everybody

We wrote last week about the absurdity of Donald Trump’s proposal to repeal the estate tax — excuse us, the “death tax,” as it’s dubbed by critics who think it’s better to fool people via linguistics than by making substantive arguments.

We weren’t alone. Figuring out how to make wealth taxes more equitable and serve the public’s interest in diluting the concentration of inherited wealth has occupied numerous economists and tax experts in recent years. Tax expert David Kamin of New York University School of Law has drawn on many of these in a new paper for the Washington Center for Equitable Growth. 

Kamin broadened the discussion to cover all the ways the American system for taxing capital is broken, including the corporate tax system and capital gains taxes. Since candidate Trump asserted last week in his economic policy speech that he wants to make the U.S. tax system fairer, he should give Kamin’s study a good read.

Inevitably, some proposals in this field are going to hit wealthier taxpayers harder than the middle- and working-class; that’s a by-product of their disproportionate reliance on income that carries preferential tax rates.

“Income that comes from capital or mixed capital and labor is highly concentrated at the top of the income scale,” Kamin told us. It’s also generally taxed at a lower rate than wage income, and can be manipulated to be exempt from any taxation permanently.

Let’s take a look at some of Kamin’s recommendations. 

First, capital gains. Income from capital is notoriously subject to gaming. For one thing, as Kamin notes, it can be hard to distinguish between capital and labor income. Because the tax on capital is lower than that on labor, sophisticated taxpayers employ all sorts of stratagems, cooked up by well-paid advisors, to make the latter look like the former. 

Income from capital gains is not only taxed less — the top capital gains tax is 23.8%, while the top rate on ordinary income is 39.6% — but it can be indefinitely deferred. Since stock or other capital assets are only taxed when they’re sold, the time value of money means that the longer one holds the asset, the greater the value of the deferral. This is a collateral benefit of the capital gains tax system, but it has no economic rationale.

“There's no good reason for the tax system to subsidize the length of time you hold your asset,” Kamin says. The incentive builds to hold on to the asset as long as possible. 

That’s especially so because of the infamous step-up in basis at death. Put simply, the capital gains tax liability embedded in long-held stock or other assets is wiped out when it’s bequeathed to an heir. The stock is simply repriced at its value as of the inheritance, and no one pays the old tax, which is why tax expert Ed Kleinbard of USC calls the capital gains tax America’s only truly voluntary tax.

Kamin says these factors reduce economic efficiency through the “lock-in” effect — the tax system encourages investors to hold their investments longer than they should, just for tax purposes. He would eliminate the step-up entirely, and would also favor annual taxation of capital gains on a mark-to-market basis: investors would pay based on the appreciation of their holdings each year, whether they sold or not. That would work best for publicly-traded assets, such as stock in public companies; for privately-valued assets, he likes a deferral charge to be paid when the assets are sold, based on how long they were owned.

Tax experts have toyed with various ways to deal with some obvious challenges in such a system, including the inherent volatility of stocks — once you’ve paid tax on a year’s appreciation, what happens if the stock goes south? And how do you distinguish between capital gains that come from real appreciation versus what comes from inflation. None of these issues is insurmountable, however — if the political will exists to change.

That brings us to the estate tax. This isn’t entirely separate from capital gains taxation, since the wealthy taxpayers who pay almost all of the estate tax also have an immense portion of their wealth in capital assets. But the concentration of heritable wealth in few hands is a phenomenon that disturbed the founding fathers. Benjamin Franklin wanted the Pennsylvania constitution to declare that concentrated inherited wealth was "a danger to the happiness of mankind." 

Yet the estate tax has been consistently pared down to the point that it raises only about $20 billion a year, a bit more than 0.1% of gross domestic product, compared to 0.3% in the 1990s. The current rate is 40% of estates in excess of an exemption of $10.9 million per married couple. As recently as 2001, the rate was 55% on estates larger than about $1.3 million ($1.8 million in today’s dollars). The tax today is “a narrow wealth tax that raises less than it used to, is easily avoided … and is small relative to both total wealth and wealth being transferred,” Kamin writes.

Kamin favors a recommendation by his NYU colleague Lily Batchelder to turn it into a genuine inheritance tax by transferring the exemption from the decedents to the heirs. Among the virtue of this change is that it would encourage the wealthy to divide their bequests among many heirs rather than just a handful, thus reducing the total tax.  

Kamin doesn’t go as far as some economists, notably Emmanuel Saez of UC Berkeley and Thomas Piketty of the Paris School of Economics, who suggest that the proper tax rate on capital should be higher than that on labor. But he believes the capital tax rate certainly should be higher than it is now. The main goal of reforming the capital taxation system is fairness, which means making it more progressive. “Taxing capital,” he says, “is a highly progressive form of taxation,” and the signs are that we don’t do it enough.

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