One of Sarkozy’s electoral promises to the French people during his recent electoral campaign has been a drastic reduction of the inheritance tax. In a country where a wealth tax on large fortunes has been introduced as recently as 1989, this has undoubtedly been perceived as a substantial break with the past.
In Italy the inheritance tax has gone through three reforms since 2000: it was initially reduced by the then-in-power center-left government. The following year, the first legislative action undertaken by the newly-elected center-right government completely cancelled the tax for close family members. Finally, in 2006, the center-left coalition reintroduced the tax, at the reduced terms adopted in 2000.
In the UK, there has been a controversy over the proposed changes, outlined in the 2006 Finance Bill, of the tax system for lifetime trusts, which represent a channel for inheritance tax avoidance. The House of Lords repeatedly debated the inheritance tax - most recently in February 2007 - out of a concern that a fiscal instrument originally designed to be paid by the very wealthy has now come to hit primarily “middle England”.
In June 2006, a clear majority of the US Senate voted a bill for permanent repeal of the tax on inherited wealth, but the measure fell short of the 60 votes required to secure passage. This vote - which had originally been scheduled for September 2005, but had been postponed after hurricane Katrina - followed an April 2005 decision by the House to repeal the estate tax permanently. These are just the most recent developments of the debate which arose in the country after the tax-reduction package adopted in 2001, which imposed a gradual phase-out by 2010, followed by complete restoration in 2011.
These anecdotes reflect an intense legislative activity which is leading to an unprecedented wave of reforms in the way inheritance tax policy is implemented. In all cases, there is a clear pressure - and sometimes resistance - toward a general reduction of the tax. Early on, the tax was altogether abolished in Canada (in 1972), Australia (in 1977), and New Zealand (in 1992). In all OECD countries, fiscal pressure on inherited wealth has been significantly reduced in the past few decades, and revenues are now at a historical low point, both in terms of GDP and total revenues.
How can the decline of the inheritance tax be explained? It is puzzling that a policy tool that has always been employed to enhance tax progressivity is being phased out when the higher degree of concentration of wealth, if compared to income, has become a well-established stylised fact, and persuasive evidence has demonstrated that intergenerational transmission is a crucial factor in explaining the persistence of wealth inequality. The academic debate on the inheritance tax has primarily focused on the trade-off it presents between redistributive equity and savings distortion, which is hardly supported by the long-run evidence, and does not explain the decline of the tax.
Figure 1. The Top 1% Wealth Share, 1913-2000
A rationale for the evolution of inheritance tax revenues can come from recent long-term empirical evidence, based on inheritance tax returns, showing that top wealth shares have decreased dramatically during the twentieth century.
Figure 1 shows the drastic decline of the top 1% wealth share in France, the UK and the US in 1913-2000.
This pattern can be attributed to the growing role of labour income at the expense of property income.
The evidence on wealth equalisation can be related to the decline of inheritance tax revenues 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 mean wealth, since it is this difference that determines the size of his net transfer. This mechanism, when embedded in a dynamic model tracking economic development, where labour income plays an equalising role and induces a decline in wealth concentration, implies a sequence of declining tax rates selected by the median voter.
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Figure 2 shows the evolution of inheritance tax revenues over total tax revenues for Italy, the UK, and the US over the century starting in 1860. Figure 3 does the same for inheritance tax revenues over GDP, from 1870. The data confirm, from some point on, the descending trend previously outlined and replicated by the politico-economic mechanism, but also reveal an initial increase. In the UK, the share of inheritance 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 inheritance tax: in this country, its share of total revenues is never larger than 5%, while its still relatively high share of GDP in 1970, at 0.35, is quickly followed by a sharp decline reaching 0.15 in 1985. The data for Italy indicate a relatively stable, albeit moderate, role of the inheritance tax. Despite cross-country differences in the timing of the turning point, the long-term evolution of inheritance taxation thus appears to be humped-shaped. However, the initial expansion of revenues is not inconsistent with the previously described framework, 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 figures also point to significant cross-country differences in the level and in the variability 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 the evolution of the tax base brought about by the process of development.
Assume that a country’s wealth can be divided into financial assets and tangible assets such as land and housing, and that the two components of wealth are subject to a fiscal asymmetry, with taxes on tangibles being harder to avoid than taxes on the latter. Indeed real estate is much harder to hide or move to a tax haven than financial wealth, and the perception that different assets are hit by the inheritance tax in a particularly distortive fashion has always been keen in the policy debate. In this expanded framework, the development process induces a reallocation from agriculture to manufacturing and shifts the tax base from hard-to-avoid taxes on tangible assets toward easy-to-avoid taxes on financial assets. The fiscal asymmetry interferes with the politico-economic mechanism, making the level of the tax decrease in avoidance. Intuitively, since tax collection is costly, voters set a lower tax rate when avoidance is accounted for, since the redistributive impact of a given rate is diluted. Moreover, the fiscal asymmetry delays the reduction of the tax due to wealth equalisation, 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 - in combination with an asymmetry between easy- and hard-to-tax assets - makes the tax rate lower but also makes its reduction more sluggish. The effect is stronger in an earlier development stage, when agriculture and land still predominate. These considerations can explain why in the US and in the UK, where avoidance is low, revenues have reached relatively high levels, then followed by a sharp decline. On the other hand in Italy, which is characterised by larger avoidance and also by a larger agricultural sector, 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. The recent boom in the housing market has further distorted wealth composition and may therefore explain the current wave of reform proposals.
To sum up, wealth equalisation and the shift of wealth composition toward harder-to-trace financial instruments both push toward further reduction of the inheritance tax, as the expression of a politico-economic choice within a democracy. Its fate shall ultimately depend on whether or not the current tendency, at least for some countries, to an exacerbation of income inequality will eventually reverse the declining secular trend of wealth inequality and thus shift voters’ preferences back toward a larger role for inheritance taxation.
This evidence is collected in Anthony Atkinson and Thomas Piketty, Top Incomes over the Twentieth Century, Oxford University Press, 2007.
The figure is from Wojciech Kopczuk and Emmanuel Saez, Top Wealth Shares in the United States, 1916-2000, NBER Working Paper No. 10399, 2004.
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 overall tax compliance rate is estimated at 74.5% in the US, 77.8% in the UK, and 29.5% in Italy for the year 1995. The agricultural share of labor in 1870 is 50% in the US, 16% in the UK, and 68% in Italy. See the working paper for details and sources.