Abstract

The upcoming one-year repeal of the federal estate tax in the U.S. creates an opportunity to reconsider the taxation of wealth transfers. This article argues that if inheritances are included in an optimal tax framework, existing evidence suggests that the ideal wealth transfer tax would be much higher than current law, and take the form of a comprehensive inheritance tax, which includes amounts inherited above an exemption in the tax base and subjects them to higher rates. Doing so accounts for the net efficiency benefits of taxing inheritances, and the direct and indirect information they provide about the heir's economic status.The article then proposes seizing the political moment to replace the federal estate tax with a comprehensive inheritance tax that takes into account administrative and political constraints. This new tax would exempt from taxation roughly $2 million in lifetime gifts and bequests received. Inheritances received beyond this amount would be taxed at the heir's income tax rate plus 15 percentage points. The proposal would improve incentives and reduce complexity relative to the estate tax. More importantly, it would enhance the equity and transparency of the tax system. The paper's estimates suggest that the estate tax does a good job in aggregate of correcting for the undertaxation of heirs relative to those whose wealth is self-made, but that it does a poor job at an individual level. The proposal would allocate tax burdens more fairly amongst heirs. Ultimately, because its form more transparently embodies its effects, it could also reinvigorate public support for taxing inheritances at more socially-optimal levels in the first place.