The gap between rich and poor is widening in the U.S., returning the country to Gilded Age-levels of income inequality. One factor that often gets short shrift in explaining what's behind that trend: The shrinking cost of passing money on to you heirs.
Americans will inherit $765 billion in gifts and bequests in 2020, but the effective tax rate on those inheritances is only 2.1%, according to new research from New York University law professor Lily Batchelder.
By comparison, the effective tax rate on earned income — such as what you bring home in your paycheck — is 15.8%.
At the heart of the issue is fairness, especially given that the U.S. tax system was designed to be progressive —that means the tax code charges higher rates on the rich than the poor, Batchelder notes. In recent decades, copious research has shown that it's gotten much harder to climb the economic ladder. Inheritances — and their low tax rates — are making the problem worse, Batchelder argues.
Her research shows that, on average, the handful of households that earn at least $1 million this year will one day inherit assets worth $3 million. But Americans with annual income of less than $50,000 can be expected, perhaps not surprisingly, to inherit a much more modest $62,000. That discrepancy in passing down money deepens and perpetuates inequality, akin to the way wealthy industrialists in the 19th century handed down their fortunes tax-free.
"Inheritances thus increase within-generation inequality on an absolute basis, conferring much larger benefits on high-income families than on low-income families," Batchelder said.
The tax code could help level the playing field by taxing inheritances at a higher rate, which would generate more federal revenue and provide funding for programs that could help middle- and low-income workers.
Replacing the estate tax
To do that, Batchelder suggests scrapping the estate tax — the tax on the transfer of property after a person dies — in favor of an inheritance tax, which would be paid by heirs.
If heirs had a lifetime exemption of $2.5 million on inherited assets, the government could raise an additional $340 billion within the next 10 years, according to her research. If the exemption were lowered to $1 million, it could raise $917 billion in the coming decade.
"The proposal would almost exclusively burden the most affluent and most privileged heirs in society, while the additional revenues could be used to invest in those who are not as fortunate," Batchelder wrote. "As a result, the proposal would soften inequalities, strengthen mobility, and more equitably allocate taxes on inheritances among heirs."
Batchelder's findings, part of a new book on the tax system published by the Brookings Institution's Hamilton Project, is likely to be met with resistance from wealthy families. President Donald Trump has proposed abolishing the estate tax, which only impacts inheritances worth more than $11.4 million.
Even so, raising taxes on the rich has support from a wide swath of Americans, according to some recent polls. About two-thirds of those surveyed by Gallup believe the rich pay too little in taxes. And Democratic presidential candidates Elizabeth Warren and Bernie Sanders have proposed their own versions of higher inheritance taxes on wealthy estates.