Friday, March 28, 2003

Mark Kleiman asks a perfectly reasonable question: "Why should money you earn be taxed more heavily than money you inherit?" Of course, it's also unclear why money you earn should be taxed less heavily than money you inherit. I always thought the right solution to the problem of the inheritance tax was to abolish it--and then make inheritances taxable as ordinary income. That probably wouldn't have satisfied "death tax" opponents, of course, but it's likely to be more politically palatable than restoring a special tax on inheritances, should the political climate eventually change and the issue re-emerge.

Another advantage of treating inheritance as ordinary income is that it goes well with a tax reform that's a particular favorite of mine: unlimited tax sheltering. Suppose that taxpayers could deposit or withdraw as much money as they pleased into or from tax-sheltered accounts (the equivalent of 401(k) plans or IRAs), whenever they wished--with the proviso that withdrawn money is taxed as ordinary income. Inevitably, all income not spent would be deposited in such accounts, to avoid taxation. In other words, the income tax would suddenly become a consumption tax--and a potentially progressive one, to boot. Economists would be happy--they generally prefer consumption taxes to income taxes. Redistributionists would be happy--the progressivity of the tax system would be preserved. Savings would be appropriately rewarded, high living would be appropriately taxed, and people with uneven incomes but steady, modest consumption would not be penalized as they are by today's system.

The one catch: the whole scheme depends on inheritances being counted as withdrawals, lest large, income-generating fortunes be passed down from generation to generation, tax-free. I guess that means we won't be seeing this particular reform anytime soon.

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