Submission on Estate Duty to Davis Tax Committee

Comments to the Davis Tax Committee (DTC)

 

on the

 

DTC’s First Interim Report on Estate Duty

 

 

 

About the Free Market Foundation

The Free Market Foundation is an independent public benefit organisation founded in 1975 to promote and foster an open society, the rule of law, personal liberty, and economic and press freedom as fundamental components of its advocacy of human rights and democracy based on classical liberal principles. It is financed by membership subscriptions, donations and sponsorships.

 

Thank you for the opportunity to comment on the DTC First Interim Report on Estate Duty for the Minister of Finance.

 

The economic justification for the DTC report on estate duty

Before commenting specifically on the Estate Duty part of the report it is important to comment on the basic economic thinking and justifications the committee has relied upon when considering wealth taxes.  The DTC seems to have been extremely one-sided in its selection of economists and theories to consider (Oxfam, Piketty, Krugman & Stiglitz) and has ignored mainstream schools of economic thought that have different things to say about inequality, poverty, wealth and tax.  Had the committee considered these other voices and their empirical findings they might have made different recommendations.

 

1. While the committee notes the increase in income inequality within most countries in recent years they fail to notice that inequality between countries has fallen dramatically over the same period and overall global inequality is also falling.

 

2. They have also failed to notice that lifetime inequality is much lower than cross sectional inequality and that measures which reduce or increase cross sectional inequality have little or no effect on lifetime inequality.[i]

 

3. There is a significant negative correlation between per capita GDP and income Gini across countries and a zero correlation (actually insignificantly negative) between a country’s level of economic freedom (market fundamentalism) as measured by the Fraser Institutes’ Economic Freedom of the World Index and its income Gini.[ii]The DTC itself admits market fundamentalism is behind the recent increases in prosperity for hundreds of millions but goes on to say that market fundamentalism does not share prosperity equitably and that one needs government action and intervention to do so.[iii]

 

It would seem that the increase in inequality within countries is not related to the degree to which the country embraces market fundamentalism (alternatively the level of government intervention in an economy) – as the zero correlation with economic freedom suggests.  Instead it is feasible that over the long term an increase in GDP per capita leads to greater equality via some unknown mechanism not related to either market fundamentalism or government action.

 

Perhaps technologically driven increases in productivity or greater equality in skill development lead to the greater equity that comes with higher national incomes.

 

 

4. The way the report portrays wealth inequality is misleading.It is not difficult for the wealthiest two people in South Africa to have the same wealth as the bottom half of the population when most people don’t acquire net property until well advanced in age.Even in developed countries on the order of 40% of adults have no wealth at all and are likely to have a negative net wealth.

 

5. There is almost unanimous disagreement among elite economists with Piketty’s thesis that returns to wealth exceeding growth is driving inequality in the US and Europe.A survey of economic experts (most of whom are ideologically well to the left of the general population) showed that only 3% agreed and 81% disagreed.[iv]The DTC itself notes that Krugman also disagrees and proposes a different explanation.[v]Many economists also suggest that his proposed wealth tax coordinated internationally has no hope of being established.

 

6. In the same survey of economists mentioned above 88% endorsed (only 4% rejected) technological change favouring the skills of some over others as the main driver of inequality.If so then recent increases in inequality within countries is very plausibly a temporary phenomenon.[vi]

 

7. Apart from the finding in point 2 that cross sectional redistribution has no effect on lifetime income inequality, a randomised control study of wealth redistribution (the Georgia Land Lottery of 1832) found it had no effect on the wealth, education and welfare of the descendants of the poorest third of the population who qualified for the lottery.This is not consistent with the view that poverty is due to a lack of assets.[vii]

 

8. Inequality is a red herring.The important issue is how poor those at the bottom are and not how much richer those at the top are.Some suggest that the poor are poor because the rich are rich but there is no convincing causal relationship between inequality per se and poverty theoretically or empirically.Stiglitz claims inequality leads to slower growth and that greater equality will speed up growth but Krugman (and most economists) disagree.

 

9. In point 3 above the point was made that inequality (and more pertinently poverty) seems to drop over the long term when countries become wealthier.In points 2, 3 and 7 the point was made that redistribution is an ineffective means to reduce lifetime poverty.

 

10. Addressing inequality directly runs the substantial risk of distracting South Africa from effectively tackling poverty.Therefore instead of considering what effect different tax regimes will have on cross sectional redistribution, the DTC should consider which tax regimes most help (or least hinder) investment, business and job creation.Many prominent economists are of the opinion that wealth taxes are likely to reduce savings and investment of those with the means to do so and therefore hamper business and job creation.If so it is plausible that wealth taxes and redistribution may actually exacerbate poverty.The DTC committee should at least consider that possibility.

 

 

11. Some forms of tax distort economic activity far more than others.There is widespread agreement among economists that consumption taxes are the least distortionary.On the other hand there is vigorous disagreement on taxes on capital.A large proportion of economists believe taxes on capital are so bad they should be dropped altogether.In light of this diversity of opinion the DTC seems highly overconfident about the causes of poverty and inequality and even more so about the effectiveness and harmlessness of its recommendations.

 

12. While the recent recession may be due to a lack of demand following the financial crisis it does not follow that there is still a demand shortfall that can be plugged by redistribution or other means to stimulate growth.Furthermore while a stimulus may be wise during a recession driven by a lack of demand it is not wise during normal economic circumstances or during supply side recessions.The argument that higher wealth taxes will stimulate growth via redistributing it to the poor who are more likely to spend it is thus questionable.Where there is not a recession driven by a demand shortfall it is likely to lead to inflation instead of growth.Since recessions are short term, a policy of stimulus via estate taxes is counterproductive long term.In any case the amount of stimulus that could be generated that way is way too small and probably inefficient.

The fairness of estate taxes

The DTC states that wealth taxes are equitable and that repealing them are likely to be seen as inequitable.  However the report also mentions the Katz Commission saying that vertical equity involves values judgements about which there is much disagreement.  There are no doubt many who do think wealth or progressive taxes are equitable but there are also many who think the opposite. 

 

Some reasons why estate taxes may be seen as unfair:

 

1. Estate taxes are double taxation.Here I am not referring to the combination of CGT and estate duties but to the fact that assets are typically purchased with after tax income so death taxes clearly qualify as double taxation.[viii]

 

2. It is unfair to over-tax individuals for building a nest egg.Harvard economist Greg Mankiw, November 4^th, 2003.“Consider the story of twin brothers – Spendthrift Sam and Frugal Frank. Each stars a dot.com after college and sells the business a few years after, accumulating a $10 million nest egg.Sam then lives the high life, enjoying expensive vacations and throwing lavish parties.Frank meanwhile, lives more modestly.He keeps his fortune invested in the economy, where it finances capital accumulation, new technologies, and economic growth.He wants to leave most of his money to his children, grandchildren, nephews, and nieces.Now ask yourself: Which millionaire should pay higher taxes?What principle of social justice says that Frank should be penalised for his frugality?None that I know of.”

Another problem with estate duties:

 

3. It is claimed that the cost of compliance with estate duties is so high that it equals or exceeds the revenue gained therefrom.

 

Declining revenues from wealth taxes

The DTC report claims that revenues from estate duties and donations taxes are declining.  If you look at their Figure 3 [ix] which they use to illustrate this there isn’t a steady decline from the peak to the present.  Instead there is a very large drop in estate duty/donations tax revenues between 1985/86 and 1989/90.  There was a change from a progressive rate to a flat rate in the middle of this decline which had no effect on the trend. 

 

Since 1992/93 there has been a long term trend of increasing real term revenues from estate duties and donations taxes. During this increase the introduction of CGT in 2001 and the increase in rebate in 2006 also had no effect on the trend.  The extent of this increase is large. During those 14 years the real revenues have more than tripled or increased at an annual rate of 8%.  The real returns have flattened since 2007 – most likely due to the financial crisis but has started to increase again and is expected to continue to increase. 

 

The lack of change in the real revenue trend in response to changes in duties and taxes suggests that changes recommended by the DTC might also have no effect.

 

The DTC goal of much higher wealth tax revenues

In assessing the wealth tax collection potential of South Africa the DTC compares RSA figures to a range of advanced economies.  This is a wholly inappropriate reference group of countries.  They have a much larger proportion of very wealthy individuals than does South Africa so they have a much larger base to tax.  Aspiring to their levels of wealth tax collection is unrealistic.

 

Recommendations to DTC

 

1. Reconsider the wisdom of not repealing estate duties and donations taxes.There are arguments that they aren’t in fact equitable or fair, evidence that they do nothing to combat lifetime inequality or poverty and there are arguments that they may be a net harm through reducing savings and investment and also in high cost of compliance.

 

2. If the DTC still decides to not recommend repealing wealth taxes completely it will be worthwhile to reduce the estate duty/donations tax rates.The DTC argues that the effective rate is below the 15% rate above which international experience suggests results in extreme avoidance and evasion measures for most payers of estate duties.

 

However the word ‘extreme’ implies that there are already substantial avoidance and evasion measures at rates below 15%.  The report refers several times to the large unproductive estate planning industry.  A reduction in rate, in addition to the increase in primary abatement, would help to reduce the extent of avoidance.  It would also be fairer.

 

3. Don’t expect a lot more revenue.The real revenues from wealth taxes and CGT are likely to increase – due to the underlying trend and perhaps loophole closing – but not anywhere near 10-15 fold.The overall contribution to revenues is likely to remain disappointing.

 

Garth Zietsman

Consultant to FMF