I just finished reading The Second Estate: How the Tax Code Made an American Aristocracy by Ray Madoff, a legal scholar and professor at Boston College Law School (no relation to that other guy). I highly recommend it (and it’s a fairly short and easy read). (This podcast episode will give you the highlights.)
The book takes a look at the history of taxes in the United States and how we’ve evolved over time into a system that’s really two systems. One system for working folks who make an income, and a second system for wealthier folks who tend to get their wealth from investments and inheritances. Historically, the United States had a much more progressive system, but since the 1980s we’ve veered away from that (despite seemingly having a “progressive” income tax) into a tax system that is heavily skewed toward the wealthy.
The essential problem is that income is easily taxed, is transparent, and even those with very low incomes still pay taxes (payroll taxes, even if they end up not owing what we traditionally call “income” taxes). On the other hand, many wealthy folks have figured out how to have little or no “income” despite making millions or billions of dollars a year.
Amusing (not) Anecdote: Jeff Bezos in at least one year was able to claim the child tax credit, meaning not only did he not pay taxes, but he actually got money back from the federal government.
Their “income” comes from various forms of investments. Those investments gains are, at best, taxed at favorable capital gains tax rates, so much lower than income tax rates. But, in fact, most of those gains of the very wealthy are never taxed, because they don’t sell their holdings before death. Instead, they borrow (huge amounts) against their assets to fund their lifestyle. Borrowed money isn’t taxable (and, in fact, sometimes gets a tax break). And because of the enormity of their wealth, they are able to get very low interest rates on those loans. They hold the assets until they die, they sell, pay off the loans, and since they get a step-up in basis no taxes are owed (even by their heirs).
For example, if you and I were to make $1 million in a year, we would likely pay well over $300,000 in federal income taxes (plus state taxes). But if Mark Zuckerberg borrows $1 million at 3% interest, he pays $30,000 in interest (and his principal is still invested and likely growing at greater than 3%, so effectively he’s coming out ahead).
In addition, inheritances and gifts get incredibly favorable treatment in our tax code, with the current exemption for a couple being $30 million. The author (pretty persuasively) argues that estate taxes are a red herring, that wealthy people have used “death taxes” as a way to make these unpopular, even though they apply to very few people and are usually taxing gains that have never been taxed previously. They also rarely – if ever – apply to those “family farms” that the wealthy seem to be so concerned about.
In 2024 fewer than 0.1% of estates were subject to the estate tax, bringing in only $30 billion in 2024, or less than Elon Musk makes on a good day.
The third aspect the author looks at is charitable giving, which has also been manipulated to heavily favor the wealthy and is often misused to support questionable causes while also avoiding taxes. Donor-advised funds and private foundations have often been used to further the aims of the wealthy person and not really as charitable giving as most of us think of it.
After going through the history of taxes, how we got to our current situation, and the inherent problems in our current situation, the author lays out four surprisingly simple solutions. Now, to be clear, these solutions don’t solve all of the problems with our tax code. In addition, if they were implemented the never-ending quest to find loopholes would continue. In the past, Congress continually addressed those loopholes in order to maintain the intent and the integrity of the law, so that would need to happen going forward as well.
Here are the proposals:
- Repeal the Estate Tax: Really. Counterintuitively, the estate tax as it exists is mostly used to convince the American public that income taxes on the wealthy should be kept low. By repealing it, it allows people to focus on how much taxes are actually being paid (or not) by the wealthy.
- Bring Inheritances into the Income Tax System: Tax the receipt of inheritances/gifts under the income tax system (with some exceptions, like transferring to a spouse). There would be an exemption limit, perhaps $1 million, with taxes only owed on the amount over that, and the inheritance would be taxed based on the heir’s tax situation, not the deceased. (The author does a good job of explaining why this is not “double taxation” despite what the public relations campaign around “death taxes” has convinced so many of us of.) You would also still have the annual gift exclusion (currently $19,000 per person, per year). There also could be an exemption for passing on family businesses, as long as the next generation was continuing the family business and with a limit on total value (maybe $20 million).
- Bring Investments into the Income Tax System: Tax unrealized gains at death (and tax them based on the deceased’s tax situation since they earned the gains).
- Reform Philanthropy: Return to meaningful payout rules on donor-advised funds and private foundations, ensuring they are actually paying out in a timely fashion, not hoarding money, and not using the funds for non-charitable purposes. There should also be a limit on the total tax benefit for large charitable contributions (perhaps 50% of the contribution), set in such a way that it still encourages wealthy people to contribute, but that it cannot eliminate that person’s taxes.
These reforms would help address some major issues in our country, including addressing our deficit and debt. Perhaps more importantly, it may be necessary to preserve our very form of government, as without some changes the government will continue to be “captured” by the wealthy and powerful and we might lose Ben Franklin’s “A Republic, if you can keep it.”
This review doesn’t do justice to the book and it’s arguments, so please read it before engaging in any discussions around it. Some of you may also note that I often talk about ways to take advantage of the tax code on this blog. I don’t see this as a contradiction. We currently have a system and everyone should comply with that system fully, but that doesn’t mean you shouldn’t also avail yourself of the tax breaks applicable to you. And I imagine that most of the people who read this blog are in the “income portion” of our current system, so any ways they can take advantage of the system the wealthy use is helping to (very slightly) level the playing field. While doing that, we should also advocate for changes that make the system – and it should be one system, not two – more effective and fair. I think these proposals are a step in the right direction.
As Judge Learned Hand said: “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”
I will also gently note that these changes would likely be “negative” for my family, as there is a good chance that we will have a decent amount of unrealized capital gains at our death that under the current system would not be taxed.
Edit: As I think more about taxing unrealized capital gains at death, I think I might favor a phase-in approach for that. For example, if these proposals were passed this year (not likely), perhaps the capital gains taxed at death wouldn’t take effect until the 2030 tax year, and then perhaps phased in over 10 years or so. This would take into account that there are many folks who have made decades-long planning decisions based on the current rules and this would provide some time for folks to adjust (and for folks to die under the current rules or during the transition period).