Chocolate and Gold Coins

Sunday, June 18, 2006

Should We Tax Transactions Between Family Members?

There is an interesting post on Half Sigma about why we should keep estate tax:
The general rule is that whenever money is transferred from one party to another, there's a tax. If a hard working middle class person has a problem with his pipes, and he pays money to a hard working plumber to fix the pipes, the plumber has to pay income tax on the money he receives. So if a child of a rich person receives millions of dollars for doing absolutely nothing, why should he pay less tax than the plumber who actually did something useful?

Actually, there is no such general rule in America or elsewhere. The general rule is that transactions are only taxed if they are between a retailer and a retail customers. Transactions between corporations are not taxed and there are important economic reasons why they aren't. Also transactions between family members are not taxed except for large gifts and estate taxes. This might be one reason why some people would like these taxes removed.

I think it is fairly obvious that we should not tax transactions between a parent and his or her underage child. Obviously children are in no position to earn income for themselves and parents have an obligation to support them. Taxing these expenses twice would be double taxation and extremely distortionary.

However, it isn't so clear to me that taxing transfers between adult members of the same family is wrong. If a working wife decides to quit working so she can stay home and be a homemaker, not only does the GNP shrink but so does the tax base. That decision tends to weaken country - we can no longer afford as much national defense. It might be reasonable to treat "homemaker services" as taxable income. But it also seems quite likely that this is a really bad idea as well. It is one of those areas that requires more thought and perhaps experimentation.

Likewise, I can see that in general that it might be reasonable to tax transfers between parents and their adult children. If the parent has died then the inheritance might seem exactly like "winning the lottery" as Half Sigma suggested. It does seem like money that is easy to tax with really causing any distortion, (if the person decides not to die because of the high estate taxes then that would seem to be a good thing).

But I can see the potential for distortion. If you pay taxes on inheritance but not on gifts then parents will be obliged to give before they die. Maybe the government doesn't really want to interfere in family matters. It is an interesting question but not so clear.