Academic journal article Economic Perspectives

You Can't Take It with You: Asset Run-Down at the End of the Life Cycle

Academic journal article Economic Perspectives

You Can't Take It with You: Asset Run-Down at the End of the Life Cycle

Article excerpt

Introduction and summary

The life-cycle model is the workhorse of most analyses of saving and is widely used to evaluate the macroeconomic and distributional effects of various policy proposals such as the repeal of estate taxation.

The life-cycle model presumes that people are forward-looking and make their current consumption and savings decisions based on their preferences for consumption and knowledge of their future income. In its simplest form, the model assumes that individuals know with perfect certainty the age at which they will die. Moreover, this simplest model assumes that individuals do not value inheritances to their children. That is, they have no bequest motive. Under this model, all individuals die with no wealth, because if an individual were about to die and had no bequest motive, he would be better off consuming all of his remaining wealth than if he died with some wealth remaining. Making a few additional assumptions about individuals' expectations of the future and their preferences (1) allows us to predict an individual's consumption and, thus, wealth at each age. (2)

Although this simple version of the life-cycle model is unrealistic, it is also simple to analyze. As a result, it is often used to evaluate policy reforms (Altig et al., 1997). However, this simple version of the life-cycle model is unable to replicate several key facts. Perhaps most importantly, empirical research shows that many households retain large amounts of assets even in old age (see Hurd, 1990, for a review). (3) Some have argued that the fact that many households do not run down their assets is evidence of a bequest motive, meaning that elderly people do not keep assets just for themselves, but also for their children.

Because most of the literature on policy reform relies on the simple life-cycle model, it has assumed saving behavior that compares poorly with the microeconomic data. It is possible that changing the assumptions of the simple life-cycle model to better describe the data will also change the results of the studies that use these models. Thus, a better understanding and quantitative analysis of household saving behavior may have a substantial impact on the evaluation of policy reforms, such as reforming the Social Security system, Medicare, and changing estate taxes.

To illustrate this point, we look at a policy issue where it is important to consider savings motives of individuals at the end of their lives: estate taxation. On July 7, 2001, the Economic Growth and Tax Relief Reconciliation Act was signed into law, which will gradually reduce estate taxation starting in the year 2002. The estate tax is a tax on assets that remain after an individual dies. The estate tax will be completely repealed in the year 2010. (4) Before the Economic Growth and Tax Relief Reconciliation Act was passed, only estates valued over $675,000 were taxed. By the year 2002, the exemption had risen to $1,000,000. Whether or not this reform increases or reduces gross domestic product (GDP) depends critically on the strength of the bequest motive. Therefore, whether we assume a bequest motive has a dramatic effect on the conclusions that we draw and the policy recommendations that we make. If, as in the simple life-cycle model, individuals have no bequest motive and, thus, do not value the estate they leave to their children, the estate tax will not affect the economic behavior of households.5 The likely alternative to taxes on assets left after death is a tax on income while alive. In contrast to estate taxes, income taxes will likely reduce savings and work effort, which causes economic inefficiency, or "deadweight loss." It is likely that any loss of federal income due to a repeal of the estate taxes will force an increase in income taxes. Therefore, assuming that progressivity is a desirable feature in a tax system and distortions on work decisions and savings are undesirable, the repeal of the estate tax might be seen as undesirable; the decrease in estate taxes reduces progressivity, while the increase in the income tax distorts saving behavior. …

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