Sen. Chuck Grassley (R-IA) defended his vote to give a significant tax cut to dead rich people this weekend by suggesting that people who do not die wealthy blew too much of their money on leisure pursuits.
“I think not having the estate tax recognizes the people that are investing,” Grassley told the Des Moines Register in a statement that was published on Saturday, “as opposed to those that are just spending every darn penny they have, whether it’s on booze or women or movies.”
That’s a lot of sex, liquor, and cinema. Under current law, estates up to $5.49 million for an individual or nearly $11 million for a married couple are not taxed. The Senate tax bill that Grassley voted for would double this exemption to about $11 million for individuals and $22 million for married couples. According to the Washington Post, only about 1,800 families a year will pay the estate tax under the bill Grassley supported.
Grassley appears to believe that rich people become rich because they engage in virtuous practices like saving, while non-rich people remain that way because they spend too much on vices. They reality, however, is often quite different. Wealth tends to perpetuate itself across generations, even if individual rich people spend quite lavishly.
Imagine, for a second, two young men who both graduate from the same college at the same time. Both take jobs at the same firm, which pays entry-level hires $45,000 a year. Both men have excellent grades and roughly equivalent qualifications. But there is one important distinction between them.
Malik comes from a working class family with a modest income. Though he received a merit scholarship that paid for his education and he graduated free from debt, he has no significant savings and very little money in the bank. He depends entirely on his salary to pay his bills.
Bob, meanwhile, was born into a wealthy family. He also graduates debt free, but shortly after his graduation he inherits a million dollars which was all invested in an S&P 500 index fund. Thus, unlike Malik, Bob has an additional source of income.
As financial adviser Paul Merriman explains, between 1928 and 2014, “the S&P 500’s compound rate of return was 9.8%” per year, or “enough to transform a $100 investment at the start of 1928 into $346,261 over 87 years.” Thus, if Bob simply sits on his million dollar fortune for one year without spending it, it will grow in value by 9.8% in an average year. If he waits another year, the original million dollars will grow by 9.8% again — and so will the money Bob did not spend in the previous year.
Malik’s annual income in his first year out of college will be $45,000. Bob’s income, meanwhile, will be $45,000 plus the $98,000 Bob earns by sitting on his ass. And Bob’s income from his investments will grow every year, assuming that he does not spend more than he earns in any given year.
If Bob waits until he is 30 before he starts spending his investment income, his original million dollars will more than double, giving him an annual investment income of roughly $150,000 (in addition to whatever salary Bob is earning at that time). Alternatively, if Bob lives to be 80, and he spends half of his investment income every year (letting the other half continue to gain value), he will die with a fortune worth more than $16,000,000 — despite the fact that he has done literally nothing to acquire this fortune.
Now, in fairness, these are rough calculations. Bob’s real rate of return will depend on factors such as the whims of the market, whether he is unfortunate enough to inherit the money shortly before a recession, and other factors related to how different forms of investment income are taxed. But the overall point is that Bob is likely to become very rich even if he retires very early or has a very unsuccessful career. Malik, meanwhile, would need to work very hard, be very lucky, and have an extraordinarily successful career in order to someday earn as much money as Bob earns simply by existing.
Bob could spend tens of thousands of dollars a year on “booze or women or movies,” even at a very young age, and still wind up much, much wealthier than Malik, even if Malik leads a frugal life and saves his money responsibly.
Two additional points are worth noting. The first is that, while S&P 500 investors saw a compound rate of return of 9.8% annually beginning in 1928, the overall United States economy has not grown by this amount or more in any year since 1943. Thus, unless there is a mechanism such as the estate tax to reclaim some of the wealth held by the very rich, investors will naturally capture a greater percentage of the nation’s wealth every year because their incomes will significantly exceed the nation’s GDP growth.
The second is that, while Bob’s $1 million dollar inheritance is quite a bit of money, it is also nowhere near the size of an estate that would actually be subject to the estate tax (though, in fairness, Bob’s $1 million could be his share of a larger estate that was taxed). If Bob had inherited $11 million, the size of an individual estate that would be exempt from taxation under the Senate tax bill, his investment income in his first year after graduation would likely exceed $1.2 million.
Meanwhile, Malik would be working away at the exact same job, trying to get by on $45,000. And Chuck Grassley thinks the reason Malik isn’t rich is because Malik sometimes likes to have a few beers after work.