The Estate T ax

When I was younger, I was taught that one reason for the estate tax is that if we don’t take money away from the rich every once in a while, they will invest it and, due to the “magic of compound interest,” they will soon have all the money in the world. Now that the government is thinking of abolishing the estate tax, I thought I would look at this “magic of compound interest” situation.

I looked at two situations:

• A rich person invests $1 million (once) in some stocks where he gets 6% gain per year after taxes. (The capital gains tax is 15 %, so his gain before taxes would have to be 7.06%)
• An average person invests $4,000 every year (in a Roth IRA) in some stocks where he gets 7% gain per year (with no income or capital gains taxes).

We assume the investments continue to grow at those rates for 100 and 200 years in the absence of any estate tax.

The math is simple. After n years,

• The rich person’s investment is worth (1 + .06)^n
• The average person’s investment is worth ((1 + .07)^n – 1) / .07

The math is even easier than that because there are many books that contain tables of how the investments grow. I used an ancient book “The Dow Jones-Irwin Guide to Interest” with a copyright date of 1981. (I assume the math hasn’t changed since then.) I have rounded off the numbers somewhat.

The rich person

• After 100 years would have $339 million
• After 200 years would have $115 billion

The average person

• After 100 years would have $49 million
• After 200 years would have $43 billion

By comparison, in 2005 the net worth of Bill Gates, the richest man on earth, was about $47 billion and the U.S. Gross Domestic Product was about $13 trillion. Of course no one knows what those numbers will be 100 or 200 years from now.

It is interesting to note that if Bill Gates invested $10 billion of his money and got 6% return per year after taxes,

• After 100 years his descendents would have $3.39 trillion
• After 200 years his descendents would have $1.15 quadrillion.

A quadrillion is a thousand trillion, a trillion is a thousand billion, and a billion is a thousand million. These definitions of quadrillion, trillion, and billion are the U.S definitions, not the U.K. definitions.

Since the expected life span in the United States in 2004 was 77.9 years (http://www.cdc.gov/nchs/fastats/lifexpec.htm), an investment period that lasts 100 years would escape one round of estate tax and an investment period that lasts 200 years would escape two (maybe three) rounds of estate taxes.

So do we need an estate tax or not?