This file is created for educational purpose not for sale. Creator of this presentation is highly appreciated the Authors:James R. Hines Jr. Source: The American Economic Review, Vol. 103, No. 3, Papers and proceedings of the one hundred twenty-fifth annual meeting of the American economic ASSOCIATION (MAY 2013), pp. 484-488

1. Income and Substitution
Effects of Estate Taxation
Author(s): James R. Hines Jr.
Source: The American Economic Review, Vol. 103, No. 3,
Papers and proceedings of
the one hundred twenty-fifth annual meeting of the American economic
ASSOCIATION (MAY 2013), pp. 484-488
Presented By Mr. Warawut Runakham,
National Institute of Development Administration, NIDA
DE 8100 Microeconomics Theory 1

2. Coverage of
presentation
1. Introduction:
I. Get to know who gives or receives
the bequest
II. Effects of estate taxes on Labor
supply
2. Model
3. Results
4. Conclusion
5. Q&A
DE 8100 Microeconomics Theory 2

3. Introduction: Get to know agents
Who gives bequests ?
• Rational (wealthy) individual
can spend their money or give it
away to others, including gifts
in the form of bequests
DE 8100 Microeconomics Theory 3
Who receives bequests ?
• subsequent legatees (those to
whom bequests are directed)
or relatives
How to bequeath ?
• Anticipated and planed ahead prior to mortality
• Make accidental bequest when die unexpectedly
• Consider portion of life-time resources and
remainder to bequest
How to receive bequests ?
• Do nothing
• Pay some service cost to such elderly

4. What are Bequests ?
• Purposeful assets leaving to legatees
• Gratuitous to (some) legatees
• Some bequest is a form of payment
(Bernheim, Shleifer, and Summers
1985)
Introduction: bequest and estate taxes
DE 8100 Microeconomics Theory 4
How is the US Estate Taxes ?
• First proposed in 1797 to finance the
wartime expenditures
• The modern estate tax was introduced in
1916, with varying exemption levels and
tax rate to large and small scale estate
Function of Estate Taxes ?
I. collect revenue from large estates
II. discourages the transmission of wealth at death
Impact of Estate Taxes
I. reduce resources available to individuals, affect
relative prices,
II. have income and substitution effects on labor supply,
consumption, saving, and other economic decisions

5. Introduction: Effect of Estate Taxes
DE 8100 Microeconomics Theory 5
Income Effects
If bequests are purposeful and gratuitous
then estate taxes have two separate
income effects on labor supply
1. To the legatees (as taxes increase the
transmitting cost and reduce real net
worth of after-tax bequest)
2. To the givers (as estate taxes reduce
the well-being of those who plan to
make bequest)
• Note: Income effect generally
encourages the labor supply
Substitution Effects
• Estate taxes increase the cost of
bequeathing relative to the costs of
leisure and present consumption
• If leisure and bequests are substitutes,
which is likely, then the substitution
effect of higher estate taxes is to
discourage labor supply
Question:
What is the net impact of estate taxes on
labor supply ?

6. Decomposing Income and Substitution effect
DE 8100 Microeconomics Theory 6
Setup of the Model
1. Individual Utility (live for one period)
• Individual utility can be expressed as a function of
exogenous income, government resources, and
relative prices
• Individual indirect utility function
Where y is exogenous resources
g is government tax’s revenue
w is after-tax wage
p is a price of bequeathing an additional after-
tax dollar to legatee
• The price of current consumption is normalized to
utility
• Individual choose their bequests requires
inclusions of price of bequeathing
),,,( pwgyv
• For convenience, estate taxes is taken to be a linear
function of bequest above an exempt amount
• Pre-tax bequests (𝐵) that individual choose to
leave are subject to tax rate (𝑡)
• Price of after-tax bequest
• Exempt amount (𝐸)
• After-tax bequest
• Government collect tax revenue from
individual’s bequest
• Take the same tax parameters to apply to receipts,
and using an asterisk to denote Individual receives
)1/(1 tP 
EttB  )1(
tEB )( 
EttB  )1(*

7. Decomposing Income and Substitution effect
DE 8100 Microeconomics Theory 7
Setup of the Model
2. Individual labor supply
• Individual labor supply expressed as a function of
exogenous income, government revenue, and
relative prices
• Individual labor supply function
• (1)
• In evaluating (1),
),,,( pwgyL
dt
dp
p
L
dt
dg
g
L
dt
dy
y
L
t
L











2
)1(
1
tt
p




• Effect of tax change on tax revenue (if labor
income is untaxed) is
• The effect of the tax change on exogenous after-tax
bequest receipts is
• derivative of labor supply with respect to the price
change can be decomposed into a substitution
effect and an income effect:
• ; where is
• the compensated effect of a price change on labor
supply
EB
dt
dB
t
t
g



*
*
EB
dt
dB
t
t
y



*
*
)1(
)1)(( tEB
y
L
p
L
p
L c









p
Lc



8. Decomposing Income and Substitution effect
DE 8100 Microeconomics Theory 8
• If government tax revenue enters the utility function in
an additively separable fashion, then
• and (1) implies
• (2)
• The terms with * reflects the effect of a tax change on
the after-tax portion of bequests that is taxable: their
sum equals the value of the derivative
• (2.1)
• If (2.1) = 0, then estate tax changes slightly increase net
receipts of legatees (by increasing the value of the
exempt amount) as pretax bequests increase in response
to the tax changes















)1(
)(
)*(
*
)1(
)1(
1
2
t
EB
EB
dt
dB
t
y
L
tp
L
dt
dL c
0


g
L
Substitution effect Income effect
 
dt
tEBd )1)(*( 
• If (2.1) = (-) , the bequest behavior is
unresponsive to tax changes ,
• In order to consolidate terms it is helpful to
consider the steady sate (in which bequest are
unchanging across generation) such that B=B*
• It is possible to define an elasticity (𝜀) of after-
tax portion of taxable bequest with respect to
one minus the tax rate
• It follows that (2) can be written as
• (3)
  )*(
)1)(*(
EB
dt
tEBd


 
)1(
)1)((
)(
1
td
tEBd
EB 









)1(
)1(
)(
)1(
1
2









t
EB
y
L
tp
L
dt
dL c

9. Decomposing Income and Substitution effect
DE 8100 Microeconomics Theory 9
• The composition of (3) has a look of standard
separation of substitution effect of price changes
(3)
• For income effect which dependent on (1 + 𝜖)
• If 𝜖 = 0 individuals make bequest
• If 𝜖 = 1 individuals receive bequests, thereby doubling
the income effect
• The presence of elasticity term on the right hand side of
(3) picks up the second income effect of estate taxes on
labor supply
)1(
)1(
)(
)1(
1
2









t
EB
y
L
tp
L
dt
dL c

10. Empirical Implication
DE 8100 Microeconomics Theory 10
• In order to evaluate the effects of estate taxation on
labor supply, it is helpful to recast (3) in the manner
that expresses empirical magnitudes as commonly
estimated elasticities.
• Marshallian own-price labor supply elasticity is
defined as
• Hicksian own-price labor supply elasticity is
defined as
L
w
w
L
M



L
w
w
L
H
c



• It follows from the Slusky Equation that
• Compensated demand properties guarantee that
H>0 , and sign of M depends on the relative
importance of substitution and income effect, it is
common to assume that M>0
• Magnitude of substitution effect depends on the
extent to which leisure and bequest are
i. Hicksian substitute
ii. Hicksian complement
• Both are possible, much of literature makes the
simplifying assumption that utility is weakly
separable in leisure and in composite of present
consumption and after-tax bequest, which carry out
that both are “Hicksian Substitute”
w
HM
y
L )( 




11. Empirical Implication
DE 8100 Microeconomics Theory 11
• With separability assumption implies that
• Applying the Hicksian definition, it follows that
• Final notational convenience to define 𝛼 ≡ 𝐸/𝐵 as
the ratio of estate tax exemption to the size of the
equilibrium pretax estate, together with
simplification of (3) that can be written as
• (4)
• According to components of (4)
• (A) = the change in labor earnings occasioned by a
change in estate tax
• (B) = substitution effect that is clearly (-)
• (C) = income effects (that is a function of difference
between Marshallian and Hicksian labor supply
elasticities)
• If 1 − 𝛼 1 − 𝜀 = 1, then (4) will become
• Means that the greater estate taxes (t) discourage
labor supply (if Marshallian labor supply schedule a
positive sloping or M>0)
• A higher 𝜶 corresponds to a greater estate tax
exemption relative to equilibrium bequests, which
dampens (reduce) income effect while leave
substitution effect unchanged.
L
tB
w
L
p
L cc
)1( 





L
tB
H
p
Lc
)1( 



 )1)(1)((
)1(
)(
 


 HMH
t
EB
dt
dL
w
(A) (B) (C)
)1( t
BM
dt
dL
w



12. Empirical Implication
DE 8100 Microeconomics Theory 12
• The value of 𝜶 depends in part on legislative choice
of how large to make the estate tax exemption, and
this has changed considerably over the year.
• How large is 𝜺
• if pretax bequests do not respond to estate taxation,
then 𝜺 = 1
• whereas if pretax bequests decline at higher tax
rates, then 𝜺 > 1
• Very little is known about the effect of estate taxes
on pretax bequests (Kopczuk forthcoming surveys
the limited available literature), so the range of
plausible potential values of 1 − 𝛼 1 − 𝜀 is
perhaps rather wide, though a high value in that
range might be two. If 1 − 𝛼 1 − 𝜀 = 2,
• then equation (4) becomes
• (5)
• If the Marshallian labor supply elasticity (M) is
negative, then the right side of equation (5) is
positive, and higher estate taxes (t) encourage
greater labor supply
• More commonly, the Marshallian labor supply
elasticity is estimated to be positive, in which case
the sign of the effect of estate taxation on labor
supply then depends on the relative magnitudes of
the Hicksian and Marshallian elasticities
)2(
)1(
MH
t
B
dt
dL
w 



13. Conclusion
DE 8100 Microeconomics Theory 13
• What conclusion is appropriate to draw from this
evidence? It would be fair to say that it is difficult
to know either the sign or the magnitude of the
effect of estate taxation on labor supply (as many
studies on male and female worker would yielded
different magnitude result of M and H)
• The estate tax discourages labor supply by
reducing the return to work, but encourages labor
supply by imposing burdens on individuals both as
recipients of bequests and those who plan to leave
the bequests
• If labor supply response to income changes, then
this double the tax burden of estate has potential
to encourages labor supply more than tax induced
–relative price changes discourages labor supply.
• Resolving implication of the substitution and
(double) income effects is “empirical matter” for
which there is no consensus on “magnitude” of
theses effects for population who affected by this
estate tax.

14. Thank You
DE 8100 Microeconomics Theory 14
• Bernheim, B. Douglas, Andrei Shleifer, and
Lawrence H. Summers. 1985. "The Strategic leave
Bequest Motive." Journal of Political omy 93 (6):
1045-76
• Blundell, Richard, Alan Duncan, and Costas
Meghir. 1998. "Estimating Labor Supply Response
Using Tax Reforms." Econometrica 66(4) : 827-61
• Brown, Jeffrey R., Courtney C. Coile, and
Weisbenner. 2010. "The Effect of Inheritance
Receipt on Retirement." Review of Economics and
Statistics 92 (2): 425
• Farhi, Emmanuel, and Ivan
Werning.2010."Progressive Estate Taxation."
Quartely Journal of Economics 125 (2): 635-7
• Kaplow, Louis. 1995. "A Note on Sub Gifts."
Journal of Public Economic 469-77.
• Keane, Michael P. 2011. "Labor Suppy Taxes: A
Survey." Journal of Economics Literature 49 (4):
961-1075
• Kopczuk, Wojciech. 2003. "The Trick Is Live: Is
the Estate Tax Social Security the Rich?" Journal of
Political Economy (6): 1318-41