Tax treatment of bequests when donor benefits are discounted

Recent literature on bequest taxation has made a case for subsidizing bequests on efficiency grounds, with the rate of subsidy declining with the size of the bequest to equalize opportunities among inheritors. These results rely heavily on the fact that bequests benefit both the donor and the recipient, creating an externality that is not taken into account by donors. The double counting of the benefits of bequests is questionable on normative grounds. We study the consequences for bequest taxation of giving less than full social weight to the benefit to donors. We analyse a simple model of parents and children with different skills where parents differ in their preferences for bequests. The government implements nonlinear income taxes on both parents and children as well as a linear inheritance tax and gives differential linear bequest tax credits to donor parents based on income. The nonlinear income taxes take standard forms. The inheritance tax and bequest tax credits are of indeterminate absolute level and together determine the effective price of net bequests. This effective price plays both externality-correcting and redistributive roles. The optimal effective price will depend on the social weight given to donor benefits and the share of donors of a given skill type.