How do inheritances shape wealth inequality? Theory and evidence from Sweden* Arash Nekoei David Seim July 30, 2018 Abstract A recent literature has found that inheritances reduce relative measures of wealth inequality. Theoretically, we show that this surprising finding stems from high inter- generational wealth mobility or low inheritance inequality. Empirically, we show that this finding is only true in the short run using Swedish administrative data and exploit- ing randomness in the timing of death. The inheritance effect on wealth inequality is reversed within a decade due to less wealthy heirs depleting their inherited wealth in contrast to more affluent heirs. Investigating mechanisms behind this depletion, we find that inheritances generate a roughly constant increase in annual non-labor in- come. 60% of this increase is allocated to consumption of goods (half of which consists of car consumption) in the first years, compared to 80% in later years. The remaining labor supply responses reflect a considerable albeit declining inheritance labor-supply elasticity. In a second quasi-experimental design, we demonstrate that large windfall inheritances due to a inheritance tax repeal were sustained over time. Our findings suggest that inheritance taxation increases short-run wealth inequality but reduces it in the long run solely through taxation of very large inheritances. *This paper has been presented and circulated under the title “On the Accumulation of Wealth: The Role of Inheri- tances” from November 2015 to July 2018. We thank Konrad Burchardi, David Cesarini, Raj Chetty, Anna Döös, Itzik Fadlon, Henrik Kleven, Wojciech Kopczuk, Per Krusell, Erik Linquist, Kurt Mitman, Robert Östling, Torsten Persson, Dina Pomeranz, Emmanuel Saez, Anna Seim, David Strömberg, Gabriel Zucman, Clara Zverina, as well as numerous seminar and conference participants (in particular the AEA-ASSA 2016 and NBER-Summer institute 2016) for helpful discussions and comments. Jonas Cederlof and Elin Molin provided excellent research assistance. We acknowledge financial support from Jan Wallander and Tom Hedelius foundation, grant P2015-0095:1 and Torsten Söderberg foun- dation, grant E18/15. Arash Nekoei: Institute for International Economic Studies (IIES) at Stockholm University and CEPR, [email protected]; David Seim: Department of Economics, Stockholm University; CEPR and Research Institute of Industrial Economics, [email protected]. 1 Introduction The fat-tailed distribution of wealth is one of the most salient aspects of economic inequality. The share of wealth held by the top 1% is consistently larger than the share of income held by the same group in all countries where data is available (Alvaredo et al., 2016). The observed wealth inequality can stem from heterogeneity in self-made wealth (generated by heterogeneity in labor income and saving behavior), or heterogeneity in inherited wealth. One idea put fourth in the policy debate is that inherited wealth should be taxed at a higher rate than self-made wealth, a proposition typically popular among citizens (Harbury et al., 1977 and Fisman et al., 2017). Starting with the work of Wedgwood(1928), an extensive literature has attempted to gauge how much of wealth inequality is inherited. The immediate impact of inheritances on the wealth distribution depends on differences in received bequests between wealthy and less affluent heirs. In the long run, the short-term mechanical effect would be exacerbated if inheritances are well invested, but attenuated if inherited wealth increases consumption of goods and leisure. The long-run effect of inheritances thus depends on the marginal propensity to consume and earn out of inherited wealth. The first contribution of our paper is to develop a simple theoretical model to show that in- heritances can increase or decrease relative measures of short-run wealth inequality depending on three well-studied moments: intergenerational wealth mobility, initial wealth inequality, and inheritance inequality.1 Intuitively, the share of wealth held by the wealthiest heirs after inher- itances increases in the share of wealthy heirs with wealthy parents (intergenerational mobility) and in the share of total estates held by the wealthiest parents (inheritance inequality).2 Our theoretical framework connects to the data in two ways. First, using existing estimates of the three aggregate moments for the U.S. and our estimates for Sweden, the model reaches the same conclusion for both countries: inheritances reduce wealth-inequality. The predictive power of our model is particularly useful in settings where the lack of microdata prevents a direct estimation of the inheritance effect on wealth inequality, but where these aggregate moments exist, as in the U.S. But in case of Sweden, we test this prediction directly. While the whole wealth distribution of heirs shifts to the right upon receiving inheritances and the distance between percentiles of the wealth distribution increases, we show that the ratios of those percentiles (Kuznet’s ratios) are reduced.3 This confirms previous empirical findings.4 1See Charles and Hurst(2003) for measurement of intergenerational wealth mobility, and Piketty et al.(2006) for inheritance inequality. For measurement of wealth inequality, see e.g. King(1927), Lampman(1962), Kopczuk and Saez(2004) and Saez and Zucman(2016). 2Following the prior literature (see Piketty and Zucman, 2015 and references therein), our empirical analysis focuses on two relative measures of inequality: namely, top percentiles’ shares and Kuznets (percentile) ratios. These relative measures of inequality have been the focus of the literature on wealth inequality due to their empirical availability and their ability to capture the skewness of the wealth distribution. 3Using data on taxable inter-vivo transfers (gifts), we show that gifts are inequality-decreasing – just as inheritances, but to a much smaller extent – implying that inheritances reduce short-run inequality more when inter-vivo transfers are taken into account. 4See Boserup et al.(2016), Elinder et al.(Forthcoming), Karagiannaki(2017) and Wolff(2002), as well as our discus- sion of those papers in Section2. 1 Second, based on the intuition of the model but without its help, we construct counterfac- tual cases where the two drivers of the inheritance effect – intergenerational mobility and inher- itance inequality – reach their extremes. This results in four counterfactual inheritance flows, corresponding to no intergenerational mobility, full intergenerational mobility, inheritance equal- ity and extreme inheritance inequality. In this step we exploit the unique administrative data on third-party reported wealth of heirs and donors, individually matched to inheritances and inter- vivo transfers, which cover the entire population of Sweden. Two main findings emerge from this analysis: (i) The empirically estimated inheritance ef- fect in each counterfactual case is aligned with the model’s prediction. For instance, inheritance flows with perfect mobility, implemented empirically by giving each heir a random parent, re- duce wealth inequality more than actual inheritance flows do; (ii) The magnitude of the actual inheritance effects is close to the hypothetical case of full intergenerational mobility (particularly at the top of the wealth distribution). This suggests that a high degree of intergenerational mo- bility is the main driver of the equalizing effect of inheritances at the top of the Swedish wealth distribution, and not low inheritance inequality. Our second contribution is to provide quasi-experimental evidence on the dynamic behavioral effects of inheritances and their implications for long-run wealth inequality. We exploit random- ness in the timing of bequests to understand how the short-run effect changes over time. We identify long-run effects by comparing individuals of the same birth cohort who happened to lose a parent at different ages. This research design allows us to study intergenerational wealth trans- fers occurring at the time of death and the behavioral responses they induce. To this end, eleven individual-level administrative datasets covering the population of Sweden are used. Importantly, the equalizing short-run effect of inheritances on wealth inequality is reverted within a decade. For instance, while we estimate a 2.5 percentage-point decline in the share of wealth held by the top 5% upon receiving inheritances, the effect is zero seven years later. We also document that the whole wealth distribution of heirs shifts to the right in the short run, increasing the likelihood of heirs being in the top of the population wealth distribution. For example, the probability of being in the top 10% (1%) goes up by 17% (26%). However, seven years later, the distribution shifts back relative to the control group with the exception of the very top. In fact, inheritances only increase the likelihood of being in the top 2% of the wealth distribution after seven years. The inheritance effects on wealth inequality differ in the short- and long-run because the rate of wealth depletion depends on the heirs’ initial wealth level. We find that heirs in the bottom 99% of the wealth distribution before inheritances deplete almost all of their inherited wealth within a decade. In contrast, for the top 1%, the inherited wealth remains practically intact over time. These reduced-form findings should be the result of heterogeneity in heirs’ responses to inher- itances, either due to heterogeneity in