SALT Speak - Joel Michael's Blog

This is another in my series of bad high school book reports on selected nonfiction books that I have read recently. I write them to memorialize my thoughts in the vain hope that I will remember a bit more of what I read.

Author and book

Ray D. Madoff, The Second Estate How the Tax Code Made an American Aristocracy (U of Chicago Press 2025).

Madoff is a tax professor at Boston College Law School. I have read some of her law review articles over the years. One of her areas of expertise is the tax law’s intersection with charities and nonprofits. (I put her up there with Roger Colinvaux and Ellen Aprill as top experts on that topic.) Until I read blurbs for this book, I did not realize that estate tax and planning was also an area of her expertise. That jibes with her interest in charities, since charitable giving is a key part of estate planning for the uber wealthy.

The title derives from the nomenclature of France’s ancien regime. The Second Estate¹ was the aristocracy, which famously paid little to no tax, shifting that burden to the third estate, the general populace. Some consider that to be a main cause of the French Revolution (well, economic and social inequality might be a broader formulation). Hence, the old French saw: “The nobles fight; the clergy pray and the people pay” and the subtitle and subtext of the book – that America’s tax system has created a sort of aristocracy of the ultra-wealthy by lightly taxing them.

Why I read it

I was interested in the book both because of my favorable view of Madoff’s work and the book’s topic – an attempt at an accessible overview of what has happened to the federal income and estate taxes over the last 50 years.² 

The more specific trigger was I knew that Madoff was doing a book event at my youngest daughter’s workplace, The Center for Brooklyn History. So, I asked her to buy a copy for me at the event, which she did, got Madoff to sign, and brought to me when she came home for Thanksgiving.

What I found interesting

Basic thesis. Madoff’s book is (to be honest) an advocacy piece to convince a reader with little to no tax background that:

• The federal tax system since the 1980s has become much more regressive, tilted to the rich/affluent as a result of systematic Congressional tax cuts and its inattention to closing loopholes as they have been developed.
• This results mainly from lower rates on realized income from capital and, more importantly, much income of the wealthy never being taxed at all.
• The net effect is to materially cut federal revenues and is a big part of the nation’s fiscal problems.
• Her reform ideas would go a long way to fixing this.

Description of how this occurred

Most of the book (all but the last chapter) is her description of how this occurred. It’s a familiar narrative for someone steeped in tax policy and she does a nice job of making it understandable to an interested, intelligent general reader.

To simplify her account, the avoidance strategies flow from various combinations of the income tax’s realization requirement (sale or exchange of an asset is needed to trigger income), stepped-up basis (capital gain tax excused by the owner’s death), allowance of share buy-backs, and the ability of business owners to characterize their labor income as income from capital. Those features enable the Buy, Borrow, and Die avoidance structure that slips the grasp of both the income and employment taxes.³ Much business and labor income becomes capital gain that is deferred until death and then, forgiven.

That leaves the estate and gift taxes, which are avoided by the ultrarich with a combination of a variety of valuation dodges (the book does not discuss this much, a failing I think), charitable giving that too often does not yield public benefits comparable to the tax avoided, and other measures.

The book provides narratives of both the tax avoidance playbook (as she puts it) and some of the legislative changes that enabled those strategies. The strongest chapter – not surprisingly, I guess, given her academic focus – is the chapter on philanthropy. (It has more detail and seems more evenhanded by discussing a bit more of the policy rationales for the overly generous – in her and my views – tax benefits and why they’re invalid.)

Three of the many nuggets in her account that I found interesting:

• 121 of the people on the Forbes 400 list inherited their fortunes.⁴ The Forbes 400 is an inexact measure of wealth. As I have noted before, it likely misses a lot of the top people. That does not lessen Madoff’s basic point that inherited wealth is a very big deal and it undercuts the policy argument that low taxes are essential to incent risk taking and work by the wealthy. That general point has never made sense to me.⁵
• Julius Rosenwald, whose fortune derived from Sears, built nearly 5,000 schools in the South in the early 20th century. I was completely unaware of this guy and his efforts. P. 147.
• The dramatic rise in the amounts of charitable contributions to private foundations and donor advised funds (rising from 6% in 1993 to 41% in 2023). I knew it had gone up quite a bit, but not sevenfold. P. 142.

Her fix

The book’s last chapter describes her reform ideas, which consist of three basic parts:

• Repeal the estate tax and tax inheritances and gifts to the recipients instead under the income tax.⁶
• Raise the tax on investment and property income. The key component is to tax capital gains at death. She doesn’t say, but I assume she would also eliminate the lower rates for realized capital gains and dividends, as well as the various dodges that recharacterize labor compensation as investment income (e.g., carried interest).
• Reform the tax treatment of contributions to charities.

All these changes make policy sense to me, although I could imagine alternatives that would augment her changes.⁷ Much of her perceived advantages are on the perception end of things (e.g., taxing inheritances and gifts under the income tax rather than transfer taxes).

What disappointed me

The book is essentially an advocacy piece. In that sense, it reads more like a legal brief than an academic article. I had the uneasy feeling it was constructed to make as strong a case as possible and did not engage enough with the countervailing arguments and rationales. That would have made a longer and more complex book that would have much less appeal to her perceived audience. At least, I assume that was her thinking.⁸

One irritation to me was that in the preface (p. xiv), Madoff implicitly teases the idea that doing a better job of taxing the very rich can solve (or maybe mostly solve) the federal “fiscal crisis” (her term, but I wholly agree). In her words:

A frequent refrain is that taxing the rich wouldn’t make much of a difference in this. But the top-line numbers of the federal budget show that claim to be without merit. p. xiv (end notes omitted).

Given that tease, I assumed the book, at some point, was going to address this issue, at least in broad terms. Roughly how much of the fiscal problem would be fixed by Madoff’s proposed solutions? It never does.⁹ That was a disappointment, since I regard the ever-growing budget deficit is one of the big fiscal challenges the country faces. I get that revenue estimating is outside of her expertise; she’s not an economist. But she could have attempted to assemble estimates prepared by JCT, CBO, TPC, etc. to at least give an impression of how much could be raised by her proposed changes. One problem is that they are stated in such general terms that it would be impossible to put numbers on them.

I think a principal reason why Madoff wrote the book is that she perceives that progressive advocates (members of Congress, staffers, think tank types, etc.) of taxing the rich have simply not done a very good job both in designing their policy proposals or in explaining and advocating for them. The book is her attempt to show them the way.

A key part of that is her thinking is to emphasize inheritances are income by taxing them directly that way, while making it utterly clear that they have never been taxed as income either to those who originally earn them or inherited them (thanks to stepped basis). Count me skeptical as to whether that will move the political acceptability needle or not. Polling, focus group, or psychological lab testing data would help (nothing that law profs do typically, though).

Some niggling reactions:

• One of her assertions is that Congress’s failure to pay attention to the tax avoidance machine and to regularly enact technical correction bills and to close developing gaps is a major cause of the problems. I think that is absolutely the case, since the late 1980s. A chapter with details devoted to that reality would have been nice.
• The book glosses over technical details to keep the account brief and assessable (I assume). I understand that but was puzzled by some apparent simplifications. For example, she regularly refers to the top capital gains tax rate as 20%. Since the NIIT applies to capital gain income, the effective rate is really 23.8%. To be fair, she is consistent and her use of the 20% rate reduces the implicit subsidy for charitable contributions (avoiding capital gain and estate taxes + subsidy for reduction of ordinary income through deducting FMV of contributed property), which she also refers to as being too high. So, it’s not like she’s fudging the numbers to favor her message.
• What’s missing from her reform agenda IMO is shoring up the FICA/SECA tax system – in particular, S corp and limited partnership distributions, as well as better indexing¹⁰ or eliminating the ceiling on the portion of tax funding OASDI benefits. I get why she did not discuss this. It doesn’t fit generally with her narrative that the problem is the under taxation of investment income and inheritances and that analyses of tax burdens too often ignore the payroll taxes (i.e., FICA and SECA).
• The book does not mention the burgeoning use of Exchange Traded Funds or ETFs, which I think are eroding the tax on mutual fund capital gain income. This affects the mass affluent more than the billionaire class who seem to be the focus of her ire. I still think it is slowly (or not so slowly) blowing a hole in the tax base and primarily benefiting the affluent although not the top 0.01%. I would stop treating them differently than traditional mutual funds.

SALT connection

The national erosion of the tax base, enacted and/or abated by Congress, filters down to state and local taxation. However, the structure of the breaks that Congress has given to capital gains and dividends – in the form of alternative lower tax rates – typically does not affect states tax bases. For example, Minnesota continues to tax capital gain and dividend income at the same rate as ordinary income. Many other states (notably CA) do so as well.

But the bigger part of Madoff’s narrative – the conversion of corporate profits and business earnings into capital gain that is deferred until realized and ultimately forgiven at death for bequests (Buy, Borrow, and Die) does affect state tax bases. All state income taxes (to my knowledge) follow the federal rule and step up basis at death. The campaign against and resulting erosion of the federal estate tax – plus EGTRA’s repeal of the federal credit for state estate and inheritance taxes – accentuated the effect on state tax bases. It has caused two-thirds of states (33) to repeal their estate and/or inheritance taxes.

So, Madoff’s story is very much also a SALT story, although she does not delve into or mention that.

My Take

I’m sympathetic to Madoff’s thesis but skeptical of just how central taxes are to the socio-economic changes in American society that have occurred from the end of the New Deal Era (roughly sometime in the late 1970s) to now, the rise inequality and particularly the growth in the very top’s share of wealth and income. Tax changes over the last 40+ years have certainly reduced the system’s progressivity but it remains progressive.

I suspect that it is more a story of cultural change and social acceptance of a winner-take-most society that started to take hold in the 1970s. Malaise (Jimmy Carter’s word) over stagflation made the nation susceptible to the philosophy of Reagan/Friedman/Mont Pelerin Society.¹¹ This philosophical shift enabled shareholders and top management to appropriate more corporate profits with a lesser share for ordinary employees (remember the “Greed is Good” narrative of the 1980s that would have been verboten during the 1930s to the 1960s), sidelining of unions, reducing antitrust enforcement, and similar. All of these are mainly non-tax stories. Tax was a factor. I just don’t think it was the or the most important factor.

Similarly, America’s tax system continues to be significantly more progressive than Europe’s, which follows a model of much higher overall taxation that is less progressive (heavy reliance on consumption taxation through VATs) but funds a more generous social safety net. Europe’s rise in income and wealth inequality has been much more modest. I tend to think their model works better. Even though America’s economic growth has been more robust, way too much of it has gone to the top and I’m skeptical how much of America’s growth is really attributable to taxing the rich at low rates.

Over the last dozen years, the US has seen a rise in the share that pre-tax corporate profits comprise of GDP with declines in the similar share of employee compensation. See the graph that I extracted from Fred below. Before 2006, pretax corporate profits (solid blue line, right axis) were consistently below 14%, typically a lot below. Since the end of the Great Recession, they are well above that. The employee compensation share (dashed green line) moves inversely to the profit share. That means they’ve been quite a bit lower over the last years – more of return is going to capital and less to ordinary workers. Interestingly, that was not the case in the 1980s and 1990s.

There is empirical evidence that top management is capturing more of the employee compensation share of corporate revenues, including part of the reduction in corporate taxes (but that does not affect the blue line in the graph which is pretax). The classic case is the dramatic rise in the ratio of CEO to average worker compensation. From Wikipedia:

[A]n April 2013 study by Bloomberg finds that large public company CEOs were paid an average of 204 times the compensation of rank-and-file workers in their industries. By comparison, it is estimated that the average CEO Pay Ratio was about 20 times the typical worker’s pay in the 1950s, with that multiple rising to 42-to-1 in 1980, and to 120-to-1 in 2000.

That these shifts were caused mainly by tax changes seem dubious to me. More likely, I would guess they were due to a vector of social and cultural variables. It’s too easy for those of us who spend most of our professional lives studying taxes and tax policy to overemphasize their importance. I suspect that Professor Madoff has fallen a bit into that trap.

That said, a very progressive tax system (like the fixes that Madoff suggests) would reduce inequality and provide material revenue to fund our current social safety (i.e., reduce the deficit) or expand it. However, I tend to think that taxing income to fund redistribution it is harder to do social-politically than creating a culture of social norms against a winner-take-most system.

The latter is what America had in the decades after the Great Depression. It meant that unions were stronger and social norms encouraged allocating more of business revenues to ordinary workers and less to shareholders and top management. Obviously, this is all pure speculation, and I think both sets of changes go hand-in-hand: the progressive tax fixes will only occur with changes in social norms. That said, I do think that a robust consumption tax system (i.e., a VAT) is necessary to provide a European style social safety net. I’m more persuaded by another tax academic, Ed Kleinbard, who wrote accessible books on this topic than Madoff, at least WRT to big fiscal fixes.

Notes

1. First estate was the clergy; third, more or less everyone else. Later, the fourth became the press. ↩︎
2. Many of her views align with mine. To wit: the overall sweep of federal tax changes over the last 50 years is characterized by a dramatic reduction in the taxation of capital income, employment compensation of high-income earners, and wealth transfers. WRT the reduction in tax on capital income, this graph per Gene Steuerle says a lot.
   I try to resist simply reading stuff that I know will largely confirm my priors, regarding it as enabling a lazy mind and wasting my time, but the book was short (>200 pp) and I’m always curious about how technical experts attempt to communicate with the nonexpert public on tax policy and law. ↩︎
3. Lifetime consumption financed by borrowing also avoids the estate tax, because the debt incurred reduces the estate’s taxable value. But the uber wealthy do not consume most of their income/net worth, so avoiding the estate tax requires additional measure such as discounting valuations, shifting appreciation in assets to later generations of heirs, creating charitable foundations that really carry out their personal agendas, and similar. ↩︎
4. There must be some ambiguity as to how to treat heirs who continued to run businesses that increase in size dramatically (i.e., more than an index fund) during their tenures. ↩︎
5. Higher rates of return, enabled by low taxes, are not necessary to increase their or their heirs’ ability to consume. The fact that a goodly portion of the very wealthy are on a never-ending quest to maintain and build that wealth has always struck me as a matter mainly of relative competition – against each other for status and to create business, social and political power. Social rules (i.e., higher taxes) that disadvantage all of them, more or less equally, will have little effect on the incentive to engage in that sort of competition. ↩︎
6. My observation: The advantages of this are largely a matter of political acceptability or public perception. Addressing the key weaknesses in the current system – valuation issues and a too big exemption amount – are not fixed by the structural change. Count me skeptical that the difference in perception will matter much. ↩︎
7. As an aside, I agree with her rejection of a wealth tax as an unnecessary diversion that SCOTUS would almost surely strike down based on what the opinions in Moore revealed. It also has a host of administrative and political acceptability problems. ↩︎
8. Ed Kleinbaum’s two books are a contrast that I found more satisfying. The problem with his more nuanced and detailed analysis is that Madoff likely considered it less assessable to the broad audience she sought to reach. ↩︎
9. I omitted two end or footnotes from the quote. Neither of them provides, in my judgment, any support for the statements. They simply cite wealth estimates of the top 1%, not how much income is excluded from the tax base. One mistakenly refers to billions when it must mean trillions, obviously just a typo. ↩︎
10. A good case can be made that it should be a fixed percentage of overall compensation, not an index of wage increases that is now used. That would capture the increasing tilt of the distribution of labor compensation toward the highest incomes. ↩︎
11. I think Friedmans’ persuasiveness was an underrated factor. PBS even made a series out of Free Choose. ↩︎