Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: the death tax’s (possible) new scythe, vaccines and the EU’s lethal central-planning fail, Merkel/Brezhnev, credit-market Jenga, lost Bitcoin/found Keynes. To sign up for the Capital Note, follow this link. Death and Taxes — Old Theme, New Threat There has always been something both greedy and ghoulish about the estate tax, a levy that deserves to be known, and often is, as the death tax. It is not enough that the deceased has, in all probability, paid taxes for the whole of his or her lifetime (and probably in quite large amounts, given that the death tax only kicks in once a certain asset threshold has been crossed). But there is also the spectacle that this tax represents: the state showing up for one last cut, hovering over the (financial) carcass of the recently deceased. But, judging by Paul Sullivan’s recent report in the New York Times, this repulsive spectacle may be about to become even disgusting, and not just because the Biden administration will almost certainly lower thresholds and increase rates. The New York Times (my emphasis added): The biggest potential long-term change involves the estate tax. But in contrast to previous changes, the tax code could be modified in a way that affects everyone who has something of value to leave to heirs. For decades, assets were valued at the time of the owner’s death, even if the value had risen. This so-called step-up in basis rule works like this: If a stock that was bought for $1 is worth $10 when the owner dies, the gain is $9. But when that asset is passed on to heirs, the embedded gain is wiped out because the base value is now $10 and no capital gains tax is owed. This treatment applies to any asset, from liquid securities and private investment partnerships to a family home. If the total value of the estate is less than the current $11.7 million exemption level for an individual or $23.4 million for a couple, then no estate tax would need to be paid, either. A Biden administration may move to change this for logical and revenue reasons. At one point, the step-up in basis made sense. Imagine trying to determine the capital gains from AT&T stock that your grandmother bought in 1943 when record-keeping was done with a pencil and paper. Today, cost-basis information can be retrieved in seconds. A cost basis that will, under current rules, not be adjusted for inflation. This ought to too basic to need explaining, but I will go ahead and say it anyway, as this is not a message that appears to be getting through. If I sell an asset that has appreciated by 10 percent since I bought it, but inflation has totaled 20 percent over the time that I held that asset, the 10 percent “gain” will, crudely speaking, represent a 10 percent loss in real terms. Nevertheless, it will be taxed, in current dollars, as a 10 percent gain. That is the situation as it applies at the moment — and (as I have noted before) it shouldn’t. The gain may be phantom, but the tax is real. To his credit, President Trump briefly floated the idea of adjusting capital gains for inflation, but that, sadly, got nowhere. The discussion (to the extent that there has been any) over inflation adjustment up to now has been focused on the gain that occurs when I (not yet dead, hurrah!) sell something that I had acquired earlier. The starting point for that discussion has been the price I paid for that asset, or its value when I received it. Now imagine selling something that you have inherited, and that the law has been changed so that its basis cost is not the value of the asset at the time you acquired it (the current rule), but the price paid by the person (a parent, say, maybe even a grandparent) who left it to you. The effect of, say, five or ten years of inflation on a nominal gain will be bad enough, even at comparatively low levels of inflation (compounding is what it is). Now imagine what it could mean in the case of an asset, which, in the case of an older person (and the ranks of those who die tend to be filled with the old) might well have been held for a very long time indeed. There have been bouts of inflation, whether general or in specific asset classes, within the lifetimes of many of those who have yet to — how shall I put this — trigger their will. And looking to the future, who is to say that inflation will remain at current depressed levels? Then there are the practicalities. As the New York Times’ Sullivan observes, cost-basis information for stock is easily available, at least for stock bought relatively recently. But what is the case when that stock was bought by a parent or grandparent, decades before such information was put into sophisticated electronic systems. And what if that wise ancestor bought that stock before the company went public — a period in a corporation’s life, to complicate things more, in which stock splits and the like are far from rare, and easily accessible information may be rarer still. And stocks are the easy assets. Take the case, say, of a family home that is part of an estate. If the rules change, will a homeowner be expected to keep records of capital improvements made, perhaps, over the decades? Is a collector expected to keep a record of the prices he or she paid for a collection, whether it be of paintings or old Harleys, and the money spent on their restoration? And the examples don’t stop there. The intricacies (to use a kind word) of our tax system have long provided legions of accountants with an excellent living, a diversion of talent and resources with no obvious benefit to the economy as a whole. Ending the step-up would add further complexity to the lives of taxpayers (and introduce it to those who currently have a straightforward relationship with the IRS) and send even more business to CPAs or their automated equivalents. But wait, there’s more. The New York Times: Two different groups of people have raised concerns about losing the step-up loophole: the very wealthy and the moderately wealthy. “Loophole.” I saw what you did there, Mr. Sullivan. If you’re Jeff Bezos or Elon Musk, the two richest people in the world, having your long-term holdings in Amazon and Tesla given a step-up in basis is a huge savings on capital gains tax, because they’re going to be paying estate tax regardless. But for people of more modest wealth, say someone lucky enough to inherit a home or a stock portfolio, the loss of step-up could be even more significant. “Lucky” is a loaded word. Yes, in one sense someone who inherits a home or a portfolio is clearly fortunate, but that “luck” may be the result of a lifetime of work and sacrifice by people who planned for a long time on passing something onto the next generation, rather than just blow it on themselves. A society where people care about providing for their children and grandchildren is better than one in which hedonism is incentivized by the tax policies of the state. Thrift used to be a virtue, is it now to be redefined as poor tax planning? Back to the Times: Robert S. Seltzer, founder and president of Seltzer Business Management in Los Angeles, said that when his mother died, he inherited her home at the top of the real estate bubble. The original cost in the 1970s was less than $70,000, but the home had appreciated to around $500,000. By the time he sold the home in 2010, it was worth $200,000 less. “I actually got a capital loss when I sold it,” Mr. Seltzer said. If not for the step-up in basis tax benefit, “I would have had to pay capital gains on $350,000 to $400,000 because I would have inherited my parents’ basis of $70,000.” For the Black community, the prospect of an heir’s paying capital gains tax on inherited property could contribute to maintaining the racial wealth gap, said Calvin Williams Jr., chief executive and founder of Freeman Capital. He noted that the average Black family passed on $38,000 to heirs, while the average white family passed on $140,000. The loss of the step-up in basis would have an even greater impact on efforts to close the Black wealth gap, Mr. Williams said. “We need every single dime to make that transfer,” he said. “I understand and appreciate what they’re trying to do, but it’s a pretty wide hammer right now. If it were more narrowly focused, that would be more advantageous for communities.” I have a nasty feeling that we are entering an era of bad ideas whose time has come. Abolishing the step-up should not be one of them. Around the Web Central Planning Fails Again Via the Guardian: A storm is raging over the EU’s failure to have ordered more of the approved Covid-19 vaccines ahead of time . . . No single decision-maker bears the blame for Europe’s vaccination debacle. But this episode should make clear that EU member states were wrong to entrust the European commission with the purchase of vaccines last summer. Article 5 of the Treaty on European Union subjects the EU to the subsidiarity principle, which leaves political actions up to member states, except in cases where supranational action can be proven to be more efficient. When it came to securing an ample supply of vaccines, this principle was wilfully ignored. There is neither the legal necessity nor a convincing economic justification for central planning in the procurement of vaccines. Had member-state governments been able to buy vaccines independently and in direct competition with other countries worldwide, they might have had to pay a slightly higher price but they would have placed their orders much earlier to avoid missing the boat. And if orders had been placed earlier, vaccine producers would have been able to invest more in expanding their production capacities. In the end, central planning and lobbying by established producers created Europe’s vaccine debacle. Europeans will now have to live with the consequences of an avoidable tragedy. Merkel as Brezhnev As the Merkel era draws to a close, the Daily Telegraph’s Ambrose Evans-Pritchard throws a few (richly deserved) brickbats: While Merkel has presided over an era of economic outperformance within Europe, it is not a Wirtschaftwunder by global standards. Germany has had one of the slowest growing economies in the OECD over the last quarter-century, slower even than Japan. Productivity growth has averaged 1.2pc annually since 1995, compared to 1.7pc in the US, or 3.9pc in Korea (OECD data). Angeline Germany has echoes of the Brezhnev era. The immobilism is remarkable, a point made by both Marcel Fratzscher in Die Deutschland Illusion; and by Die Welt’s Olaf Gersemann in his book The Germany Bubble: the Last Hurrah of a Great Economic Nation. The country was for a while able to ride the “China wave” as a supplier of capital goods for Asia. But China’s catch-up phase has since turned into import substitution at home, and mid-technology conquest abroad, more or less destroying the German solar industry in the process. Germany has not made the digital switch in time – unlike Korea – and this is becoming existential as cars metamorphose into computers on wheels. Tesla is worth three times as much as VW, Daimler, and BMW combined. Apple dwarfs the entire market capitalisation of the DAX index. Merkel has presided over this structural decay. It is not her fault but nor has she done anything about it. FWIW, I wrote about Merkel as a kind of Brezhnev for NR back in 2018. Credit Market Jenga The Financial Times: Matt Mish, who heads up UBS’s credit strategy team, likens the current state of the market to a tower of Jenga blocks. At the moment, crucial support is being provided by central bank buying across the globe, holding borrowing costs low and providing a backstop if investor demand falls. As that support is removed, piece by piece, the tower could begin to wobble. “At some point, investors are going to realise that the Jenga puzzle is losing more and more pieces,” said Mr Mish. “It doesn’t mean the tower will definitely collapse but it has the potential to create more volatility.” Bankers say that, while the topic may not pose an immediate risk, it is beginning to crop up in conversations with clients. How do central banks gently pare their commitment to support credit markets, and what happens if they fall short of it? Random Walk Lost Bitcoin, Found Keynes From Bloomberg’s Matt Levine: We talked on Friday about a guy who threw away a hard drive with 7,500 Bitcoins and now has hedge-fund backing to dig up a Welsh garbage dump to try to find it. We had some laughs. I wrote that “in another decade, when Bitcoin has become the world’s main store of value and 90% of it has been misplaced, this will be a trillion-dollar rubbish dump and Wales’s main industry will be combing through it looking for that hard drive.” But I somehow forgot that, in Chapter 10 of the “General Theory,” Keynes wrote about exactly this: “If the Treasury were to fill up old bottles with banknotes, bury them at suitable depths in disused coal-mines which are then filled up to the surface with town rubbish, and then leave it to private enterprise on well-tried principles of laissez-faire to dig up the notes again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.” Burying money under garbage as a form of stimulus is apparently a permanent feature of economics. We talk a lot around here about how cryptocurrency enthusiasts are rediscovering all of financial history; here Bitcoin has rediscovered a joke Keynes made in 1936. — A.S. To sign up for the Capital Note, follow this link.