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People live much longer than before, especially in developed countries, owing to medical advancements and overall improvement in living conditions. Therefore, we face more complicated saving decisions to insure ourselves against longevity risk. One way of insuring against longevity risk is to buy annuities. However, the annuities market is very thin because people usually desire to leave bequests.

The debate regarding the proper taxation of inherited wealth is interesting. The public debate is mainly about the equity versus efficiency trade-off. The economic debate is about the optimal taxation of inherited wealth and implications of the estate tax. Although the economic literature seems to disagree on the optimal tax rate, there is consensus on the importance of bequest motives to study taxes on inherited wealth.

Annuities hedge from the risk but reduce bequests. Thus, the choice of buying an annuity should be seen as a choice between buying an annuity and leaving bequests. A bequest tax should thus decrease the demand for bequests and increase that of annuities. In our research, we show that this effect is quantitatively relevant. Under the current US system, most estates are shielded from the estate tax because the exemption levels are high. If we were to eliminate exemptions, a much larger fraction of people would buy annuities.

Since the presence of estate tax affects the level of bequests and since bequest motives affect annuity decisions, it is of interest to study the interaction between estate taxation and annuities on individual saving decisions. We analyse the interaction between estate taxation and annuities in a model with bequest motives and entrepreneurship decisions. Explicit modelling of entrepreneurship allows us to study the implications of estate tax on annuity decisions in a model that generates wealth distribution realistically. Our framework also allows us to understand the dynamics behind the annuity demand better.

Estate tax is an important public finance instrument that would affect the amount of bequests substantially. There is no consensus in the literature regarding the implications of estate taxation on savings because of substantial heterogeneity in bequest motives. The estate tax can substitute both private annuities and social security. A strand of the literature on estate taxation shows that a higher estate tax rate leads to a decrease in the amount of bequests. Although this is a possibility, there is a line of research that states another important mechanism. In particular, altruistic individuals would want to increase their savings to meet their bequest requirements when the estate tax rate is increased. Hence, the net effect of the estate tax on overall savings is undetermined.

In order to understand the impacts of the estate tax on annuity purchases, we first create a simple analytical model that shows the direction of the relation before we generate a quantitative model.

We find that retirees are responsible for most of the annuity purchase in our benchmark economy. The annuity ownership rate is 5% as in the data. Individuals whose net worth is greater than a certain lower bound and smaller than a certain upper bound buy annuities. In most cases, the upper bound is lower than the estate tax system’s exemption level. Since bequests can be considered as luxury goods, those with high net worth are better off not annuitizing any wealth. This is because they lose relatively more when they use some of their wealth for the up-front annuity investment.

The annuity purchase behaviour of the entrepreneurs is new to the annuity literature. Since entrepreneurs receive an entrepreneurial income even when they are old, the additional annual income from purchasing an annuity contract does not mean much because they prefer to use the upfront investment required to buy annuities in their businesses. Even if entrepreneurs can use annuity payouts as a part of collateral for borrowing more capital, this does not encourage them to invest more in annuities. Our model-generated annuity payout is consistent with the average annual payment found in the data.

We find that the annuity demand decreases substantially when the estate tax break is financed by an increase in the proportional income tax rate. The annuity demand increases moderately when the estate tax cut is financed either by an increase in consumption tax rate or by a decrease in government expenditure. We also find that old retirees are responsible for almost all changes in annuity demand. When we remove the estate tax exemption level by maintaining the estate tax rate at the same level and adjusting the proportional income tax rate, the annuity ownership rate increases from 5.5% to 24.1%. This striking result suggests that making everybody pay a tax on estates would promote the annuity ownership substantially.

We also compare changes in welfare when the estate tax is set to zero. As above, this tax break is financed through one of the following three options: increasing the proportional income tax rate, increasing the consumption tax rate, or decreasing government spending. Increasing the proportional income tax rate would make the majority of old retirees worse off, while old entrepreneurs would gain because they do not buy many annuities. Only retirees who have a greater net worth than the estate tax exemption level benefit from the estate tax break. In other two experiments, the annuity ownership changes minimally, and thus, the welfare effect comes mostly from the change in the estate tax rate and in the relevant policy instrument.

In summary, our research contributes to the literature from at least four perspectives. First, it presents the directions of the interaction between bequest motives, estate tax, and annuities.  Second, it quantifies the changes in the annuity ownership rates because of the changes in the estate tax system. Third, it analyses the annuity demand in a model that gets the wealth distribution right. In turn, this gives us greater confidence for understanding the reasons behind the low annuity demand. Fourth, we shed light on the structure of annuity demand.

Based on the ANU RSE Working Paper (2016) Estate Taxation and Annuities in an Entrepreneurship Model by C. Kumru and  A. Nakornthab

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