‘The Second Estate: How the Tax Code Made an American Aristocracy’

Before the French Revolution, the nobility and wealthy citizens did not pay taxes by law. The tax burden fell on ordinary people. Similarly, right now in the U.S., ultra-wealthy people with hundreds of millions or even billions of dollars legally pay very little in federal taxes each year, in stark contrast to the rest of us.

How is this even possible?

It’s actually simple, because the U.S. taxes simple W-2 wages, and does not tax preexisting wealth effectively, or at all in many cases.

This book offers a plan to return the ultra-wealthy to our tax system.

“As the richest 1% of Americans have come to control more than 30% of the country’s wealth, the tax code has given them the tools to abdicate their responsibilities and, in a sense, to relocate to a tax-free version of American life — a wealth island of sorts,” Madoff writes.

In 2024, total federal revenue was $4.9 trillion while government spending was $ 6.7 trillion, leaving a deficit of $ 1.8 trillion. The wealth of the top 1% in 2024 was $47.6 trillion. Yes, the ultra-wealthy owned ten times the revenue collected from the rest of us.

The lucky folks on wealth island “are insulated from such workaday burdens by a tax system that imposes little or no tax on their most common sources of wealth: investments and inheritances.” This tax avoidance allows their wealth and power to grow “unabated and exponentially.” How do people avoid the existing estate tax law, which is still on the books?

Our tax system is an antique. In the early 1900s, tariffs provided most of the federal income, but soon proved inadequate, especially after World War I. The modern income tax was created by Congress in 1913, followed by the estate tax in 1916. These taxes were explicitly directed at the wealthiest people; 95% of the population was not taxed, initially.

The estate tax was specifically intended to prevent dynastic accumulation of wealth. In 1934, to cope with the Great Depression, the Roosevelt administration added another payroll tax to support Social Security and Medicare, called the Federal Insurance Contributions Act (or FICA as it appears on a typical pay stub today). The combination of income and payroll taxes “is particularly burdensome for low- and middle-income Americans, many of whom are already struggling to get by,” Madoff writes.

Wealthy people have realized that avoiding a salary is “very helpful in avoiding taxes,” so they scrupulously avoid taxable income.

People like Bill Gates, Warren Buffett, and Jeff Bezos remind us that their employees pay more income taxes than they do, hoping that we will applaud their sympathy and concern while we ignore their vast wealth.

The ultra-wealthy and their lawyers and accountants, especially their enablers in Congress, have skillfully orchestrated the public discussion about taxes with emotional myths even as they chopped away at the existing laws, according to Madoff. Hasn’t the $46.7 trillion owned by 1% of Americans already been taxed by the progressive income tax, or won’t it eventually be subject to gift and estate taxes? No: Our tax system doesn’t reach this concentrated wealth even though it did a good job of this when it was created, over 100 years ago.

Wealthy people protect and build their wealth by owning and holding stocks, property, and other investments. They rely on the growth of their wealth rather than taking income, since growth is not subject to tax unless and until the asset is sold. To pursue their glamorous lives, the ultra-rich get a bank loan against their stock or property and make a big purchase, like artwork, a private jet, or an island. Banks are happy to oblige big customers. When such assets are passed on to heirs, the value for computing capital gains tax if they’re sold is the value at death, not the original value, so taxes are substantially reduced. The strategy has earned the name “buy, borrow, and die.”

The author makes three recommendations to restore a more progressive tax system. First, repeal the current estate tax. Second, explicitly bring inheritance and investment gains into the tax system. Third, reform philanthropy.

Originally, the estate tax generated revenue and curtailed extreme inheritances of wealth. The current law has been so vitiated with loopholes that it meets neither original aim. The 30 U.S. billionaires contribute less than 0.5% of total U.S. revenue, yet have a growing capacity to influence elections and social aims. 

Next, the book suggests how inheritances and investments can be reintroduced into the regular tax system. Tax the receipt of inheritances and gifts under a new law that would also allow for certain transfers to be tax-free. The new law would also tax unrealized gains at death or on the final tax return of the decedent. Simply repeal the exclusion for inheritances and gifts. The federal tax code applies broadly to “…all income from whatever source derived.” This is perfectly consistent with the current practice of taxing earnings and rents, but also lottery winnings, prize money, gambling winnings, and money found in the street. 

A new law could include protections to support offspring or another person. It could exempt inheritances of, say, $1 million but charge taxes on anything in excess. Family farms could be inherited tax-free, up to a value of $20 million. 

Madoff also suggests reforms for charitable donations that distinguish between legitimate charities and the federal government doing their work. While there are rules that distinguish between public charities (donations are provided for) and private foundations (not tax-exempt), the creation of donor-advised funds lets a taxpayer tiptoe around the tax. Congress can make it clear that “contributions to donor-controlled intermediaries are not the same as outright donations to working charities.” New rules should “impose limits on charitable tax benefits for capital gains and estate and gift tax purposes that are similar to those imposed in the income tax world.” 

An imbalanced U.S. budget is watched all over the world. Congress has not passed a balanced budget since the Clinton administration, and the Treasury Department sells bonds each year to cover the deficit. If Treasury must raise the interest rate it pays to sell the bonds each year, consumer loan rates will rise in parallel, and inflation will inexorably rise.