Taxing bequests and consumption in the steady state

We study the optimal tax system in a dynamic model where differences in wages induce differences in inheritances, and the transition from parent ability to child ability is described by a Markov chain. In accordance with empirical evidence, we assume that in any generation more able individuals are likely to have a more able parent, which implies that in the steady state they also tend to receive larger inheritances than less able individuals. We show that the Atkinson-Stiglitz result on the redundancy of indirect taxes does not hold in this framework. In particular, given an optimal income tax, a bequest tax as well as a consumption tax are potential instruments for additional redistribution. For the bequest tax the sign of the overall welfare effect depends on the reaction of bequests and on inequality aversion, while for the consumption tax the sign is always positive because the distorting effect is outweighed by the induced increase in wealth accumulation.