28 February 2012

Whence Inheritance

Here’s an explanation called the “rotten parent theorem”:

Wealthy kids are usually wealthy because their wealthy parents left them a lot of money.  You might think that’s because parents are altruistic towards their kids.  Indeed every dollar bequeathed is a dollar less of consumption for the parent.  But think about this:  if parents are so generous towards their kids why do they wait until they die to give them all that money?  For a truly altruistic parent, the sooner the gift, the better.  By definition, a parent never lives to see the warm glow of an inheritance.
A better theory of bequests is that they incentivize the children to call, visit, and take care of the parents in their old age.  An inheritance is a carrot that awaits a child who is good to the parent until the very end.  That’s the theory of strategic bequests in Bernheim, Shleiffer and Summers.

What seems to be left out of the discussion are two important factors:  historical precedent and lack of perfect knowledge.  Also, the theory seems to be predicated on the assumption that people are perfectly rational.

In the first place, historical precedent counts for a lot when it comes to human habits.  Humans have a tendency to do things a certain way simply because that’s how things have always been done.  Given that death could come at relatively young ages, in times past, and come rather unexpectedly at many cases, it made sense to defer giving one’s wealth to one’s children until one’s death, since there was no way to know in advance how much of one’s accumulated wealth one would need to live out one’s life.  And, given that the vast majority of people that have ever existed were poor, it’s hard to give away a meaningful amount of your wealth when you’re not sure how much of it you’ll end up needing.  Really, this period of massive personal wealth—relatively speaking—is an historical abnormality, so it should come as no surprise that humans have not developed new habits to replace a centuries-old custom.

In the second place, and in keeping with the first point, people do not know when they are going to die.  Furthermore, they do not know the circumstances of their death, nor do they know what expenses they will incur between the present and their death.  As such, it makes sense to keep a decent amount of money on hand to take care of one’s expenses, as well as handle whatever emergency medical expenses might come.  Now, one might reasonably object that by keeping their money for themselves, parents are essentially saying they don’t trust their children to take care of them.  This is certainly plausible, but one must also consider the issue of convenience.  Even if one’s children were to be trusted perfectly, it still makes sense to keep money on hand anyway, since it usually easier to pay for things for yourself than to wait on someone to make your payments for you.

Finally, it makes no sense to assume that people approach the matter of inheritance with any degree of rationality.  Since the transfer of wealth via the mechanism of inheritance is closely tied to death, it is understandable that many people do not spend a lot of time contemplating the matter.  And since the current system of inheritance serves its purpose well, there isn’t that much to be gained from changing.

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