Imperfection in the Capital Market and the Institutional Arrangement of Inheritance

Abstract

In the theoretical literature of the life-cycle savings model originating from Irving Fisher's conception of optimal intertemporal consumption behaviour it has been customarily assumed that the capital market is perfect; that is, one can borrow or lend freely in the capital market. This assumption has also been made in the models of Yaari [9], Meade [5] and Atkinson [1] that include the bequest motive upon which our analysis is based.3 One of the important implications of these analyses, though unnoted, is that under the assumption of a perfect capital market the optimal programme is neutral with respect to the actual form in which inheritance is bequeathed. Namely, the same optimal programme can be followed no matter whether the bequest is given as a gift inter vivos or as a transfer at death if one adjusts the amount of borrowing and lending suitably in the capital market. When there is imperfection in the capital market, this neutrality property is no longer expected to be true. The purpose of this paper is to examine the impact of imperfection in the capital market on the welfare of individuals, to examine whether or not we can give any prediction with regard to the types of inheritance arrangements that may appear and, finally, to examine some of the welfare implications of inheritance taxation, under the assumption of a certain representative type of capital market imperfection. Our analysis proceeds as follows. The first two sections evaluate the effects of imperfection in the capital market on the optimum path of consumption and the optimum amount of bequests under alternative inheritance schemes. The third section uses the results of the preceding sections to discuss the patterns of choice of inheritance arrangement and also examines some qualitative effects of inheritance taxation. Finally, the fourth section presents some qualificatory remarks of the present analysis.