The voices of Tax Policy Center's researchers and staff
A new paper and brief explore how estate and inheritance taxes (or wealth transfer taxes) affect entrepreneurs and would-be entrepreneurs. It is a contentious issue. Efforts to repeal the “death tax”—or to slash the number of taxpayers subject to the estate tax, as recent federal legislation has done—appeal to concerns about hard-working entrepreneurs losing their life’s work to tax collectors dressed as the Grim Reaper. But the issue is not so cut and dried.
Our research finds two main effects of wealth transfer taxes. First, by reducing the size of after-tax bequests, it makes heirs less likely to start or maintain a business. Second, the prospect of future estate or inheritance taxes seems to advance a business owner’s retirement date, but it similarly discourages labor force participation for wage earners. Our research indicates that there is no simple way to characterize the effect of the estate tax on entrepreneurship.
The estate tax might affect the decision to start a business or keep it going if entrepreneurs are forward looking and want to leave the enterprise to their heirs. But the evidence on bequest motives is surprisingly ambiguous. For example, most wealthy people do not take full advantage of opportunities to transfer limited amounts of wealth through tax-free gifts during life, a very simple tax avoidance strategy. For many estates, bequests appear to be essentially accidental—a consequence of saving against longevity risk (people do not want to run out of savings while they are living) and the risk of large expenses for medical or long-term care. However, some research suggests that wealthy people are the likeliest to have a bequest motive and they, of course, are the most likely to be subject to estate taxation.
The estate tax also affects heirs by reducing the size of after-tax bequests. This too is a mixed bag. On one hand, gifts and inheritances can provide sorely needed capital to children and other heirs who would otherwise have a hard time attracting seed capital for new businesses. The existence of an estate tax can weaken this effect. On the other hand is the famous “Carnegie conjecture.” In an 1891 essay, Andrew Carnegie wrote, “The parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would.” So, the estate tax, by reducing inheritances, could encourage heirs to work.
The current federal tax applies to quite an exclusive class. There is a very generous exemption from the unified estate and gift tax—$11.2 million for singles and twice that amount for couples. Many deductions reduce the amount of wealth subject to the tax, including unlimited deductions for charitable donations and transfers to spouses and “valuation discounts” that reduce the amount of family-owned business and farm assets subject to the estate tax. Amounts of the estate in excess of the exclusion and deductions are taxed at 40 percent.
Our research finds that receipt of an inheritance raises the likelihood of having active business income by about 13 percentage points. The size of the inheritance is also a significant factor, but typically less important than the existence of the inheritance. We estimate that a $1 million increase in the size of an inheritance would raise the likelihood of owning and managing a business by about 1 percentage point. Thus, for a married couple that benefited from the recently enacted $11.2 million increase in the estate tax exemption and passed on all of the tax savings (up to $4.4 million) to one heir, that heir would be up to 4.4 percentage points more likely own and manage a business. However, very few heirs are in this situation as fewer than 1 in 1000 estates are currently subject to the tax.
We also find evidence that the specter of future estate taxation reduces the likelihood of remaining self-employed, but not because people choose wage employment over self-employment. Instead, the effect seems to primarily operate by making employment somewhat less attractive. Taxing bequests reduces the payoff to working (and saving) for those with bequest motives, which makes both self-employed people and wage earners slightly more likely to retire.
In sum, we find statistically significant but small effects of wealth transfer taxes on entrepreneurship. There are several important caveats to our conclusions. Notably, self-employment is not the same as entrepreneurship. Unfortunately, most survey data cannot distinguish entrepreneurs who innovate and take risks from business owners who don’t. Second, many heirs have parents or grandparents who were themselves successful business owners from whom they might have inherited entrepreneurial inclination and skill. Finally, even if estate and inheritance taxes are distortionary, it is not clear that they are more burdensome than other politically feasible taxes. Thus, replacing the federal estate tax with higher personal income taxes could cut overall social welfare.
And replacing or repealing the estate tax would almost surely make the tax system less progressive.
Posts and Comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.