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The Surprising Impact of Estate Tax on Entrepreneurship

Estate taxShould entrepreneurs, at the cusp of making their fortunes, worry about estate and inheritance taxes?

Research studies show two primary effects of wealth transfer taxes. One, by reducing the size of after-tax bequests, it makes heirs less likely to start or maintain a business. Two, the prospect of future estate or inheritance taxes appears to speed up a business owner’s retirement date, but also discourages labor force participation for wage earners. This indicates that there’s no simple way to characterize the effect of the estate tax on entrepreneurship.

Recent research explores how estate and inheritance taxes (or wealth transfer taxes) impact entrepreneurs and would-be entrepreneurs. Efforts to repeal the “death tax”—or to slash the number of taxpayer’s subject to the estate tax, as recent federal legislation just did—may worry hard-working entrepreneurs concerned about losing their life’s work to taxes.

The estate tax might impact the decision to start a business or keep it going, if business owners are looking ahead and want to leave the company to their heirs. However, the evidence on this is surprisingly ambiguous.

For example, most wealthy people don’t take full advantage of opportunities to transfer limited amounts of wealth through tax-free gifts during their lifetimes, which is a very basic tax avoidance strategy. The estate tax also impacts heirs by decreasing the size of after-tax bequests.

The current federal estate tax applies to a fairly exclusive class with a generous exemption from the unified estate and gift tax—$11.2 million for singles and double that amount for couples. Many deductions reduce the amount of wealth subject to the tax, including unlimited deductions for charitable donations, transfers to spouses and “valuation discounts” that reduce the amount of family-owned business and farm assets that are subject to the estate tax. However, anything over the exclusion limit and deductions is taxed at 40%.

The research finds that receipt of an inheritance raises the likelihood of having active business income by about 13%. The size of the inheritance is also a major factor, but is usually less important than the fact that an inheritance exists. In addition, the thought of future estate taxation reduces the likelihood of remaining self-employed, but not because people elect wage employment over self-employment.  It is actually because it makes employment 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.

Therefore, the research shows that the impact of wealth transfer taxes on entrepreneurship appears to be small.  However, the researchers point out that there are several important caveats to their conclusions. One is that self-employment is not the same as entrepreneurship, and most survey data can’t distinguish between entrepreneurs who innovate and take risks from business owners who don’t.

Another factor is that many heirs have parents or grandparents, who were themselves successful business owners from whom they might have inherited entrepreneurial inclination and skill. Last, even if estate and inheritance taxes are distorted, it’s not clear that they’re more burdensome than other politically-feasible taxes. As a result, they contend that replacing the federal estate tax with higher personal income taxes could cut overall social welfare. Repealing or replacing the estate tax, would almost surely make the tax system less progressive.

Reference: Forbes (March 7, 2018) “How Do Estate And Inheritance Taxes Affect Entrepreneurs?”

 

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