Does Taxing Inheritance Harm Growth?

In fact, if well-crafted, the existence of an estate tax could boost economic activity

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It's hard to add much to the cacophony of opinions out there on Republican Presidential hopeful Gov. Tim Pawlenty's economic policy speech on Tuesday. To sum it up, he calls for setting a 5% economic growth target, which he says can be achieved by much, much lower taxes. Although he made a number of controversial assertions in the speech, perhaps none was as implausible as the claim that eliminating the estate tax would boost economic growth.

Here's the key sentence from Pawlenty's speech that provides a part of his prescription for higher growth. I have included my inner monologue in parentheses from when I read it:

In addition, we should eliminate all together the capital gains tax (Okay, I can see that.), interest income tax (Hm, this might help.), dividends tax (Right, okay, sure.) and the death tax (Wait, what? You lost me.).

If you want to spur investment, then it you could argue that it makes sense to eliminate the first three taxes that he mentions. Investors will have a greater incentive to put their money at risk if the taxes they face on their gains are lower. That's what those first three tax cuts would accomplish, with varying degrees of success.

But the death/estate tax isn't an investment tax at all. It's a tax on dead people. When you die, the inheritance that you leave to your relatives or friends may be subject to taxes.

Earlier this week, my colleague Megan McArdle discussed the estate tax at length, wondering whether a 100% estate tax would be a good idea. That's very different from the status quo that Pawlenty suggests changing here. In particular, he's saying that we should change the current framework of the estate tax to eliminate it entirely and that doing so would boost economic growth. Let's think about how this might occur.

The Family Farm/Business

The most serious problem that an estate tax can cause, in theory, is when it prevents a family business to be passed down to younger generations. For example, let's say that a mother passes and bequeaths a dry cleaning company worth $1 million to her daughter, who has been working at the store for 20 years. If the tax rate is high enough, then the daughter will not be able to afford to pay it and must sell the company. This would arguably harm economic growth, since the economy would be worse off without benefiting form the expertise developed to run the company by the family member(s).

For starters, it's important to point out that this probably doesn't happen very often in practice. At this time, the estate tax only affects estates that exceed $5 million. According to the Tax Policy Center, it hits only the wealthiest 2% of Americans.

Still you can imagine ways that this problem can be easily remedied through a well-crafted set of exceptions. For example, the passing on of small businesses to a family member could be allowed tax-free under certain conditions. One such condition is when a family member has been a part of the company's management for at least five years and stays in that position for at least five years after obtaining ownership. Another provision could be created for sudden death, say if a proprietor dies before the age of 55. Then, if his/her children are too young to take over the company, it can be placed in a trust and run by existing management for a period of time.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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