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.

Your Beneficiaries Spending/Investing

The other way in which an estate gift can stimulate economic growth would be by spending or investing it. One general criticism for higher taxes is that the private sector can spend money more productively than the government. This is a sort of extension of that concept.

This assertion makes sense where you're talking about savvy business owners or investors. They will put those dollars to work in ways that often enhance growth. It also fits when you're talking about the low- to middle-class, which are both more likely to spend money and spur additional economic demand.

But there's no logic to indicate that these assets would be well spent/invested by estate beneficiaries. Indeed, if reality TV shows are any indication, then rich kids are pretty unlikely to have the first clue about how to create economic growth after being left millions of dollars.

Even if The World According to Paris is a caricature of those who can expect a big inheritance, the point here still holds. The person who was resourceful enough to amass a large fortune in the first place will be well-equip to put that money to work to create economic growth. So by leaving an estate tax in place, you encourage him/her to spend it while living, instead of leaving it to children.

Moreover, by ensuring that the inheritance a person's children receive is limited, you will also create a greater incentive to raise productive members of the economy's next generation. After all, if those children have to create their own businesses or get jobs to make ends meet, then the economy will grow faster than if they just lived off their parent's money.

So does the estate tax, as it is currently formulated, constrain economic growth? If it does, the impact is probably very minimal and could be minimized with an exception that applies to small businesses. But in other ways, the existence of an estate tax likely does more to encourage economic growth than it does to discourage it. While there may be some decent moral arguments for eliminating the estate tax, but the economic arguments don't hold up.

Image Credit: Ken_Mayer/flickr