An Analysis of the Disincentive Effects of the Estate Tax on Entrepreneurship
Background Paper No. 9
Executive Summary This paper is the second in a series of Tax Foundation studies examining federal transfer taxation. The first of these studies provided a history and overview of federal transfer taxation. This paper attempts to gauge one of the economic effects of federal transfer taxation by examining the disincentive effects of the federal estate tax on entrepreneurs.
The federal government imposes taxes on wealth transfers through its unified transfer tax system. An estate tax is paid on the contents of estates. Transfers of wealth between living persons are subject to a gift tax. Transfers to grandchildren or more distant relatives are subject to the generation skipping transfer tax. Of these, the estate tax is by far the largest generator of revenue and has the greatest effect on economic activity.
In 1994, the federal tax code includes 17 marginal transfer tax rates ranging from 18 percent on transfers of less than $10,000 to 55 percent on those in excess of $3 million. There is also a unified transfer tax credit of $192,800, which is equal to a $600,000 exemption. In addition, the benefit of the unified credit and progressive rate schedule is gradually phased out by an additional 5 percent tax on that portion of a transfer in excess of $10 million but less than $21 .04 million . The effective tax rate on estates as small as $5 million is currently 44 percent. Estates over $20 .04 million face an effective tax rate of 55 percent.
An individual’s decision to save is part of a life-long, forward-looking process. Typically, individuals save a portion of their income during their working years so that they may consume at a comfortable level during their retirement or during periods of unemployment. People often leave bequests because there is no way of knowing when death may strike and because they wish to provide their children and grandchildren with a measure of financial security.
In many instances the nature of entrepreneurial activity also results in the accumulation of large amounts of wealth. During his or her working life, the proprietor of a relatively small manufacturing operation or family farm may accumulate millions of dollars worth of land, plant, and equipment.
Whatever motivation an individual has for accumulating wealth, his willingness to do so is affected by taxes. Perhaps the most obvious example of this is the personal income tax imposed on labor income and the returns to saving. This tax discourages productive effort and reduces the incentive to save relative to consumption.
The estate tax also discourages productive effort and saving. The effect of the tax on saving and economic activity may vary significantly, however, depending on the circumstances of the wealth holder.