An Unwanted Guest: Uncle Sam at Your Funeral

by Sean Tuffnell

The American dream has always included entrepreneurs who risk everything to forge a better life for themselves and their families. America used to encourage this type of rugged individualism, but not anymore.

In the days of the frontier, the government practically gave away land to encourage its citizens to move west. The hope was people would build farms and businesses that could be passed down to future generations, creating a permanent settlement in the frontier and fulfilling our nation's manifest destiny.

Then a funny thing happened. In the early 1900s, governments all over Europe began to believe that they had a responsibility to redistribute wealth from one citizen to another. They became collectivist Robin Hoods with a government ID badge and an iron hand.

While the United States went as far as some of the welfare states of Europe, collectivism did infect our public policy. One example was the enactment in 1916 of the estate tax, also known as the death tax - the tax on assets transferred from one generation to another after death. Some say calling this tax a remnant of socialism is a little harsh. But, consider that the third plank of the Communist Manifesto calls for the abolition of inheritance.

At first the death tax only covered estates larger than $50,000. However, the revenue from the tax was small because people simply began to give away their assets tax-free during their lifetimes. This led to the establishment of a gift tax in 1924. Since 1976, the death and gift taxes have been unified into one system.

Proponents of the death tax often make two different but related arguments in its favor. First, the death tax ensures collection of a significant amount of revenue that would otherwise be lost from rich people. Second, the death tax is needed to redistribute wealth from the super rich to the rest of society, thus preventing a permanent class system. On both counts, death tax proponents are not only wrong in their goals, but history has shown they are wrong in its effects.

The death tax does not collect a large amount of revenue as its proponent's promise. In fact, it is the government's least significant revenue source - raising a mere 1.3% of all tax revenue in FY 1998.

This is partially because the death tax collects most of its revenue from assets worth under $5 million - 52% in FY 1996. Conversely, death taxes as a share of gross estates actually fall for those with assets above $20 million. Thus, instead of redistributing wealth from the super rich to everyone else, those who share the greatest burden of the death tax are the small businessmen and the modestly wealthy.

Why does the tax miss its target? Because there are a number of methods for reducing its burden that are so effective that Columbia University Professor George explains, "the inheritance tax is largely a voluntary tax. Anyone with a good tax lawyer and a willingness to engage in advance planning can avoid it."

Of course, not everyone is equally skilled at taking advantage of the existing loopholes. The complexity of the tax law favors the largest estates, since estate planning techniques are costly. Also, families with long histories of wealth (a.k.a. "old money") are more likely to be familiar with the techniques of tax avoidance. Therefore, those with recently acquired, modest wealth (farmers and small businessmen) shoulder a disproportionate share of the burden. In many cases, their actual incomes may not have been very high and they died not realizing they were considered rich.

The impact of the death tax on the families of these entrepreneurs can be devastating. Since most small businesses are built on a shoestring budget and generate modest income relative to the firm's actual value, the death tax can literally suck the lifeblood out of a business. For example, Douglas Stinson, a tree farmer from Washington state, recently told the House Ways and Means Committee that the household income of the average tree farmer is less than $50,000, but the typical tree farm can be valued at more than $2 million. The result many times is that the heirs have to sell the farm or business just to pay the death tax.

In fact, according to the National Federation of Independent Business, only about 30% of family farms and businesses survive a first-to-second generation transfer, and only about 4% survive a second-to-third. Sadly, the failure of 90% of small businesses after the founder's death can be traced to the burden of the death tax.

Enabling entrepreneurs to leave an inheritance can greatly increase the chances of a small firm's survival. It might also allow a family to continue their fight for a piece of the American dream between generations without continually having to start over from scratch.