All Commentary
Tuesday, October 1, 1996

Government’s Hostile Takeover

Estate Taxes Create Disincentives to Invest, Save, and Take Risks

In the history of modern-day capitalism, there have been occasional misplaced concerns regarding corporate raids or hostile takeovers. Worries about corporate instability, excessive debt, and job losses mount when an individual or firm attempts to seize the reins of a corporation against the wishes of current management.

In reality, of course, hostile takeovers are a source of dynamism in a free enterprise system—often removing moribund, inefficient management, and finding ways to add value and increase production. These takeovers are an integral, healthy aspect of capitalism’s ongoing creative destruction.

But there is another kind of hostile takeover that is distinctly anti-free enterprise in nature and worthy of harsh criticism: the federal estate tax, along with the gift and generation-skipping taxes. After working hard, paying taxes, and building a business over a lifetime, an individual faces the prospect of steep estate taxes—a government hostile takeover, if you will. And a primary target for government raiders under the guise of the estate tax are family businesses.

To fend off such government takeovers, family-business owners channel large amounts of resources into relatively unproductive endeavors in a struggle to pass the business on to the next generation. Legions of accountants explore creative ways to shield assets from death taxes. Indeed, people even purchase life insurance for the sole purpose of paying estate taxes. Insurance is not cheap, however, and remains out of reach for many individuals working hard to keep their businesses afloat. If estate-tax insurance is purchased, it means that resources have been diverted away from productive, market-driven endeavors. Buying insurance to cover the costs of taxation is a clear indication of a tax system gone awry.

Often, estate taxes wind up killing family-owned businesses. Sixty percent of family-owned businesses fail to make it to the second generation, and 90 percent do not make it to the third generation.[1] Perhaps most damaging is that under the estate tax, the government strips a company of much-needed capital at the worst possible juncture—under a change of ownership and oversight. Most businesses simply never recover.

Disincentive for Investment

Heavy estate taxation also acts as a disincentive for investment and entrepreneurship, just as onerous income and capital gains taxes do. With as much as 60 percent of a business enterprise essentially slated for a government takeover, there remains little incentive for individuals to continue to invest and expand a family business when the owner reaches a certain age. Rather, business owners possess every incentive to sell their family businesses before death to spare their heirs the costs and burdens of hostile estate taxes.

Federal estate tax rates range effectively from 37 percent to 55 percent, plus an additional 5 percent on very large estates. It is important to understand that this is not 55 percent of income, it is 55 percent of all assets. (The first $600,000 is exempt from taxation.) The gift tax is levied at the same rates as the estate tax, excluding $10,000 per recipient annually. In addition, a generation-skipping tax is imposed on gifts and bequests to grandchildren. The generation-skipping tax is levied at an additional flat rate of 55 percent on amounts in excess of $1 million.

As is always the case when government pushes tax rates higher, the taxed economic activity dwindles, and actual tax revenues fail to meet the expectations of government bureaucrats. Estate and gift taxes account for just a little more than one percent of total federal government receipts. Since 1974, there has been virtually no inflation-adjusted increase in federal estate and gift tax revenues. In addition, a good portion of these revenues are eaten up by the federal government’s compliance efforts related to estate and other death taxes. Some estimates say as much as 75 percent of estate and gift tax collections are offset by the costs of the IRS, the Treasury Department, and litigation.[2]

In the 1970s, Australia and Canada repealed their estate taxes. While not exactly bastions of free-market economics, both nations came to realize that estate levies hurt investment, economic growth, and job creation.

In the most extreme cases, the U.S. tax structure has pushed many upper-income individuals to reject their U.S. citizenship and take up official residence in less taxing lands. Again, estate taxes play a significant part in such decisions. Forbes magazine ran a cover story about such individuals entitled The New Refugees in its November 21, 1994, issue. While some might say, Good riddance to such traitors, the economics underlying the situation is clear. Strong incentives to flee the U.S. tax burden exist.

A simple question arises: Why does the United States impose such a punitive tax code to the point where productive individuals will take the dramatic step of renouncing their citizenship in order to prosper elsewhere? Taxing productive individuals out of a country is not new. The twentieth century offers numerous examples, such as the Soviet Union, as well as Great Britain from the end of World War II to the late 1970s. But truly oppressive levels of taxation date back centuries. In the late eighteenth century, Adam Smith warned in The Wealth of Nations:

The proprietor of stock is properly a citizen of the world, and is not necessarily attached to any particular country. He would be apt to abandon the country in which he was exposed to a vexatious inquisition, in order to be assessed to a burdensome tax, and would remove his stock to some other country where he could either carry on his business, or enjoy his fortune more at his ease. By removing his stock he would put an end to all the industry which it had maintained in the country which he left.

This warning takes on even greater significance considering today’s worldwide competition for increasingly mobile labor and capital.

In the private sector, a hostile takeover often means that the owners (i.e., shareholders) of the targeted company will benefit as their shares in the firm increase in price. Under the government’s hostile takeovers of thousands of family-owned businesses each year via death taxes, owners are decimated as the government often lays claim to more than half the company’s assets. Resources are funneled away from productive, private-sector ventures to dubious unproductive government programs.

Envy—leading to wage class warfare and failed government redistribution schemes—stands as the only justification for estate taxes. But envy is a poor foundation upon which to base a tax code. Sound economics is preferable.

Estate taxes and death strip businesses of much-needed capital; create disincentives to invest, save, and take risks; reduce economic growth and job creation; and are expensive to administer. The time has come to end government’s hostile takeovers of family businesses and assets. If not, the government will continue to destroy America’s free enterprise system and our great heritage of family-owned businesses.

1.   Grace W. Weinstein, “Keeping the Family Business in the Family,” Investor’s Business Daily, April 12, 1995, p. 1.

2.   Testimony of the Small Business Council of America before the U.S. House of Representatives Committee on Small Business on January 31, 1995.

  • Raymond J. Keating is an author and serves as Chief Economist with the Small Business & Entrepreneurship Council.