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The Damage of the Estate Tax

I recently learned that Sweden has abolished its estate (inheritance and gift) taxes.

That's an economically wise move. It's a little-understood fact, but an estate tax is among the worst possible kinds of tax. Allow me to explain why.

The wealth comprising a large estate, and particularly the wealth comprising a great fortune, is almost entirely in the form of invested capital. Its physical form is that of office buildings, industrial machinery, specialized equipment, inventories, in-progress research, and the like. The invested funds are fairly liquid — stock can be sold for cash — but ordinary transactions in the capital markets don't affect the physical capital itself, only its ownership.

Vast quantities of capital are essential to the high and rising productivity that creates the vast array of consumer goods that we all enjoy, and at prices we can afford. It is important to everyone's well-being that the physical capital invested in the economy's productive capacity stay invested in that way, for the buildings and machinery etc. that make up that capital serve the customer's needs. For example, an airline's fleet of aircraft is of little direct use to the company's major shareholders, who would probably prefer to fly in their private jets anyway. Those aircraft are instead used by ordinary travelers like you and me.

The lavish personal consumption of rich people is seldom paid for by drawing down their assets — it's usually paid for out of current income. (If you believe the bromide that "the rich get richer," this should be an intuitive point.) The transactions of the rich are generally to change the distribution of their investments, not to liquidate them.

The reason the estate tax is economically bad is that it causes invested capital to be liquidated. The government does not reinvest the proceeds, it spends them. This is capital decumulation — the destruction of capital. Of course it need not literally take the form of asset destruction such as selling a railroad engine for scrap. The economic effect is the same even if the physical result is merely to decrease the rate of accumulation of new capital.

By impairing the rate of capital accumulation, or by causing actual capital decumulation, the estate tax reduces the productive capacity of the economy. The economy's physical capital was accumulated by people who consumed less than they produced, who used the resulting savings to invest in equipment that was of little direct use to them, and built great enterprises that serve the needs of a great many customers. And then when they die the government smashes the work of their lifetimes. (Or, more accurately but less rhetorically, the government reduces the funds available to be invested in new capital, making it harder to build new great enterprises.)

Too few people understand how they benefit from the fortunes owned by others. It is especially tragic that even many of the wealthy don't understand it. It is far better economically — and for you and me as individuals living in the economy — for a spoiled heir to gradually fritter away some portion of their inheritance over their lifespan than for the government to seize and immediately liquidate it.

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