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Whenever I see the pros and cons of an inheritance tax discusses one common argument against it is as follows:

If an inheritance tax is imposed on transferring a family owned business, then this tax will have to be taken from the cash flow of the business. This will often bankrupt the business and therefore also destroy all the jobs associated with it. Hence an inheritance tax is (on businesses) is a very bad idea.

However I think this argument is based on a simply fallacy, namely that the business has to pay the inheritance tax, whereas in fact the new owner has to pay it.

So suppose the inheritance consists of exactly the family business, previously owned to 100% by the patriarch, and there is a 30% (of the value of the business) inheritance tax. Now the successor has multiple options:

  • take the tax from the cash flow of the company, this is usually very destructive to the business and hence a bad idea
  • sell a 30% stake of the business for cash to some other investor and use the cash to pay the inheritance tax
  • get a credit for 30% of the company value with the business as security from some bank and use that to pay the inheritance tax

Neither of the other two options takes any cash out of the business directly, so there is no danger for the business or the jobs attached. All that changed is that the son only has about 70% of the wealth of the patriarch.

Question: Is the initially stated argument a valid argument against an inheritance tax and I overlooked something? Or is it just a plausible sounding straw man that doesn't hold upon closer inspection?

Note that I'm not interested on whether an inheritance tax would be a good or bad idea in general, that would be opinion based and not suitable as a question here.

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  • $\begingroup$ Are you asking about inheritance tax in a particular country or generally? In the UK, for example, there is relief from inheritance tax on some business assets. $\endgroup$ – Adam Bailey Dec 4 '19 at 11:47
  • $\begingroup$ @AdamBailey I'm asking whether this particular argument is indeed a valid argument against an inheritance tax or whether this is just benefitting business owners at the expense of everyone else. In Germany businesses are currently de facto exempt from inheritance taxes and the German supreme court has stated that this is unlawful discrimination and tasked the government to fix it. This argument often appears to support keeping the status quo. $\endgroup$ – quarague Dec 4 '19 at 11:52
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It’s true that inheritance tax could pose a problem for businesses. The reason for that is that even though you are correct to say that the successor to businesses owner (I would avoid word patriarch - many business owners are women) has option of selling equity stake or take a loan this can be sub-optimal or difficult.

For example, selling equity in privately owned firm is not easy as investor can’t ‘see into the firm.’ So it might be difficult to properly value business - the equity share could be sold at very unfavorable price to the owner and going public forces firm to follow a host of special regulations that might be difficult for some firms to cope with - this is one of the reasons why not all firms are public - in principle if there would be no special rules even many family businesses could benefit from the access to capital markets. This being said in that case it’s also difficult to value the firm for tax purposes, so I am not sure how the system would work - in the above I implicitly assumed tax authorities can know the true value of business.

Taking loan could be again difficult. Usually when you are applying for a business loan you have to give some proposal of how you will effectively invest money so the bank can see you will be able to repay it with the interest. If you come to bank applying for a loan to pay taxes because you don’t have enough liquidity to do it yourself, you will most likely be turned away. So there are borrowing constrains. Even if you can get loan it could make the leverage of the firm sub-optimal and hurt the firms efficiency or ability to absorb shocks.

However, this being said you could always make the tax in a way that illiquid assets would be exempt or that the tax would not be payable in lump sum but in installments, or exclude business altogether etc. - although making tax system complex has its downsides as well. Also, all taxes, except for Pigovian taxes, are disruptive to the economy so it’s more of an question if the tax is relatively more efficient (causes less disruptions to the economy) than other taxes and then as you correctly pointed out it’s a question of philosophy and value judgements if the disruptions are worth while to get the revenue that can be used for some public purposes.

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  • $\begingroup$ I think you are overestimating the difficulties in getting a loan. If the business is profitable, you are essentially saying to the bank: 'I want a 10M \$ loan, I have this asset that procudes 1M \$ profit per year as a guarantee'. Whether the asset consists of a business, a rented out apartment block or government bonds is only a question of relative risk and how safe the profits are and you only need a loan for a fraction of the value. If the business is loosing money, this of course gets much harder but then the value should be much lower as well, especially for tax purposes. $\endgroup$ – quarague Dec 4 '19 at 11:38
  • $\begingroup$ @quarague I am not trying to say it will be problem for every firm. However, not every firm has the same profitability. There can be firms that need lot of equity - so their valuation is very high and profitability low. Example you have firm with market value 100million and expected profit 1mill per year (which can’t be guaranteed as there is always entrepreneurial risk). In your example 30% inheritance the successor would need to raise 30mill. I am not businessman or business administration major I am Economist but I don’t think it’s realistic to get 30 mill loan in that situation. $\endgroup$ – 1muflon1 Dec 4 '19 at 11:47
  • $\begingroup$ @quarague also just to add to my answer generally firms that have liquidity problems will have both lower access to credit and ability to pay this kind of inheritance taxes. Firms that already have high liquidity will be able to pay for the tax without resorting to leverage (although they could find that optimal depending on the situation)... but in economics it’s important to think about margins... for example VAT taxes don’t affect decision (and hence cause distortion) of someone who will buy the good no matter what it affect/distorts decisions of people on margin... $\endgroup$ – 1muflon1 Dec 4 '19 at 11:58

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