In today’s Finshots, we talk about why Inheritance Tax may or may not be a good idea.

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The Story

If one has $100 million worth of wealth and when he dies he can only transfer probably 45% to his children, 55% is grabbed by the government. That’s an interesting law. It says you, in your generation [,] made wealth, and you are leaving now, you must leave your wealth for [the] public, not all of it, half of it, which to me sounds fair.

That’s Sam Pitroda’s take on inheritance tax.

And unless you’ve been living under a rock, you probably know that this man who’s a telecommunication engineer, entrepreneur, and also a former advisor to Late former Prime Minister Rajiv Gandhi, has sparked a political row with this statement.

So let's look at this objectively. Is there a case for inheritance tax or is it just a bad idea overall?

Well, for starters, many institutions believe inheritance tax does have a place in the global economic system. In fact, it's something even the OECD (Organisation for Economic Co-operation and Development), an intergovernmental organisation builds a case for.

If you’re wondering why, the simple answer is income inequality. Here's a rudimentary example.

Just imagine half of the world’s population is rich and that the other half is poor. Now, let’s assume that one person from each of the categories dies. What do you think would normally happen?

Well, the rich chap would pass on all of the accumulated wealth to their heirs. The heirs didn’t have to work to earn it. It’s free money. And they can do whatever they wish with it. On the flip side, the poor chap who died wouldn’t have been able to pass on much to his kith and kin. The heirs will have to work hard to break out of the cycle of poverty.

And as of 2021, the wealthiest households (or the top 20%) in OECD countries have received close to 50 times higher inheritances and gifts as compared to the poorest households (or the bottom 20%). So, there’s little wealth that can multiply amongst the poor. And this means that the economic divide between rich and poor only grows wider. This can be a problem in any society.

Enter inheritance tax.

With this, the economic divide could narrow down because the government can add this revenue to its coffers and simply redistribute it to the poorer sections of society in the form of social welfare schemes. It doesn't sound great for the rich, but it could bridge the economic divide a bit.

Not just that, an inheritance tax can push heirs of the wealthy to earn their wealth by continuing to work. A 1993 study called The Carnegie Conjecture has evidence of that. It found that people who received large amounts of inherited wealth were more likely to exit the labour force. Even if they continued to remain in the labour force, their earnings would grow slowly because they’d rely on their inherited wealth and put in lower working hours as a result.

Now, that may not seem too bad. But another 2018 study also found that for every Euro of revenue raised directly from inheritance taxes, the government obtains an additional €0.09 of labour income tax revenue (in net present value) as a result of higher labour supply.

These basic arguments are probably why a handful of countries globally including the UK, France, Germany, Belgium, Japan, South Korea, Singapore and some states in the US, have some form of inheritance tax.

It could be in the form of an inheritance tax that’s charged directly to the folks who inherit their deceased parents’ or relatives’ wealth. Or an estate tax that’s slapped directly on the deceased, by getting them to part with a portion of their wealth to the government. Or even a wealth tax that targets the rich, depending on the value of assets they hold at the end of every year.

Now, it isn’t as if India hasn’t experimented with this. In fact, we did have inheritance tax in the form of an estate tax, way back in the day, which was struck down in 1985 after nearly three decades. Why’s that, you ask?

According to the then Finance Minister V P Singh, it didn’t actually help reduce the unequal distribution of wealth or support states in financing development schemes for the poor. On the contrary, the government barely collected ₹20 crores in revenues from this tax in FY85, which represented a measly 0.4% of the total direct tax collection. And splashing money in the form of administrative costs to recoup that drop in the tax ocean simply didn’t make sense.

So why is this even a debate again? Well, one argument is that the tax laws weren't well thought out back in the day.

It’s also something that the OECD points out. It believes that if governments have foolproof laws, taxing inheritances can actually give them a cost-benefit advantage as opposed to wealth taxes. Simply because inheritance tax is a one-time payment. So there can’t be a lot of ambiguity or even litigation that can arise from it. However, since wealth taxes are charged every year, it could turn out to be an expensive proposition for governments since it can be hard to sort out administrative issues like taxing jointly held assets by multiple legal heirs or their country of residence.

But then there's the other side of the coin. Inheritance taxes can be deeply problematic. Nobody wants to part with their wealth especially when the primary motivation for generating such wealth could be their heirs. It could also leave less money in the hands of the ultra rich, reducing investments they may make into businesses. And that could spiral into lower job creation, lower savings and hinder economic growth. It’s also why the US government’s opposition party ― the Republicans have slipped in a Bill to repeal its existing Death Tax laws.

And that’s not the only argument against it. When there’s an inheritance tax, what do you think would be the first thing the rich would do?

They’d probably try to change the timing of when they’d transfer wealth to their children.  In some cases, they’ll transfer it inter vivos, or when they’re alive, if such taxes are lower than taxes their children have to bear when they’re gone. Otherwise, it’ll be moved to some form of a tax-exempt trust that will make the transfer easier.

But that isn’t even the biggest drawback. Inheritance tax can actually get the rich to park money or wealth in tax havens. They might even choose to give up their home citizenship and buy a passport in a country that doesn’t go after their wealth. That will lead to a flight of wealth from the home country too.

So yeah, all this might defeat the purposes of an inheritance tax if such gaps aren’t closed.

Anyway, this isn’t a new debate, and you can be sure it’ll crop up again. But in the meantime, let us know what you think of inheritance taxes.

Until then…

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