Inherently Flawed Inheritance Tax

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Inheritance tax - A tax name new to many Indians has taken a front seat as it was mentioned by the opposition party alliance during their election campaigning for general elections. It garnered attention as some people viewed it as a revenue source for the government and others looked at it as an additional tax burden for common citizens.

So, let's look at what is it? Are there any countries implementing it? what are the benefits and drawbacks they are facing? and what it means to India? 

Globally, 27 countries are implementing inheritance tax and the tax rates vary between 0-80%, the highest being in Belgium. 

Continent-wise break up of countries having inheritance tax is as below

Now coming to the definition, the definition of inheritance tax varies slightly based on the country we are referring to, but if we have to generalize, inheritance tax is a tax levied on a person when they inherit properties and assets in a territory governed by a country imposing inheritance tax. 

Inheritance is when a person receives properties and assets as a legal heir of a deceased person. But some countries like the UK and France consider the gifts given by one person to their family members also as inheritance. This is a very grey area if we go with the standard definition of "inheritance". This looks complex. Right? But it becomes more complicated in the case of France.

In France, the inheritance tax rates change according to the nature of the properties and the relationship of the legal heir with the deceased person. So, a son inheriting his parent's properties will have a different rate and a daughter inheriting the same properties will have a different rate. It becomes more complicated when we get to know that the tax rates are dependent on the period of residence by the deceased person and legal heir.

The purpose of this tax is simple and straightforward. Governments looking for more revenue sources found taxing inheritance also as a way and thus it is sustaining.

Looking critically at how the assets are acquired and transferred, and how they are being used by the legal heirs gives an insight to understand whether this inheritance tax is justifiable or not.

The common way of acquiring an asset can be categorized into two ways:

1. Inheritance - Assets passed through generations.

2. Personal income through job, business, rental incomes, interests, or dividends. (Not considering the illegal income for obvious reasons).

If we look at the sources of income, the government taxes us for every income source and assets accumulate when there is a consistent flow of income through one or more income sources. 

And coming to the assets accrued through inheritance, either they will be sold or sustained and passed to the next generations. In this case, if the assets are disposed of, we have to pay taxes on the sale transactions. If the assets are retained, we have to pay the property taxes.

We are literally being taxed at various points like income sources, while selling and buying assets, and for maintaining the assets. 

Let's look at some examples here. 

1. Assume Mr. X was a first-generation entrepreneur. He has a son. He was successful in his business, was always paying the highest income tax rates in the country and accrued some $1 million in assets. He died and now his legal heir has to pay some 25-30% as tax just to get the assets transferred in his name.
2. Assume Mr Y was a working man. He has a daughter. He got some assets as inheritance and he paid some tax to transfer those assets into his name. He worked hard and he added some more assets. After his demise, his daughter had to pay 25-30% inheritance tax to get her father's assets transferred to her name.
3. Assume Mr. Z was a businessman. He had a son and a daughter. He got some assets through inheritance. But he lost all his inherited properties and his earnings also due to some wrong decisions he made in his business. At the time of his demise, he had a liability of $100,000 and the debtors sent a notice to his legal heirs to repay the liability within one year from the date of notice. Now, the legal heirs have to shell out 25-30% of their annual income to repay the liabilities.

There will be many more complicated scenarios in real life. But I just want to give a gist of how this tax works so I stopped with the above three scenarios.

If we look at the above three scenarios, it is obvious to understand that the government is taxing the persons once at the time of earning the income and once at the time of transferring the assets to their legal heirs. This is double taxation. 

People will try to avoid this scenario as no one will be interested in paying taxes again and again for the same income or asset. So, they will find ways to evade any one tax. This obviously will have a cascading effect on the economy leading to lower economic growth and evasion of taxes.

Looking at the overall picture, we can say the Inheritance tax is inherently flawed.

Coming to the Indian context, the inheritance tax was proposed by the opposition (INDI) alliance as they believed that wealthy people were not being taxed properly by the state. Then, Thomas Piketty, a French economist came up with a projection that 99.96% of Indians would be exempted from this tax if it is applied to the inheritance of properties with a cumulative worth Rs 10 crores or more. He proposed a 33% inheritance tax on inheritance of assets worth Rs 10 crores or above.

I find a few things critical in the proposal by Thomas Piketty. 

1. The proposal is based on the assumption that 99.96% of Indians do not possess assets worth Rs 10 crores or above. 

1. Only 0.04% of the Indian population (~ 5,60,000) comes into this tax bracket. 

1. He proposed a 2% annual tax on people with a net worth above Rs 10 crores along with the 33% inheritance tax.

I feel he missed a few points while making the assumptions:

• Given the growth rate of India, especially the real estate growth, we need to observe the statistics of how many people will come into the tax bracket YoY at least for the next 5 years.

• As of now, even according to his calculations, only 0.04% of the population can be taxed with inheritance tax. (Note: All the 0.04% don't need to pay this tax in the same year). So, there is no projection of how much revenue can be anticipated in a given year.

• The tax elasticity of income tax and other taxes related to properties are not estimated or even considered. (Tax elasticity is changes in tax revenue in response to changes in tax rates).

Even if this is introduced, the wealthy people in the country find ways to bypass this tax 

• by gifting assets to the heirs in the form of shares or some other financial instruments which are non-taxable.
• by faking sale transactions between the family members to reduce the tax which costs only 10-12% in many states.
• by acquiring offshore assets.

Given these uncertainties, the inherent flaw of taxing the taxed income, and the Indian mindset to reduce the asset values to avoid taxation, I feel it is not a wise decision to introduce this tax in India in the near future.