Inheritance tax: Effective if implemented slowly and incrementally

Worried over the growing wealth and income inequalities, economists are talking about plans to bridge the wealth gap. One of the avenues that they point to is the inheritance tax where the wealthy are made to part with some portion of the wealth they have inherited from their elders.

While India does not have an inheritance tax, the current heated election campaign went into a tizzy after technocrat Sam Pitroda voiced his support for such a tax during an interview. Seizing the moment, BJP leaders, no less than Prime Minister Narendra Modi, proclaimed that the Congress was coming after people's jewellery. Are they?

In reality, the inheritance tax is an attempt to improve equality of opportunity for those who lost out on the lottery of birth. For example, when Dhirubhai Ambani died, his wealth went to his sons Anil and Mukesh. While Dhirubhai was self-made and he deserved his wealth, his sons were lucky enough to have won the lottery of birth, which most did not and hence had better opportunities than most others right from birth. An inheritance tax would then would force them to part with a portion of their wealth to the society.

But don't we pay our dues as income tax, wealth tax and expenditure taxes like GST? The main factor is that the inheritance tax bifurcates wealth into earned and unearned; it leaves earned wealth untouched and taxes only unearned wealth. On the other hand, the income, expenditure and wealth taxes leave the unearned income/wealth untouched and only tax the earned income/wealth.

Just as the income tax is applicable only above a certain limit, inheritance tax is also applicable to wealth above a threshold. If this threshold is kept at say 3,000 times India’s per capita income (Rs 1.72 lakh), the figure will be Rs 52 crore. It is something most of us need not worry about, except probably the uber-rich.

The impact
Won't such a tax not kill entrepreneurs' drive and motivation? Shouldn’t we first allow the creation of wealth and become a high-income economy and only then think of taxing the inheritance of that wealth? Fair point. An entrepreneur’s motivation to create value and earn wealth will certainly be less with an inheritance tax than without. However, the counterargument is that if the proceeds of such tax are used to provide more opportunities to those less well-off, such actions may result in more risk-taking entrepreneurs entering the market. And these new business owners may more than compensate for the loss of drive of the industrialist whose wealth will be taxed on his death.

The other question is whether the inheritance tax is suited for a developing country like India. Even though India has improved a lot in terms of physical and digital infrastructure, we still lag in educating and skilling our labour force. And even in the case of educated youth, many are unemployable. To earn the country's demographic dividend, we urgently need to overhaul our educational system and provide quality education at free or subsidised cost to millions. This requires more funds and here inheritance tax can help. Thus a well-designed inheritance tax is required in a populous, lower middle-income country like India than in developed nations with high per capita income and excellent human capital.

Tax for the common good
But what guarantee is there that the inheritance tax collected will be used for improving the opportunities of the less well-off? To ensure that the tax proceeds are not given away as freebies by populist governments, it is imperative to earmark the inheritance tax to a fund that can only be used for building human capital. We have Indian and foreign examples of specific purpose funds – India had a national renewal fund which was partly funded from disinvestment proceeds and Norway has the Norwegian Oil Fund to which oil revenues are transferred, and withdrawals from the fund have restrictive clauses to ensure that it lasts for multiple generations.

All this looks good in theory. But any tax induces avoidance and evasion and the wealthy are good at it. India abolished its inheritance tax when it failed to generate even a fraction of the revenue expected. If inheritance is taxed, the wealthy can gift their wealth while alive – as Infosys co-founder Narayana Murthy did by gifting shares to his grandson worth about Rs 240 crore. They may transfer their wealth to trusts and make their heirs the beneficiaries. And some become citizens of overseas tax havens to escape domestic taxes. There are also illegal methods – benami properties; siphoning off funds abroad and keeping them in offshore shell companies.

Most of these problems can be solved with a well-designed inheritance tax:

• A 5% tax will not induce as much avoidance as a 55% tax.
• Just because the inheritance tax was a failure in the 80s does not mean it will fail today – it has been four decades and the Indian economy has changed dramatically since liberalisation. There is a lot more wealth now and much of it is in financial assets whereas in the 80s it was mostly physical assets. Today’s taxman knows a lot more about our income and wealth compared to the 80s.
• Gift taxes can be made on par with inheritance taxes.
• Changing tax residency is not so effective for Indian assets as the sale proceeds of such assets cannot be freely transferred abroad. Moreover, there is a global recognition that mega-corporations and billionaires are not paying their fair share of taxes and current laws are getting more antagonistic towards tax havens.
• Laws can be tightened to lift the veil of trusts if its sole purpose is avoidance of taxes.
• In the case of benami assets also, the taxman of today is much better equipped than before.
• Lastly, yet most importantly, inheritance tax should be imposed prospectively with a grace period so that current billionaires are given some time to reallocate their assets as per the present no inheritance tax regime. When a proposed law is too radical, it may never get implemented. Some compromise may make it practical

To sum up, inheritance tax is an idea worth exploring slowly and incrementally - the wealthy themselves will be less hostile to it if the criterion for tax threshold is something scientific like per capita income and if to know that tax proceeds will be used exclusively for building human capital. To borrow from Deng Xiao Ping, this is a river to be crossed feeling the stones.