Understanding Inheritance Tax: Implications for Wealth Distribution

« »

11-Jun-2024 | Aarifa Nadeem

Sam Pitroda, chairman of the Indian Overseas Congress, recently commented on India's 'inheritance tax', sparking debate. In India, inheritance is currently tax-free. The Inheritance or Estate Tax was abolished in 1985. There are conflicting views on whether implementing such a tax will result in fairer wealth distribution. Some say that imposing an inheritance tax in India is not appropriate citing a variety of economic and social considerations, including the possible impact on family businesses and concerns about double taxation.

Inheritance tax, also known as estate tax or death duty, is a tax imposed on the transfer of assets from deceased persons to their beneficiaries. Its implications for wealth distribution are significant, affecting both individuals and the broader socio-economic landscape. Here's an in-depth understanding of inheritance tax and its implications for wealth distribution:

What is Inheritance Tax?

“A tax levied on the estate (the total value of money, property, and other assets) of a deceased person before distribution to their heirs.”

An "inheritance tax" is a one-time levy imposed on large inheritances. It differs from the "wealth tax," which is a yearly tax levied on wealth while the owner is alive. Inheritance tax is sometimes distinguished from "estate tax"; the difference being that estate tax is levied on the wealth transferred by the donors, but inheritance tax is levied on the wealth inherited by the heirs. In other words, estate tax is paid from the deceased's estate before the money is handed to his or her heirs, whereas inheritance tax is paid by the person who receives money or assets. All of these taxes can exist in an economy.

Estate Tax vs. Inheritance Tax: In some jurisdictions, estate tax is paid from the deceased's estate, while inheritance tax is paid by the beneficiaries receiving the inheritance. The terms are often used interchangeably, but they can have different legal meanings depending on the jurisdiction
Exemptions: Inheritance tax exemptions can significantly reduce or even eliminate the amount of tax owed on an estate. These exemptions vary widely depending on the country and sometimes the state or region. Many countries provide exemptions for estates below a certain value, transfers to spouses, and sometimes to children or other close relatives.

How is the Tax on Inheritance Determined?

Identifying the estate's overall value is frequently the first step in handling a deceased person's estate. In addition to taking into account any ongoing obligations or liabilities, this entails determining the worth of any assets owned by the deceased, including real estate, investments, bank accounts, cars, and personal possessions.

The entire amount of the estate and the applicable legislation are two elements that determine whether inheritance tax is applicable or not. Certain beneficiaries, such spouses or children, may not be required to pay inheritance tax in some states or may only pay a lower tax rate.

History of Inheritance Tax in India

In an effort to reduce economic inequality, the Estate Duty Act of 1953 instituted the inheritance tax. Real estate and movable assets both inside and outside of India were subject to this levy. However, because of the tax's high rates—which might go as high as 85% for houses worth more than Rs 20 lakh—the people opposed it. Starting with properties priced at Rs 1 lakh, it was 7.5%.

Why did India Abolish the Inheritance Tax?

The law had separate procedures for valuing different kinds of property, which made it complicated and led to protracted legal disputes over property values and high administrative expenses. Since many people looked for ways to avoid paying the inheritance tax, such as hiding inherited properties and taking part in benami property transactions, collections from the levy remained low.

Moreover, the implementation of a wealth tax in addition to an estate tax was perceived as double taxation, which greatly incensed the populace. All of these aspects had a role in the tax's final abolition.

Implications for Wealth Distribution

Inheritance tax plays a crucial role in shaping wealth distribution within societies. While it can promote greater equity and social mobility, it also presents challenges in terms of economic behavior, family dynamics, and policy implementation. Policymakers need to carefully consider these implications to design inheritance tax systems that achieve desired social and economic outcomes while minimizing negative side effects.

Breaking Up Large Estates: By taxing large estates, inheritance tax helps to break up concentrated wealth, preventing it from being passed down unchanged through generations.
Redistribution: The tax revenue collected can be used by the government to fund public services and welfare programs, effectively redistributing wealth across society.
Charitable Bequests: Many inheritance tax systems provide incentives for charitable donations, allowing deductions or exemptions for amounts left to charitable organizations.
Philanthropy: This encourages wealthy individuals to allocate part of their estate to charitable causes, contributing to social welfare and reducing the tax burden on their estate.
Estate Planning: Families often engage in sophisticated estate planning to minimize tax liabilities, including setting up trusts, making lifetime gifts, and other financial strategies.
Tax Avoidance and Evasion: While legal tax avoidance strategies are common, inheritance tax can also lead to attempts at tax evasion, necessitating robust legal frameworks to prevent abuse.
Savings Behavior: The presence of inheritance tax can influence how individuals save and invest, potentially encouraging spending or charitable giving during their lifetime to reduce taxable estate value.
Investment Choices: Some may prefer investments that are more tax-efficient or look for ways to transfer wealth in forms that are less heavily taxed.
Equitable Distribution: Inheritance tax can encourage more equitable distribution among heirs, especially in large families where one or few members might otherwise receive disproportionate shares.
Impact on Small Estates: However, for smaller estates, even a relatively modest inheritance tax can be burdensome, potentially necessitating the sale of inherited property to pay the tax.

Policy Considerations and Future Directions

Inheritance tax policies must be carefully crafted to balance revenue generation, wealth redistribution, and economic incentives. Future directions should focus on making the tax system fairer, more efficient, and adaptable to changing circumstances. By addressing these considerations, policymakers can create inheritance tax systems that contribute positively to social and economic goals.

Progressive Taxation: Implementing progressive tax rates that increase with the size of the estate can help ensure that the wealthiest bear a fair share of the tax burden.
Exemptions and Thresholds: Setting appropriate exemption thresholds can protect small estates and ordinary families from undue hardship.
Stronger Regulations: Implementing and enforcing robust legal frameworks to close loopholes and prevent tax evasion.
Transparency and Reporting: Enhancing transparency in financial reporting and estate planning to ensure compliance with tax laws.
Supporting Economic Mobility: Allocating inheritance tax revenue to education, healthcare, and social welfare programs to support economic mobility and reduce inequality.
Targeted Interventions: Developing targeted interventions to assist disadvantaged communities, funded by inheritance tax revenue.
Economic Considerations: Balancing the need for wealth redistribution with the potential impact on savings, investment, and economic growth.
Stakeholder Engagement: Engaging with stakeholders, including financial experts, policymakers, and the public, to design fair and effective inheritance tax policies.

Global Perspectives

Inheritance tax policies vary widely across the world, reflecting different priorities and values. While some countries focus on wealth redistribution and reducing inequality, others prioritize simplicity and economic incentives. Understanding these global perspectives can provide valuable insights for policymakers seeking to design effective and equitable inheritance tax systems.

Differing Approaches: Countries vary widely in their approach to inheritance tax. Some have high rates and low exemption thresholds, while others have abolished it altogether. These rates illustrate many techniques countries use to distribute wealth and tax. Inheritance tax has a substantial impact on economic policy and social welfare systems, impacting decisions on wealth transfer and intergenerational justice.
Worldwide inheritance taxes: Inheritance taxes are common across the world in countries including Finland, the UK, Japan, and France. The US has one of the highest inheritance tax rates, at a startling 40%. With a rate of 55%, Japan tops the list, followed by South Korea at 50% and France at 45%.
- As of 2023, inheritance taxes are uncommon in the US and are only levied in the following states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The value of the inheritance, the beneficiary's relationship to the deceased, and local laws all influence how much tax is due. Inheritance tax may also be levied by the state in which the dead resided or owned property.
Policy Debates: The effectiveness and fairness of inheritance tax are subjects of ongoing policy debate, with arguments about its impact on investment, entrepreneurship, and intergenerational equity.

Conclusion

Inheritance tax plays a pivotal role in influencing wealth distribution and addressing economic inequality. By breaking up large estates, encouraging charitable donations, and affecting savings and investment behavior, inheritance tax can contribute to a more equitable society. However, its design and implementation must carefully balance the goals of fairness, economic growth, and prevention of tax avoidance. Continuous evaluation and adaptation of inheritance tax policies are essential to meet the evolving socio-economic needs and challenges.

Sources