Bad ideas in taxation
Taxation of wealth and inheritance has been tried before
There is a great populist urge in India — to take from the rich and give to the poor. This is the path to sustained poverty and economic failure. Two specific mechanisms that are being discussed — wealth tax and inheritance tax — are well known in the field of public finance. All over the world, there is analytical clarity on their lack of usefulness. They have been tried in India. They should not be resurrected.
Roughly once every decade, in India, the taxation of wealth and of inheritance comes up in the public debate. These ideas have been around since the 19th century and have been tried in many countries. The removal of these taxes, as part of the shift to greater economic freedom, has coincided with greater prosperity.
In India, estate duty was present from 1953 to 1985. The rates could be very high, as much as 85 per cent, but in practice collection was small. It was abolished by Rajiv Gandhi. Taxes on the estate or of inheritance are present in many advanced economies. On average, in the 24 countries of the Organisation for Economic Co-operation and Development (OECD) where these are found, they account for 0.5 per cent of tax revenues. It seems like a lot of complexity to suffer, in public administration, in return for a small amount of tax revenue.
The prospect is even less appealing with wealth tax. This was introduced in India in 1957. As of 201213 it generated ~800 crore. It was abolished in 2015. It is present in four OECD countries and generates a negligible amount of tax revenue.
Going down these routes comes at a cost: The loss of focus on the core business of establishing a sensible tax system in India. Taxation in India is at very high levels, with a maximal personal income tax of 42 per cent, a corporate income tax of 25 per cent and a peak goods and services tax (GST) rate of 28 per cent. Taxing imports, and non-tariff barriers, has been steadily rising. These add up to an extremely high tax environment when compared with most of the post-1991 period. Tax administration in India fares poorly on fair play, rule of law and the arbitrary power of tax officials. The priority in tax policy is not adding on the fresh challenges of a wealth tax or an inheritance tax. It is to make the present machinery (income tax, GST, property tax) work well at the level of both tax policy and tax administration while abolishing all other taxes.
An economist is someone who wonders whether what works in practice works in theory too. Is the empirical experience made of just a few accidents, or is there a conceptual foundation that is inescapable? It is interesting to go under the hood and ask why inheritance tax and wealth tax work poorly.
People respond to incentives. The first response to more taxation is to work less. If wealth and inheritance are penalised, people will work less hard to create wealth. This is harmful for the country.
The second response is to reorganise life into tax-efficient structures. Instead of going to the end of life with a will, persons will transfer assets to the chosen ones while living. This distorts behaviour while hindering the ability of the government to obtain revenues. Many a parent may prefer to repeatedly edit a will in the years leading up to the unexpected death event, instead of losing power by transferring assets to children early in order to avoid taxes.
The third level of response is to relocate business activity to friendly jurisdictions such as Dubai, Sri Lanka, Cayman Islands, Singapore, or Ireland. This hampers tax revenues.
If India were an open economy, nothing else would go wrong: A person would establish a tax residence in Ireland and run business activities in India without any friction. But India is not an open economy and there are myriad hindrances against crossborder activities. Convertibility is absent on the current account and on the capital account. Hence, once a person shifts tax residence to a location outside India, a process of estrangement sets in, and the focus upon building organisations in India tends to subside. India’s future is in the hands of about 10,000 firms, and it is better to organise the Indian state in a way that nurtures the energy and ambition of each of these leadership teams.
In sum, wealth tax and inheritance tax work poorly because (a) they distort the behaviour of people, which harms gross domestic product (GDP), and (b) the behavioural distortions are sufficient to not generate meaningful tax revenues. These taxes thus end up with the worst of all worlds: Behavioural distortions that harm GDP, a complex tax bureaucracy (which will abuse the arbitrary power that tax officers in India have), and poor tax revenues.
This debate fits into the larger puzzle of redistribution vs growth. We should not get distracted into arguments about how to divide the pizza. India is a lower middle-income country. There is a daunting journey in front of us, which is of sustaining growth, of developing state capability, over the coming 100 years. Only four countries which were poor in 1947 have graduated to “advanced economy” status today: The journey to development is a difficult one, and there is no guarantee of success. Emphasising class warfare will hamper private dynamism and hold back the emergence of state capability.
Lant Pritchett says that 99 per cent of the variation in the poverty rate across countries is explained by one number: The median income. If we want to change the poverty rate, the number to focus on is the median income. All the redistributive efforts of the state, through taxes, social programmes, etc sit in the residual 1 per cent (of the variation of the poverty rate which is not explained by the median income) and come at the price of reduced growth of the median income. The emotions of envy, of resentment, of takers rather than makers, should be excluded from public life.