Tax Avoidance and Tax Evasion: A killer argument?
A popular and influential strand of arguments against inheritance taxes (and other wealth-related taxes such as capital income tax) doesn’t bother to question its desirability per se, but rather its feasibility. One of the two common concerns is tax evasion, the second being the administrative burden and efficiency. The following article will deal with the former.
Tax evasion and tax avoidance
The argument goes as follows: no matter whether inheritance or gift taxes are desirable, any attempt to increase these taxes will be offset largely by tax evasion. Additionally, some argue, that tax evasion doesn’t happen homogenously across the basis of taxable citizens, but tax evasion capabilities or success rates increase with wealth so that higher inheritance taxes can have perverse effects on distributional equity and fairness.
Before we look into the validity of the arguments and the empirics, let’s get an overview of what types of tax evasion and avoidance we are talking about. There are plenty.
Tax avoidance is usually the term used for legal or semi-legal attempts to minimise taxes.
- Optimised gifting during lifetime using repeating allowances
- Optimised bequeathing using allowances, e.g. spreading across nuclear and extended family members according to certain allowances
- Use valuation techniques to reduce the tax burden. Artificially undervalue the estate.
- Shift to favourable asset types, e.g. (family) business shareholding, trusts, agricultural businesses
- Relocate assets and/or residency to other countries and tax regimes. We may call this tax migration or tax nomadism.
- Using life insurance schemes, in which the insurance holder is not the beneficiary, e.g. a cross-purchase of insurance among partners or family members.
- Using pension savings schemes, which are sometimes treated preferentially.
- Holding wealth in financial assets with unrealised capital gains. In some countries, the heir inherits the estate at current market prices, so that the value increases that have happened before death will not be taxed).
- Transferring ownership, while retaining usufruct rights, can sometimes reduce the gift/tax burden, as deductions are applied on the tax basis because of the “limited value” of the ownership without usufruct rights. This preferential treatment is not corrected upon death.
- Misusing non-profit/charitable tax benefits, including the over-evaluation of physical donations
Tax evasion is the illegal type of inheritance and gif tax minimisation, which can be willingly/knowingly or not. The most common forms are:
- Gift or inherit in cash.
- Exclude assets from inventory at death. Gift without notifying tax authority.
- Hide wealth offshore in tax havens, ideally with bank secrecy.
- Abuse of deductions. Expenses (such as funeral and “estate administration” expenses) and loans can be deducted from the inheritance tax base often. These costs and loans may be fraudulent or inflated.
Evidence, Magnitude and Fairness
Okay, we can see there are many possible ways to try at least to avoid or evade taxes. But is this actually (successfully) done, or are these mere theoretical options? The empirical evidence -despite difficulties, data availability issues and widely differing estimates – points in a clear direction: There is substantial inheritance and gift tax avoidance and evasion.
The estimated magnitude of tax evasion (which is likely the smaller amount when compared to legal avoidance) ranges between 10 and 75% across studies.[1] This means, that of each million € that should have been paid as inheritance tax, 750,000€ are evaded by illegal means. The magnitude of tax evasion has led governments such as New Zealand to abolish the inheritance tax.[2] Not all of the forms of avoidance and evasion may be empirically relevant. Tax-induced migration, as an example, seems to be rather uncommon, with extremely wealthy households being the exception.[3]
Avoidance and evasion abilities and skills are not equally distributed among the tax payers. The richer you are and the more inheritance taxes (also proportionally) you are to pay in theory, the better your arsenal of options to avoid and evade, up to an extent where the superrich pay half the tax rates on their inheritances than the ‘ordinary’ wealthy[4], resulting in factually regressive tax regimes despite formally progressive tax rates. On paper, we are social and meritocratic. In reality, we fail to achieve that. For Sweden, this unfairly higher burden on the middle classes was the major reason to abolish inheritance taxation.
However, there is some wind of change with progress on fighting tax evasion globally. We see progress on international tax transparency, such as through the Automatic Exchange of Information (AEOI ) or the Exchange Of Information on Request (EOIR), both reducing the possibilities of undetected tax evasion.
Not a natural law
There is tax avoidance and evasion, because the wealthy have an interest in this, and because societies let it happen. It is not a natural law. It is a bit ridiculous that one of the most popular arguments against something is its evasion. It is like the following dialogue: People: “We will increase inheritance taxes! – Rich: “I’m sorry, no point; we will somehow avoid it anyway.” – People: “Hah, but what if we close those loopholes?” – Rich: “If you really wanted that, you could have done that before.” Tax avoidance and evasion are nothing exogenous to the policy making process. The majority of tax minimisation possibilities are legal and are a direct or indirect outcome of policy making.
The avoidance might be either through explicit exemptions that are there by design (such as allowances and preferential treatments) or they are a clever combination of legal options. But either way, policymakers can change it. Exemptions can be reduced. Favourable treatments (e.g. for family businesses or farmers) can be made subject to certain conditions that prevent misuse. Exit taxes can be instated to prevent tax migration. Even where it comes to illegal tax evasion, governments are not passive victims that need to live with the decisions of tax dodgers. Recent progress in tax cooperation and exchange in information is going in the right direction and shows that it is feasible.
Cancelling off inheritance taxes on the grounds of tax evasion appears absurd, because tax avoidance and evasion is to a considerable extent an outcome of political choices. If a majority (or a government acting on behalf of a majority) of people is willing and able to increase inheritance taxes, then it is also able to change the policies that stand in its way. It is in the nature of proposed changes that, in fact, things need to change.
Further Reading
[1] Joulfaian (2007): „The Federal Gift Tax: History, Law, and Economics”, https://doi.org/10.7551/mitpress/10365.001.0001 ; Kopcuk and Slemrod (2000): “The Impact of the Estate Tax on the Wealth Accumulation and Avoidance Behavior of Donors”, https://www.nber.org/papers/w7960
[2] Drometer et al. (2018): “Wealth and Inheritance Taxation: An Overview and Country Comparison”, https://econpapers.repec.org/RePEc:ces:ifodic:v:16:y:2018:i:02:p:45-54
[3] OECD (2021), Inheritance Taxation in OECD Countries, OECD Tax Policy Studies, OECD Publishing, Paris, https://doi.org/10.1787/e2879a7d-en.
[4] International Investment: (“SPECIAL REPORT: INHERITANCE TAX – how good advice protects the nest egg”, https://documents.chitra.live/api/v1/documents/9e22039f-124b-4d5e-b1ff-30592ec4a110/download
