Inheritance tax is not a lone island

There is little point in considering its abolition of inheritance tax unless you suggest how the capital gains taxation should then be reformed, Essi Eerola writes.

Luola Saaren Rannalla. (c) Pekka Jylhä (kuvaa rajattu)Image: Cave on an island beach (detail). (c) Pekka Jylhä (image has been cropped)

As a citizens’ initiative proposing the abolition of inheritance and gift tax will soon be considered by the Parliament, there has been lively public debate on the pros and cons of inheritance tax. While many points have been made in this debate, there has been less talk on how the inheritance tax links to the overall taxation system. Taxes that are particularly interesting in this respect are the capital gains tax and the capital income tax.

The essential task of the capital gains tax is to complement taxation on capital income. The returns from different investments may take the form of dividends, interest, or an increase in the value of assets. If dividends or interest is taxed annually through capital income tax, but there is no tax on the increase in value, there is an incentive in the taxation system to channel the returns from capital into an increase in value.

The existing capital gains tax targets the increase in value when the asset is sold, not when the increase in value is created. If the value of an investment has increased, the return after tax may be greater than the return from an alternative investment, even if the return before tax would be smaller. In such a situation, it is reasonable to postpone the sale of the investment instead of realising it and investing the money in a more profitable asset. Therefore, the capital gains tax leads to a sub-optimal allocation of resources.

Naturally, capital gains tax is typically related to a situation where assets have once been purchased and are later sold. But what if the assets have been received as a gift or inheritance? When the inheritor later sells the assets, the acquisition cost, which is employed in calculating the capital gains tax, is determined on the basis of the value of the assets at the time of receiving the inheritance. Due to this non-continuity principle, the increase in value that took place when the asset was still held by the previous owner is entirely excluded from capital gains taxation. In Finland, therefore, inheritance tax can be considered complementary to the capital gains tax, although not precisely of course. The reason for this is that the inheritance tax applies to the full value of the asset, not just to the increase in value that has not been realised yet.

When Norway abolished the inheritance tax in 2014, a so-called continuity principle was introduced in capital gains taxation. When selling an asset received as inheritance, the inheritor pays tax also for the increase in value created during the time of the previous owner. A continuity principle is also applied in Sweden. In the Swedish and Norwegian models, the “lock-up” effect of capital gains tax described above increases from one generation to the next, provided that the value of the asset keeps increasing.

Another solution would be that the person leaving inheritance or giving a gift is deemed to have realised capital gains or losses just before the title to the asset is transferred. In such a system, each owner is responsible for the increase in value created during the period when they owned the assets, irrespective of whether the asset is eventually sold or given as a gift. Similarly, when the recipient of a gift later sells the asset, the acquisition cost is the value of the asset confirmed at the time of receiving the gift. The system in Canada, for example, complies with this principle.

Naturally, the incentive effects of these two systems are very different, and as is often the case, the ultimate impact depends on many details.

Almost all forms of taxation guide the behaviour of businesses and households in one way or another. They reduce the exchange of commodities and production and thus cause welfare losses. Some forms of tax are more detrimental than others, of course, so it matters how the tax revenue is collected. When different forms of tax were compared in this study, inheritance tax was not considered as particularly harmful (read the considerations of fellow economists here; in Finnish).

Whatever your opinion on inheritance tax is, there is little point in considering its abolition unless you can suggest how the capital gains taxation should then be reformed.