Why Inheritance Tax Should Be Reformed

22nd January 2024

Around 50 Conservative MPs called for inheritance tax to be abolished after the Telegraph launched a campaign urging the government to scrap the tax in summer 2023. The move has since been discussed as a potential "pre-election giveaway" in the government's upcoming spring budget.

Beyond the coming election, another longer term reason for recent discussion of this tax is the increase in the size of inheritances in recent decades. Inheritances are growing in absolute terms as the amount of wealth held by older people increases over time. Inheritances are also growing relative to lifetime employment income, so they are set to be increasingly important determinants of people's overall economic outcomes.

This means how we choose to tax inheritances is becoming increasingly consequential.

Inheritance tax is applied at 40% to transfers of wealth on or close to death, above a minimum threshold - currently £325,000. Most people don't pay it: less than 4% of deaths resulted in inheritance tax in 2020-21. While this figure is set to rise over time - around 5% of deaths are forecast to result in inheritance tax this year, rising to 7% by 2032-33 - it's still expected to remain low.

One factor holding this number down is that there is no inheritance tax payable on wealth left to a spouse or civil partner. But even if we count someone as an inheritance taxpayer if either they or their spouse or civil partner pay the tax at their death, the total number of taxpayers would still be fewer than one in 10 .

The main reason why few people pay inheritance tax is that the effective threshold at which they (or their spouse or civil partner) would begin paying the tax is typically much higher than £325,000. In addition to the £325,000 that can be given tax-free, there is a £175,000 allowance for residential property transferred to direct descendants.

For most people, this means the threshold rises to £500,000. Unused portions of tax-free thresholds can also be passed to a surviving spouse or civil partner, resulting in an effective threshold of £1 million before inheritance tax is payable for most married couples.

Since so few people actually pay inheritance tax, it brings in a relatively small amount in government revenues - around £7 billion in 2022-23, or 0.3% of GDP and less than 1% of government revenues. That said, the growing levels of wealth held by older generations mean that revenues are forecast to reach £15 billion or 0.5% of GDP by 2032-33.

Potential effects
Abolishing inheritance tax would currently cost the government £7 billion per year. As discussed, this figure is expected to grow over time. Abolition would mean that the government would have to either raise other taxes, cut spending elsewhere, or increase borrowing.

Around half of the gains from abolishing inheritance tax would go to the wealthiest 1% at death, whose estates would see an average tax cut of £1 million. Around half would also go to estates in London and the South East, where the wealthiest individuals are concentrated. More than 90% of people don't have inheritance tax paid on their or their partner's death and so wouldn't benefit from abolition.

There are some reasons to think that cutting inheritance tax might be popular. Only around 20% of people called inheritance tax "fair" in a 2023 YouGov poll, compared to around 60% for National Insurance contributions. However, research from Demos shows most people wouldn't prioritise inheritance tax for cuts, but would prefer to spend the money that abolishing inheritance tax would cost in other ways. Of course, interpreting public opinion is not straightforward.

Reforming inheritance tax
Inheritance tax in its current form involves various reliefs and exemptions. These are unfair, distort people's choices about how to hold their wealth and reduce government revenues. Abolishing or curtailing these reliefs would improve the tax system.

Pension pots are totally exempt from inheritance tax, as they are not counted as part of a deceased person’s estate. This means people are incentivised to fund retirement through non-pension assets such as ISAs or savings accounts, while using pension pots for bequests. This avenue of tax avoidance will become open to more people over time, as these pots become an increasingly important part of households’ overall wealth.

Agricultural and business reliefs mean that interests in farms and businesses can be passed on untaxed, encouraging people to hold wealth in those forms too. It’s hard to justify this on economic grounds. A cap on such reliefs could allow those passing on small farms or businesses to be taken out of inheritance tax, if desired, while preventing agricultural and business investments from being used simply to avoid inheritance tax.

A reform capping business reliefs, including the value of pension pots in people’s estates, and treating residential property identically to other assets could raise up to £4.5 billion in tax revenues. This could fund a cut in the rate of inheritance tax from 40% to 25% or an increase in the threshold after which inheritance tax is charged to £525,000. Alternatively, it could be used fund public spending or tax cuts in other areas.

There are arguments for and against abolishing inheritance tax, but addressing problems in the current system is increasingly important and would raise revenues. Beyond the implications for the government’s finances, such a reform would make the UK tax system fairer and reduce some of its perverse effects on people’s economic choices.

Author
David Sturrock
Senior Research Economist, Institute for Fiscal Studies
Bee Boileau
Research Economist, Institute for Fiscal Studies

Note
This article is from The Conversation web site. To read it with links to more information go HERE