Inheritance tax (IHT) is a hot topic that regularly prompts press campaigns for its abolition, the latest being from the Daily Telegraph.
Indeed, it is frequently branded as the UK’s most disliked tax, with the latest YouGov survey showing 50% of respondents think it ‘unfair’ or ‘very unfair’, against 20% who call it ‘fair’ or ‘very fair’.
But as the Office of Tax Simplification (OTS) demonstrated in its first report reviewing IHT, there is a perception the tax has a much greater impact than is actually the case.
Even 26% of those who responded to an OTS public call for evidence (a self-selecting group who ought to have had some knowledge of the tax) believed 20% or more people paid IHT. The latest HMRC figures (for 2020/21) show just 3.7%.
The current cost of IHT abolition would be £7bn. Almost half that benefit would go to those with estates of £2.1m or more at death
A new report on IHT from the Institute for Fiscal Studies (IFS) does not answer the impossible question its director Paul Johnson recently posed in an article for the Times: what is the question to which abolishing IHT is any sort of plausible answer?
However, the report does make a range of points about the operation of the tax and its potential reform:
1. Inherited wealth is growing compared with earned incomes and will have a growing impact on inequalities by parental background.
Those with the wealthiest fifth of parents are set to benefit from a rise in averages of 17% of lifetime income for those born in the 1960s to 30% of lifetime income for those born in the 1980s.
2. The share of deaths resulting in IHT is small but a growing proportion are potentially affected by the tax.
The proportion of deaths resulting in IHT is projected to grow to over 7% by 2032/33. However, inter-spouse/civil partner exemptions means the number of people affected by IHT is larger. By 2032/33, one in eight people are projected to face IHT either on their death or their spouse/civil partner’s death.
3. IHT revenues are small, at £7bn (or 0.3% of GDP) a year.
The 2032/33 projection is just over £15bn in today’s prices (0.5% of GDP), driven by increasing levels of wealth held by subsequent generations of retirees.
4. The current cost of IHT abolition would be £7bn.
Almost half (47%) of that benefit would go to those with estates of £2.1m or more at death. That group, which represents the top 1% of estates, would benefit from an average tax cut of around £1.1m. The circa 90% of estates outside the IHT net would not be directly affected by such a reform. Those figures underline the political risk for prime minister Rishi Sunak in IHT abolition.
5. IHT reliefs for agricultural and business assets, and defined contribution (DC) pension pots, create opportunities to avoid the tax and distort economic decisions.
The residence nil-rate band, which gives special treatment to property passed to direct descendants, raises similar types of problems and is of greater benefit to those in London and the South. IHT would be a cleaner, more coherent, tax if there was no special treatment for certain types of asset.
Abolishing reliefs for agriculture, businesses and DC pension pots could raise up to around £1.5bn a year – 20% more IHT revenue. Combining these changes would reduce the scope for substituting one avoidance channel for another.
Other changes to taxation at death could improve efficiency and fairness, as well as raise revenue
80% of the tax revenue from business relief reform could be captured just by capping the relief at £500,000 per person instead of outright abolition. Most business wealth is concentrated among those with high wealth, so the fiscal cost of such a threshold would be low.
Around 90% of business wealth bequeathed is given as part of an estate worth over £2m.
The IFS makes no comment on defined benefit pensions. Its stance presumably reflects the general absence of meaningful death benefits beyond survivor’s pensions once retirement has been reached.
6. Scrapping the residence nil-rate band (NRB) and extending the NRB would make the system fairer.
A single £0.5m NRB would cost around £0.7bn a year and hold the proportion of deaths resulting in IHT down at around 4%.
7. Combining simple reforms could lead to a better IHT structure.
A package that capped agricultural and business reliefs, brought DC pension pots within the scope of IHT and abolished the residence NRB could fund an increase in the NRB to around £525,000 on a revenue neutral basis. Alternatively, the IHT rate could be cut from 40% to around 25%.
8. Maintaining the share of deaths resulting in IHT at its long run 4% level requires the current NRB to be £380,000.
It would cost about £0.9bn a year for such a 17% increase in the NRB – well below the 53% CPI increase from April 2009, when the NRB reached its current £325,000. The cost of limiting the scope of the IHT system to a 4% share would grow over time, reaching £2.7bn by 2032/33.
9. Other changes to taxation at death could improve efficiency and fairness, as well as raise revenue.
Levying capital gains tax at the point of death would produce around £1.6bn a year. Levying income tax on all withdrawals from inherited pension pots would also raise further revenue.
10. IHT has only a small impact on the distribution of inheritances received and intergenerational wealth mobility.
The wealthiest fifth of donors will bequeath an average of around £380,000 per child and pay IHT of around 10% of this amount. The least wealthy fifth of parents will leave less than £2,000 per child.
By the time inheritances are received, wealth inequality is already substantial. Inheritances are most often received when people are in their late 50s or early 60s. Around the ages of 50–54, children of the wealthiest fifth of parents have an average of £830,000 in wealth, while children of the least wealthy fifth have on average £180,000.
The main political parties, particularly the Conservatives, cannot afford to ignore this report
The IFS report is a useful exercise in showing how IHT can be reshaped by removing the reliefs which have accumulated over time. However, the proposals outlined above are a long way from some of the more radical ideas that have appeared in recent years, such as applying income tax to beneficiaries’ (not donors’) receipts above a cumulative lifetime threshold.
The main political parties, particularly the Conservatives, cannot afford to ignore this report. The IFS is the media’s go-to think tank for tax matters. The parties’ strategists and spin doctors would all be aware of the need to have responses ready when a journalist raises questions based on IFS material.
That is particularly pertinent for Sunak et al considering nearly half of the benefits of IHT abolition would go to those with estates over £2.1m.
Tony Wickenden is managing director of Technical Connection
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