The future of inheritance tax

Good morning from New Economy Brief

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Inheritance tax is in the news, for two rather different reasons. Firstly because of one person who isn’t paying it, and secondly because of the mounting rumours that it may be a leading candidate for the highly anticipated pre-election tax cut.

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The myths around inheritance tax are many and various, and the politics and economics of inheritance tax interact with each other in complicated ways. The tax has important distributional consequences, and proposals exist for reform from different sides of the political spectrum. This week’s briefing explores the political and economic debate around inheritance tax and examines the proposals for reform.

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Who pays inheritance tax? King Charles has been crowned, but the Monarch is exempt from paying any tax on the £15.2bn royal estate he inherited from his mother. Some have argued that this is unfair, as the rest of us have to pay a 40% levy applied on assets valued over £325,000. 

• A minority tax. It’s not just the King who doesn’t pay inheritance tax (IHT) though, in fact the relatively high threshold means that very few people actually pay the tax. HMRC data from 2019-20 reveals that only 3.25% of deaths resulted in an IHT charge, and Demos calculate that only 6,000 estates actually pay inheritance tax each year because of the high thresholds and exemptions. It’s not just those at the bottom that don’t pay inheritance tax though, analysis from the Office for Tax Simplification (p5) finds that the very wealthiest also don’t pay much IHT either, as there are many loopholes used to avoid paying. This results in a surprisingly low IHT revenue figure of around £7bn per year - although this is set to rise as asset values inflame while the threshold remains frozen.
• But inheritance tax is unpopular. Inheritance tax has an almost mythical political status. The prospect of any cut raises the spectre of George Osborne’s famous inheritance tax gambit which allegedly convinced Gordon Brown not to call an early general election in 2007. Despite most people not paying it, public attitudes research shows that IHT is unpopular, for instance only a third of Labour supporters think inheritance tax is fair, whilst two thirds think income tax and National Insurance are fair. Oxford Professor Ben Ansell suggests that “when it comes to property or savings, there’s very little public support because it gnaws away at many people’s fundamental views of desert, effort, and prudence”. Essentially, many people believe that parents should be able to pass on assets accrued over their lifetime to their children.

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However, inheritance tax has important distributional consequences. IHT remains one of the only taxes on wealth in the UK and is an important way of transferring wealth as inequality soars. A combination of rising house prices, declining home ownership and stagnating incomes has created stark inequality between generations, but this will accelerate as newer generations inherit wealth from their parents. An IPPR report explains that “wealth transfers, such as inheritances, confer opportunity on the recipient. Taxing and redistributing transfers, either to individuals or through investment in collective services, therefore promotes equality of opportunity… As such, failing to tax wealth transfers sufficiently perpetuates economic injustice, and negatively impacts social mobility, while also constraining economic growth.”

• Failing to tax inheritance will accelerate wealth inequality. The IFS have argued that wealth is the growing economic divide in the UK today, warning that the economic prospects of young generations are struggling to match those of their predecessors, and recent declines in social mobility may accelerate as inherited wealth becomes an increasingly important part of lifetime resources. The Spectator’s Ross Clark explains why “scrapping inheritance tax is a terrible idea… There’s nothing conservative about encouraging unearned wealth”. Demos’s Andrew O’Brien argues that “Any tax cut is not only unlikely to incentivise inheritance (given the growing levels of inheritance) it would also be a change that would benefit only a handful of already wealthy people”. They also found that a typical person in the South of England born in the 1970s is set to inherit three-and-a-half times as much as a typical person in the North East. A report from Demos on the UK’s ‘New Age of Inheritance’ found that the real value of inheritances transferred annually in the UK has doubled roughly every 20 years since 1979 to over £100bn a year. The Resolution Foundation expects ‘peak inheritance’ to be reached in 2046, where the value of inheritances is forecast to double again.

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But it’s not perfect, and can be reformed. IPPR propose abolishing IHT and replacing it with a lifetime donee-based gift tax levied on the gifts received by an individual above a lifetime allowance of £125,000. After this limit is reached, any income from gifts is taxed annually at the same rate as income from Labour. This would increase the tax level on higher earners who receive large gifts and also encourages gifting to less well-off beneficiaries. It also has fewer exemptions so no one can exploit the current loopholes which allow many wealthy people to game the system and avoid paying IHT, for example by putting their assets into trusts.

• The potential tax take. A similar gift tax has also been advocated for by the Resolution Foundation. They calculated that taxing gifts through the income tax system with allowance of £125,000 could have raised £15bn in 2020/21, £9.2bn more than the current IHT system, and would do so more progressively as most people would pay the basic rate, whilst a higher top rate helps to reduce wealth inequality by levying more from the highest earners.
• Getting around the politics. IHT currently taxes estates, not the inheritance of the individual receiving it, making it easier to be classed as a politically unpopular ‘death tax’, rather than a social mobility enhancing gift tax, which can be framed to appeal to values of equality of opportunity and fairness. Ben Ansell’s public attitudes research has shown that emphasising the benefits of lower income taxes and higher public spending “led to a decline in just under ten percentage points in people thinking inheritance taxes were too high”.
• Other options. The fact that IHT is one of the only taxes on wealth in the UK means it is doing a lot of heavy lifting in terms of redistribution. If there were better ways of taxing wealth more consistently, such as a land value tax, or a net wealth tax, the imperative for a tax on inheritances would reduce, although there would still be an argument from a fairness perspective.

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It’s all politics. Bloomberg’s Alex Wickham recently reported that PM Rishi Sunak is “considering cutting the UK’s unpopular inheritance tax ahead of the next general election, people familiar with the matter said, a move senior Conservatives think will give his ruling party a major boost”, particularly from ‘Blue Wall’ voters. This is worth exploring. The political logic of pursuing pre-election tax cuts has two driving motives. One is the desire to do something that will leave voters feeling better off before polling day, and given that improvements to public services or rising real wages are harder for the government to deliver in the remaining 18 months or so of the parliament, tax cuts begin to look attractive. The second is a belief held by many Conservatives that lowering taxes will lead to growth, and that championing low taxes can tell a story about a kind of small-state economy a Conservative government would create that is distinct from anything other parties are offering. It is hard to see how cutting IHT fulfils either of these objectives. By its very nature few people will feel any kind of material benefit from such a tax cut, compared to cutting income tax by 1p for example (which has a similar price tag), and even the most Thatcherite of Conservatives would struggle to argue that the rate of IHT is holding back the UK economy. 

• The language of priorities. Reading the above polling on IHT, it’s easy to see why a party in need of a polling boost and a dividing line with the opposition might be tempted by this idea, but it is also worth remembering that this is a party extremely vulnerable to the charge that they are determined to cut taxes for the 1%, as seen in the recent row over pension lifetime allowances. There is also the question of priority; while people might not like IHT, is it really a vote-moving issue for them? With the cost of living crisis devastating household finances and public services on their knees, there is a real risk of such a move backfiring and the government looking extremely out of touch with people’s priorities.
• Opposition choices. Finally, there is the question of how opposition parties and others would respond to such a move. There are important reasons, both principled and practical, for defending taxing inheritances. In principle the idea of restricting the ability for inequality to be passed through the generations is an important one, and practically while there are options for reform it is always easier to keep an existing tax than to create a new one. But if IHT were to be abolished before an election, the above examples demonstrate that there are options to replace the revenue and actually raise taxes on the wealthy in ways which are perhaps less politically difficult than pledging to reintroduce IHT.