Death to the death tax?

Published on 4 April 2014

Last week the Prime Minister, David Cameron, stated that he would like to increase the inheritance tax threshold, reviving memories of the 2010 Conservative Party manifesto pledge to increase the threshold to £1 million. This observation sets out how much this would cost, who would benefit and sets out arguments for alternative reforms to inheritance tax.

Last week the Prime Minister, David Cameron, stated that he would like to increase the inheritance tax (IHT) threshold, reviving memories of the 2010 Conservative Party manifesto pledge to increase the threshold to £1 million. Such a reform would leave IHT affecting few estates and bringing in little revenue, perhaps raising the question of whether it was worth continuing with the tax at all. But equality of opportunity concerns might point to an alternative direction for reform with the replacement of IHT with a tax on lifetime receipts. At the very least IHT is in need of reform.

Currently IHT at death is charged at a rate of 40% on estates’ values in excess of a threshold, while transfers made up to seven years before death are taxed at reduced rates and transfers made seven years or more before death are not normally taxed. Bequests to a spouse or civil partner are exempt from IHT and, since October 2007, any unused allowance is transferred to the surviving spouse. The threshold is currently set at £325,000 which means that married couples can collectively bequeath £650,000 tax-free. Agricultural land, certain business assets and bequests to UK registered charities are also exempt from IHT.

As illustrated in the figure below, receipts from IHT fell sharply following the 2007 reform and the onset of the financial crisis and associated falls in asset prices, and at less than 0.2% of national income (0.6% of all tax revenue) they remain at low to moderate levels by historical standards.

The Office for Budget Responsibility (OBR) forecasts that IHT will have raised £3.5 billion in 2013–14 and that this will increase to £5.8 billion in 2018–19. If the increase materialises, this would bring receipts as a share of national income to a level slightly above the previous peaks in in 2007–08 and 1986–87, as shown in the figure below, and would be the highest level of receipts since at least 1973–74 (not shown). The numbers paying IHT are also forecast to increase sharply from just 2.6% of deaths in 2009–10 to 9.9% of deaths in 2018–19, as shown in the figure.

Inheritance tax receipts and taxpayers

Inheritance tax receipts and taxpayers

Note: Figure shows total receipts and number of estates liable for IHT and (for years before 1986–87) capital transfer tax at death.

Source: Authors’ calculations based on data from HM Revenue and Customs, the OBR and the Office for National Statistics.

In part this predicted growth in receipts and taxpayers is due to the economic recovery and, in particular, a forecast bounce back in house prices. It is also in part caused by government policy. The last Labour government announced that the IHT threshold would be frozen at its 2009–10 level of £325,000 through to 2014–15 and the coalition government has chosen first to continue with this policy and then, in Budget 2013, to extend the planned freeze through to 2017–18. This eight-year freeze represents a cut of 22% or £70,700 relative to inflation as measured by the Consumer Prices Index. Thus while Mr Cameron wants to increase the threshold, the policy of his government is for the threshold to continue falling in real terms even after then next general election.

The last Conservative Party manifesto pledged an increase in the threshold to £1 million. Our calculations using data from HMRC suggest that in 2010–11 an increase in the threshold to £1 million would have cost the exchequer at least £1.8 billion. A £1.8 billion giveaway would have reduced IHT receipts by 70% from £2.6 billion to just £0.8 billion. It would have reduced the numbers paying IHT by three-quarters from 2.8% of deaths to just 0.7% of deaths. Of the total £1.8 billion giveaway £0.8 billion would go to those taken out of IHT as a result of the reform while £1.0 billion would go to those still liable for IHT. Much of the gain would go to those in London and the South-East since, in 2010–11, they paid half of all IHT. Given that IHT receipts are projected to increase sharply over the next few years an increase in the threshold to £1 million in, say, 2018–19 would cost considerably more than £1.8 billion.

Increasing the IHT allowance to £1 million would abolish IHT for all except a very small number of very rich families who do not plan their affairs in a tax-efficient manner (by giving away all except £1 million or £2 million of their assets at least seven years before their death, for example). And those individuals who would still be paying IHT after the reform was introduced would be paying considerably less: a couple whose joint estate was worth more than £2 million at death would attract £540,000 less tax as a result of this reform. This policy would leave IHT as a tax that very few estates were liable to pay and that raised little revenue.

The IFS-led Mirrlees Review, funded by the Nuffield Foundation and the ESRC, noted that IHT is “a somewhat half-hearted tax, with many loopholes and opportunities for avoidance through careful organization of affairs. This leads to charges of unfairness and makes a principled defence of inheritance tax difficult”. (See ch.15 Mirrlees Review) Inheritance tax is not very effective at achieving wealth redistribution. Were the threshold raised to £1 million it would also be much less effective in terms of raising money.

In these circumstances more radical change should surely be considered.

One option would be simply to abolish the tax. That would cost little more than increasing the threshold to £1 million, though the total cost would be £5.8 billion in 2018–19 relative to current policy. It would simplify the tax system and get rid of an ineffective and unpopular tax which can be criticised in any case as a source of double taxation in cases where bequests are financed from earnings that have already been taxed.

There is, however, also a case for moving in a different direction. The main justification for an inheritance tax is on grounds of equality of opportunity. Individuals do not control whether or not they are born to wealthy parents and therefore it might be seen as unfair that some are able to inherit much more than others. This argument points to taxing what each recipient gets, rather than what each donor passes on. It is also hard to see in principle why gifts made during someone’s lifetime should be treated differently from bequests at death, The simplest way to avoid IHT is simply to pass on assets above the threshold well before death – easier for the very wealthy than for the merely quite wealthy whose main bequeathable asset is their home.

The Mirrlees Review therefore argued that, if concern for equality of opportunity justifies taxing transfers to the next generation, a more logical approach than the current one – albeit with practical challenges of its own – would be to tax individuals at progressive rates on the total amount of gifts and inheritances that they receive over their lifetime. Systems broadly along these lines were proposed by the Conservative government in 1972 and by the Liberal Democrats as recently as 2006, and one has been in place in Ireland since 1976. (See ch. 8 Mirrlees Review)

Less radical reforms to IHT could also improve it by reducing the scope to avoid the tax. Such a package of reforms could involve removing or reducing the reliefs given for agricultural land and business assets and extending the reach of the tax to gifts made more than seven years before death (an increase to 15 years is current Liberal Democrat policy (See Liberal Democrat Conference)). But whatever happens IHT should not live on in its current form.

We are grateful to the Nuffield Foundation and to the Economic and Social Research Council (ESRC) for supporting much of the research that underpins this analysis.