Inheritance Tax (IHT) is a topic that often sparks discussions about whether it should be abolished.
According to a recent YouGov survey, many find it the least favourable tax. It revealed that 50% of respondents consider it ‘unfair’ or ‘very unfair’, while only 19% held the opposite view. Interestingly, there is a common misconception that a large percentage of people pay IHT. Even among those who knew of the tax, 26% believed that 20% or more of people are subject to it. The figure is only 3.73%, per the latest HMRC data from 2020/21.
What is the current thinking on IHT?
A recent report from the Institute for Fiscal Studies (IFS) delves into various aspects of IHT, though it has yet to offer a clear answer on whether it should be abolished. However, it does shed light on how the tax operates and possible areas for reform:
The wealth passed down through generations is increasing compared to earned incomes.
This will likely contribute to more significant economic disparities based on parental background. While those with less wealthy parents may not receive large inheritances, those with more affluent parents could see a rise from 17% to 30% of their lifetime income.
Although the percentage of deaths resulting in an IHT liability is relatively small (around 4% in 2020/21), a larger and growing number of people are potentially affected by the tax.
This is projected to increase to over 7% by 2032/33. When considering exemptions for spouses or civil partners, the number of people facing IHT is even higher.
IHT revenues are relatively modest.
They currently stand at £7 billion (0.3% of GDP) annually. By 2032/33, this is projected to increase to just over £15 billion (0.5% of GDP) due to higher levels of wealth among subsequent generations.
Eliminating IHT would cost approximately £7 billion.
Nearly half of this benefit would go to estates worth £2.1 million or more, benefiting the top 1% of estates with an average tax cut of around £1.1 million. This highlights a potential political risk for policymakers.
Certain reliefs for agricultural and business assets and defined contribution pension pots can create opportunities to avoid paying taxes and influence economic decisions.
The residence nil-rate band, which offers special treatment for property passed down to direct descendants, presents similar challenges, particularly favouring those in London and the South. Simplifying these rules would lead to a more coherent tax system.
Removing the residence nil-rate band and expanding the nil-rate band would make the system more equitable.
A single £0.5 million nil-rate band would cost around £0.7 billion a year and keep the proportion of deaths resulting in IHT at about 4%.
Combining various reforms could lead to a more effective IHT structure.
For instance, capping reliefs for agriculture and business, including DC pension pots in IHT, and doing away with the residence nil-rate band could fund an increase in the nil-rate band to around £525,000 without impacting overall revenue.
To maintain the 4% share of deaths resulting in IHT, the current nil-rate band would need to be £380,000.
This would cost about £0.9 billion a year. This might be a reasonable expense considering the 53% increase in the Consumer Price Index since April 2009.
Implementing Capital Gains Tax at the time of death could generate approximately £1.6 billion annually.
Taxing income on all withdrawals from inherited pension pots would provide additional revenue.
IHT has a limited impact on the distribution of inheritances and intergenerational wealth mobility.
The wealthiest donors typically leave around £380,000 per child, paying about 10% in IHT. In contrast, the least wealthy parents leave less than £2,000 per child.
What will happen?
Ultimately, the IFS report offers valuable insights into reshaping IHT by removing longstanding reliefs. However, it stops short of endorsing more radical ideas like applying income tax to beneficiaries’ receipts above a certain lifetime threshold.
Politically, this is a significant issue, especially for the Conservatives, as the IFS holds considerable influence in discussions around taxation. It’s crucial for policymakers to have well-prepared responses to questions based on IFS findings.