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From: Think Tanks
Published: Wed Sep 27 2023

We set out issues with the inheritance tax system and examine options for reform and the distributional impacts of reforming or abolishing the tax.

Inheritance tax is arguably the UK's most disliked tax. A recent YouGov poll found that just 20% of people deemed inheritance tax ‘fair' (see Ansell (2023)). This compared with almost 60% for National Insurance contributions. There is near-universal agreement that inheritance tax in its current form needs reform, but no consensus about what that reform should be. Complaints range from saying that the tax is far too easy to avoid - because of exemptions for certain types of assets and for gifts made more than seven years before death - and so needs to be expanded, to claims that there is no justification for (further) taxing those who choose to pass on their wealth to their children and that the tax should be abolished.

Figure 7.1. Number of inheritance-tax-liable estates per 100,000 residents, by parliamentary constituency

There are a number of well-noted and established issues with the current design of inheritance tax and indeed with the way that the tax system treats death more generally. These have been set out by, for example, the Office of Tax Simplification (2019) and the All-Party Parliamentary Group for Inheritance and Intergenerational Fairness (2020). There is good reason to think that reform could make the tax system fairer and more economically efficient.

Reform of inheritance tax is a topic worth considering now for multiple reasons. In the immediate term, a group of Conservative MPs, in consort with a Daily Telegraph campaign, have sought to push the Chancellor to commit to abolishing the tax. Looking to the near future, governments of all stripes may seek to raise more revenues from taxing wealth and wealth transfers in order to meet fiscal pressures. There are many political considerations that bear on choices around inheritance tax, not least its unequal effects across the country. Figure 7.1 shows that there are far more inheritance-tax-liable estates per resident in the South of England.

Taking a longer-term view, the rapid growth of wealth compared with earnings over the past several decades has brought with it questions about the balance of taxation across generations and the growing role of parental wealth transfers in driving differences in life outcomes within today's working-age generations. Inheritances have grown, and are expected to continue to grow, faster than earnings, meaning that they are projected to have a growing negative impact on intergenerational mobility (van der Erve et al., 2023). Put simply, it is becoming harder to use savings from earnings to make up for a lack of inheritance relative to others born at the same time. Questions around how inheritances should best be taxed will become more pressing with time.

In this chapter, we consider problems with the current design of inheritance tax, examine the revenue and distributional consequences of potential reforms, and discuss some wider issues about how the tax system operates at death. Our focus is on incremental reforms which build on the current structure of inheritance tax, although we note areas where more fundamental reform could be considered. We consider some reforms that expand the tax base and eliminate exemptions for certain types of assets. We also analyse the effects of reforms that would take some estates out of paying inheritance tax, including increasing tax-free thresholds and complete abolition of the tax. We show combinations of reforms that would bring certain assets into the inheritance tax base while at the same time reducing the tax liability for some. Our options encompass some that raise revenue, some that would reduce it and some that are revenue-neutral. While our focus is on inheritance tax, we also note some other ways in which taxation around the point of death should be reformed.

Key findings

1. Inherited wealth is growing - and set to continue to grow - compared with earned incomes, and it will have a growing impact on inequalities by parental background. While inheritances will remain small for those with the least wealthy fifth of parents, for those with the wealthiest fifth of parents they are set to rise from averaging 17% of lifetime income for those born in the 1960s, to averaging 30% of lifetime income for those born in the 1980s. If the annual flow of non-spousal inheritances next year was equally shared across those aged 25, this would imply each receiving around £120,000.

2. Exemption thresholds, which allow many couples to pass on up to £1 million tax-free, mean that the share of deaths resulting in inheritance tax is small, at around 4% in 2020-21, but a larger and growing proportion are potentially affected by the tax. The proportion of deaths resulting in inheritance tax is set to grow to over 7% by 2032-33. The number of people affected by inheritance tax will be still larger. By 2032-33, one in eight people (12%) will have inheritance tax due either on their death or their spouse or civil partner's death.

3. Inheritance tax revenues are small, at £7 billion (or 0.3% of GDP) a year. However, we forecast that by 2032-33 they will rise to just over £15 billion in today's prices (0.5% of GDP), driven by increasing levels of wealth held by subsequent generations of retirees. It is of growing importance that this tax is well designed.

4. The current cost of abolishing inheritance tax would be £7 billion. Around half (47%) of the benefit would go to those with estates of £2.1 million or more at death, who make up the top 1% of estates and would benefit from an average tax cut of around £1.1 million. The 90% or so of estates not paying inheritance tax would not be directly affected by such a reform.

5. There are several problems with the current design of inheritance taxation.Reliefs for agricultural and business assets and certain classes of shares, and the total exemption of pension pots from inheritance tax, open up channels to avoid the tax and are consequently costly and inequitable 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. There is a clear case for eliminating the special treatment of all of these types of assets.

6. Abolishing agricultural and business reliefs and bringing pension pots within the scope of inheritance tax could raise up to around £1½ billion a year. How much revenue would be raised is uncertain and depends on various factors including whether other channels are used to avoid inheritance tax. Making these changes together would reduce the scope for substituting one avoidance channel for another.

7. Four-fifths of the tax revenue from reform to business relief could be captured just by capping the relief at £500,000 per person, rather than outright abolition. Most business wealth is concentrated among those with high wealth, so the fiscal cost of an additional half a million pounds threshold for business wealth would be low, though the special treatment would remain unfair and distortionary. Around 90% of business wealth bequeathed is given as part of an estate worth over £2 million.

8. Removing the special treatment for residential property, by abolishing the residence nil-rate band (currently set at £175,000) and extending the nil-rate band from £325,000 to £500,000 would cost around £700 million a year and hold the proportion of deaths resulting in inheritance tax down at around 4%, while making the tax system fairer.

9. A reform that capped agricultural and business reliefs, brought pension pots within the scope of inheritance tax and abolished the residence nil-rate band could fund an increase in the nil-rate band to around £525,000 or a cut in the inheritance tax rate from 40% to around 25%.

10. Increasing the nil-rate band to hold the share of deaths resulting in inheritance tax down at its long-run average of 4% would require a nil-rate band of £380,000 and cost around £900 million a year. The cost of limiting the scope of the inheritance tax system in this way would grow over time, reaching £2.7 billion by 2032-33.

11. There are other changes to taxation at death that would improve efficiency and fairness, and raise revenue. Levying capital gains tax at the point of death would raise around £1.6 billion a year. Levying income tax on withdrawals from inherited pension pots regardless of the age at which the giver passed away would also raise further revenue.

12. Inheritance tax as currently designed has only a small impact on the distribution of inheritances received and therefore on intergenerational wealth mobility. The wealthiest fifth of donors will bequeath an average of around £380,000 per child, and pay inheritance tax of around 10% of this amount. By contrast, the least wealthy fifth of parents will leave less than £2,000 per child. To have a larger impact on intergenerational mobility, inheritance tax would have to be substantially expanded in scope.

13. 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. While a reformed inheritance tax could do more to promote intergenerational mobility, big wealth inequalities by parental background already exist before inheritances are received.

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Company: Think Tanks

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