11 May 2018

Replacing inheritance tax is easier said than done


The Resolution Foundation’s suggestion that every 25-year-old be given a £10,000 “citizen’s inheritance”, to be spent on education, housing, or a business venture — or else saved for retirement — received a great deal of coverage earlier this week.

Less attention was paid to how such a grant would be paid for: namely, by replacing inheritance tax with a “lifetime receipts tax” that would raise more than twice as much money. In essence, the idea is to redistribute wealth as it passes between generations, so that the benefits of inheritance are spread more widely — and arrive earlier in life — than is the case at the moment.

Something tells me, however, that the the new receipts tax is going to have more staying power in public debate than the “citizen’s inheritance” it is meant to finance. Big new spending programmes might capture headlines, but given a stubborn budget deficit, rising demands on the welfare state, and the possibility of an economic downturn around the corner, it is the prospect of increased revenue that will set pulses racing at HM Treasury.

What’s more, the current inheritance tax system is a mess. It is complex and costly to administer: the Taxpayers’ Alliance suggests that it accounts for 10 per cent of Britain’s tax code, despite raising less than 1 per cent of government revenues. It is widely resented, with polls suggesting voters see it as Britain’s most unfair tax. And it is riddled with exemptions that mean the truly wealthy and well-advised often avoid paying it; instead, those whose wealth is tied up in a valuable family home can be hardest hit.

Changes designed to address that last injustice have made inheritance tax even more complex. In addition to the “nil-rate band” of £325,000, the government introduced an extra allowance of £100,000 (rising in steps to reach £175,000 in 2020/21) that applies only when a main residence is left to a child or grandchild. Both allowances can be shared between spouses, but the one for main residences tapers away once the value of an estate exceeds £2m. Rules making it possible to apply the main residence allowance to other assets when someone has downsized further complicate matters, as do long-standing exceptions for business property, agricultural land, and trusts. And that’s before we even consider the impact of gifts made before death.

Little wonder, then, that chancellor Philip Hammond has asked the Office of Tax Simplification to review inheritance tax and suggest ways to make it more straightforward.

The Resolution Foundation propose scrapping the entire system and starting again — taxing individuals based on the assets they receive over their lifetime, rather than taxing a dead person’s estate based on the assets they left behind. Specifically, people could receive £125,000 in gifts and inheritances before any tax was due. The next £375,000 would be taxed at 20 per cent. And any lifetime gifts or inheritances beyond a cumulative £500,000 threshold would be taxed at 30 per cent.

There is sound logic behind taxing recipients rather than estates. As the Institute for Fiscal Studies’ Mirrlees Review pointed out, if the point of taxing wealth transfers is greater equality of opportunity, then it is the recipient’s gains that matter. Why tax a £1m estate divided between 10 beneficiaries more harshly than a single bequest of £100,000? In each case, the individual gain is the same. Likewise, why should someone who receives one large bequest pay more tax than someone who receives the same amount via several smaller inheritances?

Nevertheless, there are some obvious problems with the proposed lifetime receipts tax. First, such a system may prove difficult to enforce and operate. The Resolution Foundation suggests that people will have to proactively declare any gifts over £3,000 (per donor, per year) they receive to HMRC, and that HMRC will have to maintain a record for every individual recipient. At best, people are likely to resent such increased interaction with the tax authorities; at worst, they might go out of their way to avoid it (making unreported cash transfers, for example). Bringing tax-free accommodation, interest-free loans, and non-cash gifts such as cars into the fold will only increase HMRC’s administrative burden — and amplify taxpayer resentment.

Then there’s the thorny issue of housing. A lifetime inheritance and gift allowance of £125,000 might sound generous, but it is still less than the average price of a property in the north-east of England. The average London property, meanwhile, was valued at £484,000 in December 2017.

As things stand, someone could in theory inherit a £1m family home from their parents in 2020/21 without it being subject to tax. Under the proposed lifetime receipts tax, by contrast, the same person would face a tax bill of £225,000. That is an extreme case, but it serves to illustrate how people could be pulled into the tax net. For better or worse, it’s political dynamite; it will take an exceptionally courageous minister to pursue a reform with that effect.

Finally, there’s the question of whether we really ought to tax wealth transfers at all. For one thing, inherited money may already have been taxed when it was earned, when it was invested, and when it produced any returns. It will likely be taxed again when it is spent by the recipient. Is it really fair to tax it a further time when it is transferred?

As the 2020 Tax Commission’s Single Income Tax report showed (p. 291–2), earned income that is saved and invested in a company for 35 years at a 10 per cent return, and then inherited, could face a total effective tax rate of 95 per cent — another extreme example, perhaps, but one that neatly demonstrates the cumulative effect of double, triple, and quadruple taxation.

More fundamentally, there is something rather unseemly about the state inserting itself into transfers between family members and trying to take a cut. The feeling that taxing inheritance punishes those who save and accumulate assets, and discourages people from providing for the next generation, is, I think, as much of a factor in the unpopularity of inheritance tax as is its actual financial impact. Put simply, it doesn’t accord with people’s sense of fairness.

Ultimately, then, it is hard to see the lifetime receipts tax making the transition from proposal to practice in the UK — at least in the form outlined by the Resolution Foundation.

Despite its theoretical appeal, the lifetime receipts tax faces significant practical, political, and even philosophical barriers to successful implementation. In the short term, efforts to reform inheritance tax are instead likely to focus on simplifying the existing system. In the longer run, inheritance tax will surely remain a tempting political candidate for outright abolition — if and when budget considerations allow.

Tom Clougherty is Head of Tax at the Centre for Policy Studies.