Cut IHT rates and scrap exemptions

The arguments for taxing inherited wealth are obvious: inheritances are unfair as they benefit a lucky few and are inefficient as they reduce incentives for heirs to work and deter efficient business succession. 

And, as the OECD sets out in its report Inheritance Taxation in OECD Countries, they have been given a new urgency, with the concentration of wealth growing fast today, while the pandemic has sent government debt soaring,

The arguments would have been familiar to British politicians a century ago, when, in 1925, Winston Churchill raised death duties to reduce income tax on the middle class saying: “The process of the creation of new wealth is beneficial to the whole community. The process of squatting on old wealth though valuable is a far less lively agent.”

But opinion later shifted and from 1986 the UK made inheritance tax (IHT) a largely voluntary tax for the very wealthy: those who can afford big lifetime gifts can pass on much of their wealth tax free.

Why then, does IHT remain so unpopular? Among critics of the current system, there is a strong sense of injustice: that the rich get away with not paying their fair share of taxes. But donors tend to see themselves as exercising their fundamental property rights: abstract concepts of equity are not terribly persuasive to people wanting to leave money to their children. 

Any proposal that involves increasing the overall IHT burden therefore needs to bridge the gap between these emotions. A cross-party consensus must also be reached: wealth taxes, including IHT, require political stability otherwise people will delay transfers and await a more favourable government. 

The OECD recommends a recipient-based inheritance tax rather than an estate tax levied on donors, and suggests including lifetime gifts as well as bequests. This option interested Margaret Thatcher before being dismissed as too complex to administer. It may be more feasible now that tax can be digitalised.

But there are problems. First, the 21 OECD countries which operate a recipient-based tax system provide limited evidence that it generates more revenue. A pragmatic chancellor may worry about expending political capital for little financial reward.

Next, most countries taxing recipients (apart from Ireland) have a forced heirship system where family members are entitled to inherit fixed shares. By contrast, England, Wales and Northern Ireland generally allow donors more freedom in writing their wills. But Scotland does not: relatives can claim fixed legal rights. A recipient-based tax system may work better where property law requires compulsory division among children on death.

Third, there are design problems, particularly in the UK where trusts are often used to hold wealth. How is the trust taxed? What if the donor is UK resident, but the recipient is not? The OECD report does not consider these issues in any depth, but they cannot be ignored. 

The OECD recommends progressive tax rates with the rich paying at a higher rate. However, if rates and thresholds are high, history suggests millionaires will find ways to avoid IHT and lobby hard for reliefs.

The tax base then becomes narrow and unfair — exactly what has happened in the UK where the high headline rate of 40 per cent has encouraged lifetime giving and clever use of trusts. People can hardly be criticised for taking advantage of the reliefs on offer, but these benefit the rich — estates valued between £1m and £8m now pay at an effective tax rate of 20 per cent; estates above £10m pay at just 10 per cent, thanks to reliefs.

There is another alternative: a low flat-rate estate tax. Tax the donor on all transfers, whether in lifetime or on death and whether to trusts or individuals but at a low flat rate of, say, 10 per cent.

 The donor would have a £10,000 annual exemption which would exempt virtually all lifetime giving for most households where average lifetime gifts are under £5,000 yearly. Complicated anti-IHT avoidance provisions could be abolished. 

The quid pro quo would be to scrap all reliefs including on business and agricultural property, apart from spouse and charity exemptions. There would be an additional exemption available only on death and not (as at present) renewable in a complicated way every seven years.

Crucially, the rate and exemptions must be low enough to ensure that tax avoidance is not worthwhile. It may not be the best option that theory can devise but it could succeed in raising money where other more principled options such as a tax on the super-rich fail. Should the best be the enemy of the good? 

Emma Chamberlain is a barrister and a chartered tax adviser