David Cameron’s proposal to reduce inheritance tax on many properties is controversial. But does the way we tax inherited wealth need an overhaul anyway? Simon Wilson reports.
What have the Tories proposed?
Currently, a married couple can pass on a total of £650,000 free of inheritance tax (IHT) (an allowance of £325,000 each). The Conservatives, if elected, propose to introduce a further £175,000 per person transferable allowance for main residences left to children or grandchildren. This would give a married couple a total allowance of £1m (£325,000 plus £175,000 each) when the second spouse dies and passes on the couple’s home to children.
The allowance will be tapered away on estates of more than £2m, with the effect that couples leaving more than £2.35m won’t benefit. The cost of the changes would be about £1bn a year, to be met by withdrawing pension relief on very high earners.
Is this a popular idea?
Polling suggests that IHT is widely seen as an unfair tax. According to a recent YouGov survey, 59% say it’s unfair and 22% fair, making it the UK’s least-liked tax. No doubt the perception that IHT is unfair has partly to do with the failure of successive governments to raise the IHT threshold in line with inflation.
What’s more, the dramatic rise in property prices in London (where an average house is around the £500,000 mark) and the South means that more estates are being dragged above the current zero-rate threshold.
The number of estates paying IHT remains small and is projected to rise from about 6% now to about 10% by 2019 (under current rules, according to government figures). Nevertheless, there’s a growing unease that it is the better-off middle-classes who are paying the tax, rather than the truly rich, who can pay to avoid it via a variety of schemes.
Who’s opposed to the Tory plan?
Critics say that letting families pass on properties worth up to a million pounds tax-free will only do more harm to our housing market. That’s because one of the key challenges facing UK policymakers, in terms of controlling house-price inflation and freeing up the supply of underused houses, is to convince older homeowners to downsize. Cutting inheritance tax (or, in this case, raising the threshold) on property doesn’t incentivise downsizing, but the opposite.
Just like the capital-gains tax exemption on primary homes, it instead encourages Britons to buy and keep hold of the biggest and most expensive houses they can. This situation worsens all kinds of related problems, from high house prices to generational inequality, to labour-market rigidities.
But isn’t IHT fundamentally unjust?
Many would argue that the act of taxing earned income while allowing people to inherit vast sums tax-free is economically undesirable, since it encourages idleness and discourages enterprise. It is also socially regressive – entrenching wealth in the hands of the existing elite, which is bad for the economy.
This is not necessarily an argument that slots into conventional political perspectives. Plenty of “right-wing” economic liberals, who generally argue in favour of a smaller state and smaller overall tax take, are (for the reasons outlined above) in favour of abolishing inheritance tax on estates but replacing it with a simple “gift tax” on recipients – ie, an income tax on inheritances and pre-death gifts.
What do other countries do?
Among the 34 members of the Organisation for Economic Cooperation and Development (OECD), the UK is an outlier, with a far higher rate of IHT (40%) than the average (15%). The only three OECD countries to have higher rates are Japan, South Korea and France.
Fifteen of the OECD countries have no inheritance tax, including New Zealand, Norway and Sweden. The United States has the same 40% rate, but the zero-rated threshold is $5,430,000. Germany has a broadly similar system to us.
However, unlike the UK, which allows businesses (and farmland) to be passed on free of IHT, Germany imposes strict conditions on family businesses aimed at encouraging the next generation to continue growing the business. Another interesting model is Canada, where inheritances other than a principal residence are taxed as capital gains.
| Should IHT on estates be replaced with income tax on gifts/inheritances? | |
|---|---|
| Yes | No |
| It is iniquitous only to tax earned income. Taxing gifts and inherited income means that overall income-tax rates could fall. | Parents should be free to pass on their hard-earned property and gift their wealth to their children without the state grabbing a slice. |
| The double taxation objection is a red herring: a lot of existing taxes (notably VAT) really are double taxation, but IHT is generally paid on unearned, untaxed property gains. | Inherited assets will originally have been bought out of taxed income. Why should the taxman get a second bite? |
| A gift tax for the recipient is both simpler and kinder: older people no longer have to worry about giving away too much too soon in the hope of avoiding IHT under the seven-year rule. | Inheritances are not just frittered away, but are put to productive use. Why should that money go to the Treasury, rather than be invested in businesses or spent? |