Tax the inheritors, not the workers

I think the state in most Western countries takes and spends too large a share of GDP. I think taxes across the board are too high and much too complicated. I think we should tax less and spend less.

But here’s something else, I think: the inheritance tax (IHT) threshold shouldn’t be raised from its current level of £325,000 (or £650,000 for a couple) to £1m, as David Cameron suggests. It should be abolished. And then the tax rate that is paid should be changed to reflect the circumstances of the recipient, not of the deceased.

Let me explain why. We think of inheritance tax as a wealth tax on the estate of the deceased and hence a nasty attack on the family houses we are all so obsessed with (inexplicably, given that according to the Office for National Statistics, almost everyone sells the family house as soon as they get probate).

That’s the wrong way around. We should think of it in an entirely different way – as a (rather low) tax on the unearned income received by the heirs. Someone earning £1m a year would pay total income tax of £436,127. Someone sitting on the sofa watching telly when their great aunt died and left them £1m would pay £270,000. Someone actually going out and earning £250,000 a year would pay £98,627 in tax. Someone inheriting £250,000 would (assuming that was the sum total of the estate in question) pay nothing.

There’s a problem here. An inheritance, from the point of view of the bank account of the heir, is unearned income. Why do we treat unearned income so much more kindly than earned income?

Why is it that a person who works 14-hour days for 20 years, but inherits nothing, ends up paying more in tax and being poorer overall than someone who barely works, but whose parents happened to buy an old vicarage with an orchard in the south 40 years ago?

Here’s a quote from the (generally right-wing, and prone to long sentences) Statist magazine from 1962 which sums up the feeling then, and rather my feeling now:

“In an era when the government appears to find itself obliged to tax an individual’s current earnings so highly that it is difficult, if not impossible, for the industrious able and thrifty person to save a substantial amount of money for himself, it is very wrong that another person who may well be idle, stupid and spendthrift should be in a position to receive a fortune by gifts or inheritance virtually without paying tax at all.”

I know that Cameron’s suggestions will make sense to lots of readers, but to me – with my old-fashioned assumptions that we should be encouraging equality of opportunity and enterprise – they are utterly bemusing. So here’s what I think we should do. Let’s dump all the IHT thresholds and allowances and turn IHT into an income tax.


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Instead of taxing the estate (the donor), let’s tax the recipients (the donees) such that everyone pays tax on anything they inherit (or is gifted in advance of a death) at their marginal income tax rate. So the guy who wakes up one morning with a cheque from the executors for £250,000, or £50,000, or £10,000 in his lap pays at least the same as a guy who makes £250,000 or £50,000 or £10,000 from his own efforts.

This would be simple in that it would mean that all inheritances could just be put down as income on everyone’s self assessment forms. The lawyers wouldn’t like it, but probate would suddenly be almost ridiculously easy. There would be fewer fees and less stress.

This new simplicity would chime nicely with the recent suggested change to the pension rules; in just a few sentences George Osborne cut swathes of pointless rules and complications.

Taxing inheritances in this way might also mean that people would spread their wealth more widely via their wills, taking in more heirs on basic rate tax and fewer on higher rate, perhaps. It would be harder to avoid; now the wealthy mostly avoid IHT with a variety of complicated strategies, trusts, exemptions and early gifts.

A good 50% of estates valued at over £1m pay no tax at the moment thanks to such chicanery. But changing the tax from being on what you get, instead of what you leave, would instantly remove all these possibilities.

Getting rid of every IHT loophole and making it an income tax will also raise significant revenue – bringing the take from about £3bn a year (about the same as insurance premium tax, about which we hear rather less squealing) to at least £10bn, leaving some scope for tax cuts elsewhere.

But most importantly, it would level the playing field slightly so that those who earn money aren’t actually paying a significantly higher rate of effective income tax compared to those who simply receive money.

I don’t know about you, but, while I’d like to pay less on any money my parents might leave me, I’d much rather pay less on the money I am working slightly too hard to make right now. I’d like to be allowed to keep more of my money than I am allowed to keep of my mother’s money.

Yes, in an ideal world we’d have a smaller state than we do now; the government wouldn’t need to raise £700bn a year to keep the show on the road; and absolutely all taxes would be significantly lower. But as long as that’s not the case we need to make choices about where the tax take comes from.

It seems to me that if we want to incentivise growth, enterprise and work, more of that tax needs to come more from unearned income and much less of it from earned income.

• I’m not the only person thinking along these lines. After this piece was first published several readers contacted me to say that think tank IFS has come to very similar conclusions. You can find their arguments here.

• This article was first published in the Financial Times.

• Stay up to date with MoneyWeek: Follow us on TwitterFacebook and Google+

29 Responses

  1. 07/04/2014, Natalie wrote

    An interesting thought, but I’m more interested in reducing the size of the State and getting people to stand on their own two feet more. Has MoneyWeek ever explained to its readers how much people actually pay in tax? For, say, Ms Wealthy, Mr & Mrs Average, Mrs Low paid and Mr On Benefits. Not just income tax, but VAT, National Insurance, Road Fund License, stamp duty, Airport taxes etc. and deducting child benefit and family tax credit etc?

    I’m fed up with a nanny state that has held people’s hands so much that they can’t stand on their own two feet, for example when a lady got her car stuck in a snow drift she complained that there was no one from the council to come and help her out.

    • 12/04/2014, Average Joe wrote

      ‘I’m fed up with a nanny state that has held people’s hands so much that they can’t stand on their own two feet…’

      Hmmm…many people seem confused/contradictory on this…they complain about the ‘nanny state’ BUT want the state (i.e. the taxpayer i.e. me) to pay for their care and health provision in old age. The words ‘cake’ and ‘eat it’ spring to mind.

  2. 07/04/2014, r wrote

    I completely support @Natalie’s views. We do need a smaller state but I don’t think we will get it with the current “left” and “right” parties that we have at the moment. They are too similar in practice. Neither is trying to reduce the debt; the existing borrowing requirement goes up every year, regardless of which is in power.

    How about it, Moneyweek? Let’s see the difference in tax demands from each income class. Also, what about a “where our tax goes” article. This should include total taxation, of course.

    Just a thought.

    r.

  3. 07/04/2014, mr clyde wrote

    I would be less bothered about parents being able to pass on their money to their children free of tax if they were properly charged CGT on their wealth in the first place. At the moment CGT reliefs; entrepreneurs’, primary residential property, ISAs, VCTs, EISs, etc, etc allow the shielding of millions which can then be by-passed around IHT. If ‘death’ were a universal chargeable event for CGT then there wouldn’t be much need for IHT at all. Although I do like the idea of charging bequests as income to the beneficiaries.

  4. 07/04/2014, Sceptical wrote

    I entirely agree with Natalie that the root of the problem is a overspending State where politicians of all parties are now finding their past electoral bribes are unaffordable! Will that change their behaviour – no.

    That said, I disagree fundamentally with Merryn on this one. She can view it as “untaxed income” in the hands of the inheritor if she likes, but I view what will go to my son and daughter as hard earned and highly taxed income. Taxed when I earned, spent, saved and invested it. And taxed again when I die, either as IHT or as the Pensions Death Levy (assuming I live past 75 that is). Nor is it a product of rising house prices as she claims since I reckon the value of my house does not exceed 20% of my net worth.

    I do agree however that IHT as currently constructed is a silly tax. Why should a single earner couple where the wife has never worked get an allowance of £650k whereas I as a single person only get £325k?

    I know it is not the only example of nonsense taxation e.g. the reduction/removal of Child Benefit from single earner families exceeding £50k whilst leaving double earning households the privilege of an income of £100k before the reduction. And we could go on to revisit the ‘Poll Tax’ debate cf Council Tax where the occupants of social housing may have a very significant total household income.

    Frankly, I despair of the situation we find ourselves in while looking at the choice of muppets we have as elections roll round.

  5. 07/04/2014, mr clyde wrote

    Erratum -For ‘death’ please read ‘death or any other Capital Transfer’. NB. we could call it Capital Transfer Tax, now there’s an idea!!

  6. 07/04/2014, David Morgan wrote

    Merryn is dead right on this one. I’d even go further – charge a premium tax rate on inherited money, and use the surplus to fund reduction in earned income tax rates. The tax system should encourage us all to create and produce, as distinct from sit and wait for the vicarage to be sold.

  7. 07/04/2014, Clive wrote

    The UK is spending £100bn more than it earns each year. This idea conveniently skips over trying to fix that, and concentrates simply on who we can tax more. This adds to that idea, keep ramping taxes up, never reduce spending.

    Message with this idea comes down to – if you work hard for yourself/your family, you’ll contribute ever more to the running of the state. Can’t see people accepting that, when there are ever increasing numbers get state handouts (help with mortgages up to £600K, child care despite huge earnings, etc).

    Also makes a common mistake with tax, to think “Government does X to raise Y, people won’t change their behaviours”. But, they do. The more you try to take money from people, the more effort they’ll put into evading it, legally (e.g. accountants) or not. Or, they just won’t work so hard.

    I can see a lot of people being in favour of this, just like they are with the so-called “mansion tax” (seem to remember Merryn being in favour of property taxes). Imo, that’s because a lot of people figure “heh, I won’t have to pay it, perhaps it’ll bring my taxes down”.

  8. 07/04/2014, Greg wrote

    We should replace all taxes with one tax – a Land Value Tax – so that there is more incentive to earn. Those who are retired and have a reduced income would pay their LVT from their estate upon death – so effectively replacing Inheritance Tax. Raising the Inheritance Tax threshold as proposed would unfairly distribute income and wealth and arguably increase the divide between the rich and poor, whilst the windfall would arguably discourage work and enterprise. I agree we should reduce the size of the state and I’d prefer more local decisions on tax and spending.

  9. 07/04/2014, Natalie wrote

    I’d also like to simplify the tax system. There are too many people in our economy, such as tax accountants and lawyers who are making money out of the tax merry-go-round instead of creating wealth. Gordon Brown helped to create a huge amount of useless work in this respect.

    • 07/04/2014, David Brand wrote

      I agree, Natalie. That man severely damaged this country.

  10. 07/04/2014, Clive wrote

    @ Greg

    As I rent, I like the idea of a Land Value Tax. I’d simply rent a house the size I want with the lowest LVT.

    How would they assign rates and keep them up to date ? They’ve failed to do it with Council Tax. Plus, flat rate or bands (always gives anomalies) ?

  11. 07/04/2014, TJ wrote

    Totally agree that government taxes and spends far too much.

    However I have a big issue with IHT and other similar wealth taxes. Once tax has been paid on earnings through income tax or CGT, these same earnings should not be subject to tax again. Double taxation does occur when we pay VAT but this is I think fundamentally different from IHT.

    A tax system should be fair as this encourages compliance, double taxation is not fair to the person leaving their estate. Taxing people, through IHT, who have earned their money, paid their taxes and saved to look after themselves and their families just hits those who are the most conscientious. Social equality can not be achieved by repeatedly discouraging people to look after themselves and their families.

    Finally, many countries including Australia and Canada do not have any IHT for this reason.

    • 07/04/2014, mr clyde wrote

      TJ – In principle I would totally agree with you, however with the current system a lot of people (with enough money) haven’t ‘paid their taxes’ – see above. A cynic would suggest our tax system is deliberately made so complex just to ensure that this remains the case.

    • 07/04/2014, David Brand wrote

      Yes, TJ, IHT is, in effect, triple taxation, and, as such, grossly unjust.

      Abolish it, and treat it as a gift to the inheritors. Merryn, I’m sure that you will move towards the idea of abolishing IHT entirely as the years pass, and it becomes a less theoretical possibility.

  12. 07/04/2014, davidstuart wrote

    As has been mentioned, such a policy would ONLY increase the total tax take by some £7 billion, at a time when the government is overspending by £111 billion a year! If the deficit isn’t eliminated and the overall National Debt reduced, the whole nation, prince or pauper, is facing financial Armageddon when people refuse to fund such government profligacy at today’s derisory interest rates! We need to cut spending to match income and that means stopping paying people under pension age from government (i.e. you and me) coffers for starters. The welfare state is bankrupting the nation and has led to an “entitlement” culture which needs to be abolished!

    • 08/04/2014, Boris MacDonut wrote

      I think Merryn is more concerned with saving the rich a few quid than incressing the tax take.

  13. 07/04/2014, Clive wrote

    I’ve recently read “When the Money Runs Out: The End of Western Affluence” by Stephen D. King. It details how the UK has been ramping up benefits without worrying about the cost. No doubt because we think we’re “entitled” to all these (uncosted) benefits.

    Very lazy argument suggesting that all we need (or what we need most) is simply to tax the richer ever harder. a) it won’t bring spending down. b) people will push back (something governments never seem to consider when raising taxes)

    Book also mentions the case of Argentina few decades back. They tried the old “let’s hit the rich again and again”. Good plan, except the rich refused to play ball. Hid their money and/or took it out of the country. Bottom line : country went bust.

  14. 07/04/2014, David Brand wrote

    But David Morgan, by investing my money, I am, surely, enabling companies to “create and produce” just as much as if I were working for those companies.

    This leads us back to the concept of a Flat Tax: Let’s have a single rate of tax (as low as possible), on all income from whatever source, whether earned or unearned.

  15. 08/04/2014, Ellen12 wrote

    I agree with Clive, above, in that the state continues to need more and more funding and do not properly consider how the reduce the size of the state. Indeed, a lot of the ‘work’ performed by government are against the interests of the general population e.g. peeping Tom camera culture, underwriting housing market to prop up prices, encouraging people to overburden themselves with debt, criminalising people who commit miner misdemeanours. The state needs to be redefined and be stay within the boundaries of how it is defined.

    Inheritance is pure luck – it’s where you landed at birth as opposed to work and ingenuity and the fruit of ones own labour, so the argument to stop focusing taxes on income instead of wealth, is perfectly valid but as the people who make the rules are generally the people who gain the most through inheritance I would say it is a waste of energy going up that path.

  16. 08/04/2014, Ralph wrote

    Any major change to the tax system will change behaviours and this needs to be considered.

    If you increase IHT significantly you create a disincentive for people to be self-sufficient during their own lifetime.

    If the pension changes made in the budget go through, then logically there will be a sharp increase in the numbers of people taking drawdown. Their pension funds are currently not part of their IHT liability (or so I believe) but this would seem to be an unsustainable position, moving forwards.

    If the situation doesn’t change then towards the end of their working life clearly everyone should try and move as much of their free assets as they can inside their pension funds, which would then avoid probably pretty much all of their IHT liability completely.

    Assuming it does change (or if I am wrong on this point) then your proposal to (in effect) increase IHT will encourage everyone to be more profligate with their savings/pension funds in the early years of their retirement, in the knowledge that they still have the welfare state to fall back on.

    Changes to the tax system are naturally always emotive and will generate huge debate between the winners and losers arising from the change in question.

    A major area that I personally think needs looking at more is the advantages enjoyed by the self-employed, who often pay little or no tax at all, despite seeming to enjoy quite attractive life-styles.

    Every time I hear a self-employed person boast about how little tax they pay I always think two things to myself. Firstly – if I was you I would keep my trap shut and secondly why on earth does this situation continue to be allowed? Has MW ever looked into this?

  17. 08/04/2014, Boris MacDonut wrote

    Merryn’s theory has some legs, but it does entsil taxing the relatively poor. Say someone earns £10,000 pa and inherits £60,000, instead of no tax they will pay 30%.

  18. 09/04/2014, Merryn wrote

    @MrCLyde I do think this is a very good point – why not a capital transfer tax. But then we might have to talk about why CGT is lower than income tax…

  19. 09/04/2014, Daniel H wrote

    This is a simple and fair way to deal with inheritances. One might spread the logic wider and roll all amounts received (salaries, dividends, capital gains, inheritances) into one single category of “income” and tax it together. If one must tax land, it could be by way of a deemed rental income (though with the ability to roll the amount over until disposal of the property).

    As regards gains on the sale of shares, and save in respect of the person originally acquiring the shares on issuance and who has therefore made a genuine investment, there seems to be little logic in taxing them as anything other than income.

  20. 09/04/2014, Daniel H wrote

    As others have noted, the real issue now is not taxation but spending, and in particular the health service. I have recently returned from a period living in Japan; no-one there complained about having to pay something for their health care at the point of use, and no-one complained about the quality of care. The big difference is that they don’t have a dependency and compensation culture where everyone expects to be given what they want. The situation in the health service will not improve, and the cost to the exchequer not be reduced, until there is a sea-change in attitudes, which would require a untied front from across the political spectrum spelling out that the gravy-train cannot continue.

  21. 11/04/2014, mr clyde wrote

    Merryn – Absolutely agree, and for what it is worth, my view is that CGT should be charged at your marginal Income Tax rate.

  22. 22/04/2014, Merryn wrote

    Here’s another interesting view on IHT. It’s existence encourages the avoidance that perpetuates the passing down of huge fortunes. http://www.adamsmith.org/blog/tax-spending/its-inheritance-tax-that-stops-inheritors-losing-their-fortunes

  23. 22/04/2014, Merryn wrote

    And an interesting comment in the FT on the matter – suggesting that a GT would lead to massive migration from the UK. But that hasnt been the case in other countries with gift taxes (instead of IHT). http://www.ft.com/cms/s/0/9d010716-c4a9-11e3-b2fb-00144feabdc0.html?siteedition=uk

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