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).

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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.

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.