Abolish inheritance tax and replace it with something better

Inheritance tax is unfair and full of loopholes, says Merryn Somerset Webb. We should replace it with a gift tax.

Inheritance tax isn't a tax on the dead, it's a tax on the living

Filed away in my basement I have every edition published of The Statist, a financial magazine from the 1960s and early 1970s. I flick through them often to see how things have changed and how they haven't. It is amazing how often seemingly new ideas are recycled and how our money gripes stay much the same, whatever the government.

Anyway, this week I looked for articles related to inheritance tax (IHT), or estate duty as it was then. There were almost none. The index yielded an awful lot on the rights and wrongs of wealth taxes, capital gains taxes and income taxes but just one (deeply dull) article on estate duty.

If you were to check the contents of a similar magazine today it would be wall-to-wall IHT: what it is, how you can avoid it, why it should be abolished, why it isn't fair that we can't all get out of it like David Cameron's mum, and so on. So why did the media consider estate duty to be of little interest to most ordinary people 40-odd years ago (it was of just as much interest to the very rich then as it is now)?

The first part of the answer might be about the interplay between thresholds and house prices. In 1972, the nil-rate band for the tax was £15,000. That's the equivalent of just over £180,000 today. You will note that this is rather less than today's threshold £325,000.

But look at another number and you will see my point. In 1972, the average house price was £7,000. You could have two and a bit houses before you hit the threshold. Data from the Office for National Statistics tell us that due in part to years of low interest rates the average house price in the UK today is £298,000. So you can have only one and a bit houses before you hit the threshold.

The high relative price of housing makes more people care about the tax itself (the average estate might have to pay). But it also makes them worry about their children's housing: they feel they need to pass the money on so that other people's mortgages can be paid off.

The second part might be pensions. Back then, if you worked, you probably had a final salary pension to look forward to: so as long as their kids had jobs, parents didn't much feel the need to fret about their retirement incomes any more than they did about their housing. No more.

The final-salary pension is dead: we're all on our own with our all too empty-looking defined contribution wrappers. And as BlackRock's Larry Fink pointed out this week, that's a nasty place to be. With interest rates at 2% and pension incomes reliant on pension pots, you have to save three times as much for the same retirement income as you do when rates are 5%.

[cfsp key="IHT-banner-snippet"]

The mistake people make with IHT is to think of it as a tax on the dead. But the dead don't pay taxes (no one has a cheque book in what doctors charmingly call the "fridge room"). Their heirs do. IHT is simply a tax on the money transferred to them and a bizarrely regressive one. When it hits the bank account of the heir it is no longer the capital of the dead, but new (and unearned) income for the heir.

As such, it is taxed much more leniently for most than any other income a vast allowance, lots of loopholes and a single rate lower than our top rate of income tax. A better way forward might be to recognise this and start taxing all capital transfers (from the dead or the living) as income to the recipient at their marginal rate of income tax.

I wrote about this at length in columns in 2014. But it works because the tax then isn't just about death, the income of the unproductive is taxed at least as much as that of the productive, the loopholes disappear (the tax is payable regardless of when the transfer takes place) and, best of all, presented with an unavoidable tax to be paid by their children not by them, parents might stop worrying about how to avoid it. We could call this a gift tax or perhaps dig into our own taxation history to call it capital transfer tax a name that might at least stop me getting emails headed "Tax birthday presents? When will it end?"

This isn't a new idea other countries have gift taxes, and before the 1889 imposition of estate duty all taxes on legacies were paid by the beneficiaries after, rather than before, the distribution of the estate.

Fink reckons his numbers show that low rates now have "profound (negative) implications for economic growth". I suspect that they also have profound implications for how much we all care about passing wealth on to our children.

The government has done its best to deal with some of the effects of unfortunate monetary policy: it has introduced its silly family home allowance and allowed couples to pool their allowances, for example. But the wall of worry is too big a hurdle: the average homeowner can still imagine himself paying IHT, at a time when he thinks his kids really need what he sees as his money. And the average homeowner doesn't like that idea one bit.

So what's to be done? We could normalise interest rates. But failing that, it seems a good idea just to abolish IHT, and replace it with something both less emotive and better.

I also think George Osborne quite fancies the idea. Why? Look at what he has done with pensions. When you die you can arrange for these to be handed to your children. There is no IHT on the transfer. But there is something else: when they withdraw money from the pension (which they can at any time) they pay their marginal rate of income tax. You think you are passing on capital. But it's taxed as income at the point at which it is received.

It is exactly what I have described above a gift tax. How about that? Before I finish, I should point out that if you have assets over the threshold and you really don't want to pay much IHT, saving into a pension is a really good idea. IHT is 40%. But if your heirs are clever they will draw down from the pension only when they are lower rate taxpayers (or not taxpayers at all). That will both cut the end tax bill in half and stop you worrying about how your heirs will ever save into a pension. They'll already have one and they'll have it IHT-free.

If you are interested in the history of capital transfer taxes in the UK, here is a great paper on it.


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