To parents, inheritance tax can feel unfair. The urge to pass what you have to your children and ensure their financial security after you are gone is natural. Taxing transfers between generations, however, is a sensible way of correcting the injustice of hereditary wealth, whereby some have to work for riches while others are gifted them by the lottery of birth. What is important is to make sure any system is transparent — and not easily avoided.
The British system tries to balance these concerns. A tax-free allowance exempts inheritances of the size most children can expect. Richer estates face a 40 per cent rate on assets worth more than £325,000. Married couples can pool their allowance and family homes are treated favourably, potentially raising the tax-free threshold to £950,000 in some circumstances. Only 5 per cent of estates are taxed.
The extraordinary growth in UK house prices — especially in London and south-east England — over the past quarter-century, however, means many people on middle incomes can still face big tax bills if they try to pass on their home to their children. It also creates an even bigger incentive to keep the house in the family.
The way the UK system now works is complex, arbitrary and needs reform. Inheritance tax has turned into a tax on the merely well-off that the super-rich can easily dodge. Exceptions for certain assets, such as farmland, as well as assets in trusts mean it can be avoided by judicious planning and giving wealth away while still alive. Estates worth more than £10m pay an effective rate of around 10 per cent, the Office for Tax Simplification estimates, compared to about 20 per cent for those with assets of between £2m and £3m.
The OTS has proposed adjusting the tax to make it more efficient. Gifts made at least seven years before someone’s death are currently exempt from inheritance tax. The OTS suggests reducing that to five years, and simplifying other allowances. Changing the time limit, however, does little to alter the arbitrary nature of the system — and the element of lottery over when a donor actually dies.
Ultimately, Britain and other advanced countries need to take a deeper look at how they tax inheritance, and wealth more broadly. Low interest rates and a decade of unconventional monetary policy have helped to raise asset prices, but young people struggle to get on the property ladder. Those without access to the “Bank of Mum and Dad” resent those with it. Inheritance tax is widely disliked as a solution, including by those with little prospect of paying — partly because it is so arbitrary, and partly because they aspire to be rich themselves one day.
An alternative would be to shift to recurrent wealth taxes — ending the focus on transfers, and potentially enabling taxes on income to be reduced. Such a policy might still struggle to deal with the super-rich, who have more ways of keeping the tax office at bay. What is clear is that taxing wealth transfers at death is arbitrary and disadvantages those who die suddenly and cannot plan.
Another idea gaining traction is one raised by a report for the UK Labour party that suggests a radical shift of emphasis away from death duties. Instead, inheritance tax would be replaced by a lifetime allowance of £125,000, covering both legacies and gifts. Anything received over that level would be taxed as normal income. This threshold is far too low, but the idea is worth further consideration.
Any new approach should be simple, hard to avoid and fair to all. The current system passes none of these tests.