Passing on: options for reforming inheritance taxation

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Executive Summary

Over the past 18 months research for the Intergenerational Commission has illustrated that, in a range of areas, the assumption that each generation will do better than the one before it is under pressure.

This paper is one of a series that moves beyond the diagnosis of these problems to consider what action is needed to address generational living standards challenges. The Intergenerational Commission’s final report will recommend a specific suite of reforms across a broad range of policy areas. In this paper, we present policy options that incorporate ideas from leading thinkers, history and abroad, and set out the strengths and weaknesses of different policy approaches. Here we look at options for reforming or replacing inheritance taxation.

Inheritance Tax is not set to keep pace with the growth of inheritances or with the UK’s fiscal pressures

Bequests are a key way in which older generations seek to help those who come after them, with inheritances and other gifts totalling an estimated £127 billion in 2015-16. That’s an average of £4,600 for every household in the UK. And the scale is growing rapidly. Inheritances have more than doubled over the last 20 years and are estimated to do so again over the next 20 as larger, wealthier cohorts pass through retirement. These inheritances will boost the wealth of younger generations like millennials (born 1981-2000) as a whole. And high home ownership rates among the baby boomers (born 1946-65) mean that the coming wave of inheritance is set to be spread more widely than in the past. This is particularly welcome given that younger cohorts have been less successful in accumulating assets in other ways.

But the silver spoon of inheritance will not be a silver bullet. For one, we have previously noted that inheritances are likely to come late in life for today’s young people, with an average age at receipt of 61. And second, this wealth will continue to be shared unequally within generations. Of 20-35 year olds who don’t own a home, around half have parents who are also non-homeowners, for example.

The forecasts for inheritances should be seen in the context of existing high wealth inequality, particularly among young people. Among older millennials (born 1981-1985), for example, the top 10 per cent owned 54 per cent of the group’s net wealth at age 30. What’s more, with the growth of wealth having outpaced that of income in the UK, wealth gaps have become even harder to bridge through work alone. The fact that some have far more luck in this birth lottery than others is one of the reasons why the UK has long taxed inheritances in one form or another.

Inheritance Tax, however, is now limited in scale. For every £100 raised in taxes nationally (£708 billion in all), only 77p comes from Inheritance Tax (£5 billion) and only 4 per cent of estates are now subject to it. Compared to the £127 billion of inheritance and gifts, that Inheritance Tax revenue represents an effective tax rate of only 3.5 per cent. It is also failing to keep pace with the growing importance of wealth transfers. Between 2006-07 and 2022-23, Inheritance Tax receipts are roughly forecast to grow less than a quarter as fast as inheritances.

This means that more of the strain in responding to the UK’s ageing population and health needs must be picked up by other taxes, with clear implications for basic equity. In 2018-19 someone can inherit £900,000 tax-free from their parents (and this will rise to £1 million in 2020-21). In contrast, someone working 40 hours a week on the National Living Wage from age 18 to 70 would only earn £753,000 in their entire life (in today’s money), and would pay almost £100,000 in tax.

The reason why Inheritance Tax has raised relatively little is partly because the tax is especially unpopular, with this political pressure leading to large tax cuts – particularly in 2007-08 (via the nil-rate band transfer between partners) and from 2017-18 (via the residence nil-rate band). If inheritance taxation in some form is to play more than a negligible role in funding spending on Britain’s big challenges in a fair way, it is clear that major reform is needed.

Inheritance Tax is unpopular and unfixable

Indeed, polling shows that Inheritance Tax is considered to be the most unfair of the major taxes, with only 22 per cent seeing it as “fair”. Its unpopularity can be ascribed to three reasons:

  • Taxing giving: It is negatively perceived as a tax on the dead (rather than the living); on giving (rather than receiving); and as double taxation of those who have earned the wealth (rather than a tax on the income of the lucky recipients).
  • A high rate: Its flat marginal rate of 40 per cent sounds high, particularly to basic rate taxpayers used to paying 20 per cent, even if most people’s effective Inheritance Tax rate is far lower or zero.
  • Ease of avoidance (for some): It is perceived as being ‘voluntary’ for the rich and well-advised.

What makes Inheritance Tax avoidable? The finger is often pointed at trusts, but reforms in 2006 have ensured that taxes are relatively high on trusts, with an entry charge, a charge every 10 years, and an exit charge. The number of trusts in 2015-16 was 25 per cent smaller than a decade earlier, and 31 per cent smaller than in 2001-02.

More problematic are the uses of Business Property Relief and Agricultural Relief – including by trusts. While these reliefs may be seen as ways to help small businesses stay in families, the current reality is far removed from this. For example, anyone can invest money in relevant AIM (originally ‘Alternative Investment Market’) shares – with no personal relation whatsoever to those companies – and thus avoid Inheritance Tax. And the price of farmland has been pushed up by investors similarly seeking to find an asset free of Inheritance Tax. In addition to these reliefs, the tax-free treatment of ‘normal gifts out of income’ in the years before death, and of some pension inheritances, are notable holes in the current system.

However, the main flaw in Inheritance Tax is that those with substantial, liquid assets and long lives can plan to avoid it by giving more than seven years before death (including via trusts and family investment companies). This is an option generally not available to those with limited wealth that is usually concentrated in a single property. More fundamentally, there is no obvious reason why money given far in advance of death should be taxed more favourably than transfers at or around death. The current ‘seven year rule’ means that lifetime gifts within that period before death can be taxable (though there are various allowances). One option would be to expand this period (say to 10, 15 or 30 years) but this would require more administration and uncertainty – given that it is not known at the time of giving whether tax will be payable or not, and gifts need to be accounted for retrospectively – and would in turn be circumvented by the wealthiest.

The ‘ease of avoidance’ and ‘taxing giving’ aspects of Inheritance Tax are therefore both fundamental to it. And there is little fiscal scope for fixing its ‘high rate’ problem in isolation. What is needed is reform that addresses all three problems at once by replacing Inheritance Tax.

Inheritance Tax should be abolished and replaced by a Lifetime Receipts Tax

In line with public feeling about Inheritance Tax, it would be better to tax the lucky recipients of large inheritances rather than those who decide to give rather than spend their money – and this is a distinction with both perceptual and practical benefits. In addition, to close off opportunities for avoidance (and to deliver basic fairness between recipients) it is important to tax all (large) gifts equally regardless of whether they are near the time of the donor’s death or not.

Inheritance Tax should therefore be replaced by a Lifetime Receipts Tax. This would keep track of a person’s cumulative receipts, excluding gifts of £3,000 or less (except where the recipient receives multiple gifts from the same person in the same year) and excluding transfers between spouses. A key element would be a Lifetime Receipts Tax Allowance allowing the first £125,000 of inheritances and gifts received over a person’s life to go tax-free. This would exclude the great majority of inheritances, and the tax would not apply retrospectively so gifts and inheritances before the date of introduction would not be included. The UK can also look to its nearest neighbours – Ireland and France – for good examples of a tax on gifts and inheritances received.

Our modelling shows that such a tax would allow significantly lower rates than Inheritance Tax’s flat 40 per cent rate while still raising money. Beyond a £125,000 Lifetime Receipts Tax Allowance, a basic rate of 20 per cent should apply, with a top rate of 30 per cent (paid by relatively few) above £500,000 of lifetime receipts. If introduced in 2020-21, such a system would bring in an estimated £11 billion, compared to Inheritance Tax’s projected £6 billion. Revenue would then rise further, driven by a forecast increase in inheritances and because in future years some people may no longer have any Lifetime Receipts Tax Allowance remaining due to earlier inheritances. Over the 2020s as a whole it would raise an additional £7 billion a year on average to help address the country’s revenue needs.

A progressive recipient-based tax such as this would also give donors an incentive to target their bequests on those who have not received large amounts before. In our costing we assume (for simplicity) that for every three people currently set to receive an inheritance, one extra person would receive one due to that extra incentive to split estates – with the average inheritance being lower as a result. So while the state can redistribute inheritances directly, it can also encourage donors themselves to spread wealth wider.

By moving away from being a ‘death tax’ to capturing all lifetime gifts, a Lifetime Receipts Tax would reduce many of the current opportunities for avoiding Inheritance Tax. However, questions of how to treat inheritances of businesses and farmland would remain, as would the thorny issue of how trusts should be taxed. As part of any reform, Business Property Relief (costing £710 million a year) and Agricultural Relief (costing £515 million) should be focused far more on family businesses and farms and far less on encouraging particular assets to be held purely for tax reasons. This could be done through introducing a cap, increasing the minimum ownership period and clawing back the relief if the asset is sold soon after death, and introducing a ‘farmer’ test and ‘family business’ test. In the case of Agricultural Relief, consideration of its cost should form part of any post-Brexit redesigning and retargeting of agricultural subsidies.

In addition, the extraordinarily generous treatment of some pension inheritances since 2014 should be changed to avoid significant perverse incentives and avoidance risks that could become very large over time. And, regardless of what changes are made to inheritance taxation, the forgiveness of capital gains tax on death should be ended (though tax could be delayed until the recipient sells the asset). This relief costs an estimated £1.2 billion in 2018-19, and leads to assets (including non-main homes) being held onto until death to avoid tax. At least, this relief should be removed for additional homes and where Business Property or Agricultural Relief has applied.

This package of recommendations would be a significant change to the tax system. But with private inheritances set to become even more important, it is crucial that the way we tax inheritances and gifts works well and commands public confidence. Replacing Inheritance Tax with a broader tax with lower rates and levied on recipients is the way to do this.

Summary of key policy recommendations

  • Abolish Inheritance Tax and replace it with a Lifetime Receipts Tax, paid by the beneficiary
  • Give each person a Lifetime Receipts Tax Allowance of £125,000 (indexed to inflation)
  • Beyond the Lifetime Receipts Tax Allowance, apply a progressive rate schedule with a basic rate of 20 per cent and a higher rate of 30 per cent above £500,000
  • Lifetime gifts would be included in the tax, excluding those of £3,000 or less (per donor per year) with the current additional exemption for ‘normal gifts out of income’ abolished
  • Transfers to spouses and charities would be exempt
  • Restrict Business Property Relief and Agricultural Relief (including within trusts) to small family businesses by:
    • Introducing a cap (e.g. £5 million) for the value that can receive relief
    • Increasing the minimum ownership period from two years (e.g. to five), and introducing a period after receipt in which tax relief can be clawed back if the inherited assets are sold on
    • Introducing a ‘farmer’ test for Agricultural Relief, as in Ireland and France, whereby the overall assets of the beneficiary (including the inheritance) must comprise at least 80 per cent agricultural property; and a ‘family business’ test for Business Property Relief whereby the beneficiary must receive at least 25 per cent of the business and the donor must have had a demonstrable working relationship with the company
  • Redesign the trusts tax regime to reflect the Lifetime Receipts Tax
  • Remove the tax-free treatment of pension pots inherited on deaths before 75, and for recipients other than spouses levy both the Lifetime Receipts Tax and Income Tax on pensions to give parity with other assets
  • Scrap forgiveness of Capital Gains Tax upon death, at least for additional residential properties and assets qualifying for Business Property Relief or Agricultural Relief