Should IHT be abolished or reformed?

This article is part of
Inheritance Tax - May 2014

But in fact relatively few estates are liable to inheritance tax, and the prime minister has said he hopes to reduce the future scope of the tax.

Going further and abolishing it entirely would have some obvious attractions. But equality of opportunity concerns might point in a different direction, towards the replacement of IHT with a tax on lifetime receipts. At the very least, IHT is in need of reform.

IHT at death is charged at a rate of 40 per cent on estates’ value in excess of a threshold, while transfers made up to seven years before death are taxed at reduced rates and transfers made seven years or more before death are not normally taxed.

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Bequests to a spouse or civil partner are exempt from IHT and, as a result of Alistair Darling’s October 2007 change, any unused allowance can be transferred to a surviving spouse. The threshold is currently set at £325,000, which means that married couples can collectively bequeath £650,000 tax-free.

The recent IFS-led Mirrlees Review of the UK tax system noted that IHT is “a somewhat half-hearted tax, with many loopholes and opportunities for avoidance through careful organisation of affairs. This leads to charges of unfairness and makes a principled defence of inheritance tax difficult”.

Agricultural land and certain business assets are exempt, for example, creating obvious avoidance opportunities; and of course the simplest way to avoid IHT is to pass on assets above the threshold more than seven years before death.

Exploiting such opportunities is easier for the very wealthy than for the merely quite wealthy whose main bequeathable asset is often their home, so IHT is not very effective at achieving wealth redistribution.

Scaling back reliefs and extending the reach of the tax to gifts made more than seven years before death would be an improvement. If desired, the extra revenue generated could be used to reduce the rate or increase the threshold.

An alternative direction of reform would be to abolish the tax completely. IHT is not a big tax. HMRC estimates that in 2013/14 it was levied on less than one in 20 estates and raised only £3.4bn – less than 0.6 per cent of all tax revenue, or around 0.2 per cent of national income.

As shown in the chart below, these figures have fallen sharply since 2007/08 – a result of the 2007 reform combined with the financial crisis and associated falls in asset prices.

IHT revenues are forecast to rise sharply in the coming years, due partly to growth in the price of houses and other assets, but also to the government’s decision to freeze the threshold at £325,000 through to 2017/18.

By 2017/18 the threshold will have been frozen in cash terms for eight years – a reduction of 22 per cent or £70,700 relative to inflation. Such a large real-terms cut stands in stark contrast to Mr Cameron’s aspiration to increase the threshold, stated both in the 2010 Conservative Party manifesto (which proposed increasing the threshold to £1m) and again last March.