What Would it Cost to Scrap Inheritance Tax?

With many Tory MPs suggesting that Rishi Sunak should scrap Inheritance Tax, a recent analysis by the Institute for Fiscal Studies (IFS) indicates that scrapping this tax could result in almost £15bn a year in lost revenue by 2032 for the UK government.

The debate around IHT reform has been heating up lately, following propositions from Tory MPs to abolish the primary tax on inherited wealth. This article will explore the prominent aspects of this debate, and the potential effect on government funds, individual wealth, and socio-economic mobility.

What is Inheritance Tax and Who is Affected?

Let’s start by understanding what IHT is. This tax is currently charged at a rate of 40% on estates over £325,000. Individuals can avail of an additional relief of £175,000 if their main residence is being transferred to their children or grandchildren. The good news for couples is that spouses can share their allowances, leading to a combined allowance of £1m. This means that they can pass on a million pounds tax-free to their heirs.

However, the number of estates affected by this tax is relatively small. According to the latest HMRC statistics, less than 4% of estates paid IHT in the year 2020-21. Interestingly, this trend might change shortly, with the IFS predicting this figure to rise to over 7% in the next decade, mainly owing to a steep increase in wealth among the elderly.

Regional Variation and Wealth Disparity

The distribution of taxable estates is not even across the country. While London hosts the highest number of estates liable to pay IHT, locations such as Sussex, the Cotswolds, and areas around Birmingham surprisingly top the charts for the highest number of liable estates per 100,000 residences.

The IFS report, titled “Reforming Inheritance Tax”, also underscores the vast wealth disparity in the UK. In 2024, it’s expected that the wealthiest fifth of parents will leave behind an average of £380,000 per child, paying about 10% of this as IHT. On the other end of the spectrum, the least affluent fifth of parents will be leaving behind less than £2,000 per child.

Potential Reforms and their Implications

The IFS suggests that if the total inheritance money were equally divided amongst all 25-year-olds in the UK, each would receive approximately £120,000. This is an interesting perspective as Rishi Sunak, the Chancellor of the Exchequer, considers changes to IHT, which some see as a strategy to consolidate voter support by contrast to Labour’s policies.

Despite official denials, speculation is rife that the prime minister could abolish the tax altogether, amidst a growing clamour in the Conservative party for allowances to be increased.

Tory MP for South Cambridgeshire, Anthony Browne, recently expressed concerns about middle-income households being disproportionally burdened, while the super wealthy exploit trusts and loopholes to avoid IHT. This sentiment is echoed by Nadhim Zahawi, a former chancellor, who called IHT “morally wrong” and a haunting spectre alongside death in an article for the Telegraph.

The Cost of Abolition

Though reducing the 40% rate itself is currently under contemplation, an outright abolition of IHT might end up being costlier than expected. According to the IFS, if IHT were to be scrapped right now, it would cost the government £7bn this year. It’s interesting to note that almost half (47%) of this benefit would go to those with estates of £2.1m or more at the point of death. These wealthiest 1% of estates would experience a tax cut of approximately £1.1m on average. However, the significant majority (90%) of estates that don’t currently pay IHT wouldn’t see any direct effect from such a reform.

On the other hand, the Treasury spokesperson emphasised the importance of IHT in supporting public services. They were quoted saying that while over 93% of estates are expected to have zero IHT liability in the near future, the tax currently raises more than £7bn annually, providing vital support to public services that millions rely upon daily.

What the Experts Say

Arun Advani, a University of Warwick tax specialist, and David Sturrock an IFS researcher, call for a more balanced approach in their report. They suggest that instead of total abolition, IHT should initially be reformed to eliminate opportunities for the super-wealthy to exploit loopholes to their advantage.

Recommending the end of exemptions worth £4.5bn annually for those who inherit businesses and farms, they argue that abolishing such relief would allow the government to increase the threshold to £500,000, or even £525,000 if farm relief is also cut. Their assessments also suggest that such changes could bring down the tax rate from 40% to 25%, without impacting the revenue earned from it.

A Look at the Bigger Picture

Exploring long-term implications, the swift growth of wealth surpassing earnings in the past few decades has ignited a debate about the balance of taxation across generations and the increasingly significant role of parental wealth transfers.

Inheritances are growing and are projected to grow faster than earnings, thereby augmenting concerns about their adverse impact on intergenerational mobility. If unchecked, this could potentially result in a society increasingly divided along lines of inherited wealth, rather than earned income.

In all these considerations surrounding the potential impact of altering the IHT framework, policymakers need to strike a balance between encouraging financial growth and maintaining societal equity. Understanding these dynamics will be key to the formation of stable, fair and effective tax policies for the future.