Former Chancellor of the Exchequer, Nadhim Zahawi, has prompted a heated debate with his recently published comments on inheritance tax. In a newspaper article, he described the tax as “morally wrong” and called for it to be scrapped. While opposition parties are furious at the suggestion, Zahawi is supported by more than 50 colleagues although some Conservative MPs are uncomfortable with his call for change. So, is inheritance tax unfair?
Brief history of inheritance tax
Many people will be surprised to learn that inheritance tax has its roots going back to 1694 and a tax which was known as probate duty. This was a charge on the gross value of a deceased individual’s estate. In 1894 this was replaced by estate duty which included a tax on death and lifetime transfers. The change was prompted by wealthy individuals transferring assets to family and associates just before their death, escaping what we call inheritance tax today.
The capital transfer tax in 1974 replaced estate duty as a means of doubling down on lifetime gifts. Capital transfer tax was replaced by inheritance tax in 1984 as part of a financial revolution in the UK. This is a tax which has attracted various uncomplimentary descriptions such as:-
“A voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue.”
Roy Jenkins, Labour Chancellor
As a side note, income tax was not introduced in the UK until 1799 when William Pitt the Younger replaced the Window Tax, first imposed on England in 1696. This was a means of paying for weapons and equipment in preparation for the Napoleonic Wars. Brief history lesson over!
Inheritance tax allowance
There are several issues to consider when looking at inheritance tax, an allowance which has been frozen at £325,000 since 2009. While the fact it has been frozen appears irrelevant, this is a form of fiscal drag – a means of subtly increasing tax receipts.
Traditionally, tax allowances increase in line with inflation to maintain an individual’s relative spending power. If the £325,000 inheritance tax threshold had risen in line with inflation from 2009 to the end of the 2022/23 tax year, it would now stand at £483,812. To put this into perspective, increasing in line with inflation, assets worth £325,000 in 2009 would have been worth £483,812 in March 2023, maintaining parity with the inheritance tax allowance. In this scenario, upon death, the estate’s value would not exceed the inheritance tax allowance; therefore, there would be no tax to pay.
As the inheritance tax allowance has been frozen since 2009, an estate worth £483,812 today would exceed the allowance by £158,812. The standard inheritance tax rate of 40% equates to a £63,524 charge, demonstrating the power of “fiscal drag”.
Why might inheritance tax be deemed unfair?
Those in favour of abolishing inheritance tax, or at worst, making adjustments to the legislation, will often bring up several common arguments:-
The most basic argument is that we pay tax in life, in terms of income tax, VAT, etc., so why should we pay more tax on death?
Impacting the less wealthy
As we demonstrated above, the ongoing action of freezing the inheritance tax allowance will see more people exceed the threshold despite not being wealthier in relative terms.
Inheritance tax in the UK, currently standing at 40%, is one of the highest in the world, which is another reason many people believe it is unfair.
UK house prices
While there are exemptions for partners, spouses and children, the average UK home is now valued at around £285,000. Someone without immediate family, an “average” property, and additional investments could easily see their estate exceed the allowance.
Expensive tax to collect
Inheritance tax has long been recognised as one of the most expensive taxes to collect. While it raised £7 billion in the last tax year, due to its complex nature, it isn’t as “easy” to collect compared to, for example, income tax.
Considering these arguments, each has a degree of credence, and there is sympathy for some of those impacted by inheritance tax. However, it is crucial to introduce balance to the argument.
Why might inheritance tax be deemed appropriate?
It is only fair to appreciate the counter arguments favouring inheritance tax, proposed changes and the benefits to the broader UK population.
Multibillion pound annual income
Due to the freezing of the inheritance tax allowance, there has been a significant increase in inheritance tax receipts in recent years. Currently, inheritance tax raises just over £7 billion a year, which is used to fund public services such as schools and the NHS.
Removal of exemptions and tax breaks
Many believe it is time to remove exemptions and potential tax breaks to level the inheritance tax playing field. Data suggests that those in the moderately wealthy middle-class bracket will pay a greater average inheritance tax rate than multimillionaires. Due to legitimate tax schemes, tax planning and exemptions, many high net worth individuals will pay on average around 20% inheritance tax, which is half the standard IHT rate.
Supporting social mobility
Some people argue that inherited wealth is a barrier to social mobility because it restricts the movement of individuals and families across different social statuses. The insinuation is that wealthy families retain their social status simply due to wealth, while those born into other social classes will have difficulty moving higher. Inheritance tax will reduce the family wealth of many high net worth individuals, and, to a certain extent, level the social class playing field.
Additional factors to consider
Even though it is tempting to focus on the headline arguments for and against inheritance tax, there are a number of other issues to discuss.
An inheritance tax charge could lead to the sale or closure of an individual’s business with a knock-on effect on corporation tax, income tax, national insurance and employment for the workforce.
Enhanced IHT allowance
While the basic inheritance tax allowance has been frozen since 2009, an additional tax allowance will protect the transfer of the family home to your children.
Transfer allowance to spouse/civil partner
Aside from tax-free transfers between married couples/civil partners on death, you can also transfer any unused inheritance tax allowance. In theory, using the residence nil rate band of £175,000 and the basic inheritance tax allowance of £325,000, twice, a surviving spouse/partner could shield up to £1 million in assets from inheritance tax.
Only 7% will pay inheritance tax
Official estimates from HMRC suggest that 93% of estates are expected to avoid paying any inheritance tax in the coming years. However, the tax is still likely to raise more than £7 billion a year, which, if removed, would create a significant budget deficit.
There are many arguments concerning the pros and cons of inheritance tax, whether it should be abolished or the structure amended. What we do know for sure is the freezing of the inheritance tax allowance will see more families facing an inheritance tax liability in the future.
Some people argue that the government should introduce a lower flat rate of inheritance tax while at the same time removing exemptions and ways in which to reduce tax liabilities. An interesting idea in theory, but in practice it reveals the complex and challenging nature of the UK tax system.