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What is the point of inheritance tax?

It is less important for social mobility, and more important for tax revenue, than you think.

By Arun Advani and David Sturrock

Rumours have been swirling all summer that the government is looking to make a big move on inheritance tax, possibly going so far as to abolish it entirely. Many on the left, including Labour MPs, have challenged this as a giveaway to the rich. Meanwhile Red Wall Tory MPs have complained it is a giveaway to the south of England.

On this at least they are both right. If inheritance tax were abolished, almost half of the gains would go to the 1 per cent wealthiest in the population. The estates of this group, made up of people with wealth of over £2.1m at death, would benefit by an average of more than £1m each. Around half the money would also go to London and the South East, consistent with the entrenched regional wealth disparities across the UK.

Defenders of inheritance tax sometimes make another argument as well: that inheritance tax is important for social mobility. This is a completely logical argument, but it also misses some crucial context. Inheritance tax is a tax on money going, usually, from parents to children. Without it, the argument goes, children of wealthy parents get windfalls that give them access to opportunities children of less wealthy parents could only dream of.

The problem with this claim is that inheritance tax as we currently have it in the UK is too little too late when it comes to social mobility. The average person receiving an inheritance is in their fifties by the time they inherit, and as parents live longer this age of receipt will rise to the early sixties. By this point there is already a yawning chasm in the level of wealth people have, depending on who their parents are. By their early fifties, children of the wealthiest fifth of parents have accumulated an average of £830,000 in wealth. Children of the least wealthy fifth of parents have only £180,000 by the same age.

This isn’t to say that inheritances are irrelevant. Those with parents in the top fifth will get an average inheritance of £372,000. Those at the bottom will get an average of just £2,000. But inheritance tax does little even to reduce these colossal differences. After inheritance tax, the average transfer to a child of parents in the top fifth is still £334,000.

[See also: Rishi Sunak is not serious]

By contrast, the received wisdom is that inheritance tax is not particularly important in terms of the tax revenue it raises. That claim is only half right. The £7bn it is expected to raise this year is worth just 0.3 per cent of GDP. That isn’t nothing, but it is pretty small. However, that number is set to rise rapidly. Within a decade it will more than double, to the equivalent of £15bn in today’s money.

That growth is because the people who will die in the next ten or twenty years are much wealthier than those who died in the past decade. Less than 4 per cent of deaths led to inheritance tax in 2021. Generational effects mean that this will almost double to over 7 per cent by 2032. And the number of families affected by the tax is still larger: since inheritance tax is usually only paid on the second death for a married (or civil partnered) couple, one in eight people will have inheritance tax paid on either their or their partner’s death.

The growth in the levels of wealth held by those close to death makes it even more important that inheritance tax is fair and working well. The government’s own numbers show that the current structure of reliefs makes inheritance tax regressive at the highest levels of wealth. People leaving £2m to £3m pay an average tax rate of 24 per cent; those leaving more than £10m pay an average of just 17 per cent.

The obvious solution is to shut down some of these reliefs. Business relief allows those holding assets in a private business or shares of companies listed on the Alternative Investment Market to pass on unlimited assets tax free. Removing this could increase the revenue from inheritance tax by 20 per cent, coming mainly from the very wealthiest. Even capping it at £500,000 would raise almost as much money, if there was a desire to protect smaller businesses. That would make the system fairer, shutting down some of the easy avoidance that leads to the decline in tax rates paid at the top. It would also be better for productivity, by removing the incentive to hang on to a business past the point where someone can manage it, just for a tax break on death.

Combining this with other sensible reforms could raise up to £4.5bn, which is big in the context of a tax that only raises £7bn at the moment. That could be vital revenue for public services. Or, if reform is too difficult without additional sweeteners, that is enough money to raise the tax-free inheritance threshold from £325,000 to £500,000.

What does all this mean for social mobility, which is so often at the centre of debates about inheritance tax? Ending some of the obvious problems with inheritance tax, while a good idea, would barely change the story for inheritances received by the next generation. And it wouldn’t touch the major gifts received when children are not in their fifties, but in their twenties and thirties and looking to get on the housing ladder.

The main contribution inheritance tax, in its current form, can make to social mobility is by raising revenue. This can be used to fund programmes that tackle the emergence of inequalities much earlier in life.

[See also: Britain’s great tax con]

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