Why Tory plans to reform Inheritance Tax will make a bad system even worse

Philip Booth
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WHENEVER we approach a General Election or Budget, the competition for the daftest tax policy idea is always intense. The current front-runner is probably the proposal to largely exempt houses from Inheritance Tax.

Some Conservatives are currently pushing plans to increase the amount of an estate which will be exempt from Inheritance Tax by the value of a family’s primary residence up to £350,000. This will save many families up to £140,000.

Tax rates should be low and flat. Tax exemptions lead to discrimination and distort economic behaviour. If this tax change goes through, two families with identical total assets could find themselves paying vastly different amounts of Inheritance Tax if one of the families invested in shares and the other invested in their home. Such discrimination against business investment is wholly unjustified. It adds to the already heavy tax discrimination in favour of owner-occupation.

The proposal will encourage investment in housing rather than in other forms of investment. Given the fixed supply of housing due to planning constraints, the result will be higher house prices. It will also encourage older people to remain in larger properties rather than downsizing, moving into more appropriate sheltered accommodation, or moving back in with their family. The incentives will not be trivial. A 90-year-old woman, for example, living in a four bedroomed house in Leicester might pay an extra £100,000 in Inheritance Tax by choosing to move into sheltered accommodation, or an extra £140,000 by choosing to be cared for in her son’s or daughter’s house.

Ideally, we should follow Australia, Sweden and many other countries and abolish inheritance tax entirely. People should not pay tax on assets accumulated from income on which they have already paid tax. And the inheritance of assets can give people a chance to invest in establishing a business. However, pending abolition, the worst features of the tax could be avoided by radical reform.

Many countries that have retained an inheritance tax instead tax recipients on their lifetime gifts received rather than taxing people on their assets when they die. Indeed, it is more logical to tax the beneficiary of a gift rather than the donor.

Our Budget submission proposed that each individual should be granted a £500,000 lifetime gifts and inheritance allowance (indexed to wage rises). When this allowance is exhausted, any further gifts received would be taxed at a flat rate of 20 per cent. Small gifts of a few thousand pounds would not count towards the lifetime allowance, and gifts would not count towards the allowance if they did not take an individual above the personal income tax allowance that year. Transfers between husband and wife, of course, would be entirely exempt.

The broad principle would be that those receiving substantial gifts would pay tax at a much lower rate. Further, estates split between many beneficiaries would incur less tax, as the recipients would be receiving less money.

Such a reform would make Inheritance Tax less bureaucratic and avoidance much less worthwhile.

Philip Booth is editorial and programme director at the Institute of Economic Affairs, and professor of insurance and risk management at Cass Business School, City University.

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