What is the Purpose of Inheritance Tax (IHT)?

Partner Caroline Casagranda, in our Wills, Probate, Tax & Trusts team, explains the purpose of Inheritance Tax (IHT).

When the Chancellor of the Exchequer George Osborne declared before the recent election that the threshold for Inheritance Tax should be raised from £325,000 to £1m, reiterating the view he expressed before the 2010 election that “inheritance tax should only be paid by the rich”, he reignited a series of burning questions that continue to resonate with the British public: what is the purpose of Inheritance Tax? Who should lose and who should benefit in the reallocation of wealth?

What is the purpose of Inheritance Tax?

Inheritance Tax (IHT) accounts for less than 1% of the annual tax take and receipts are not ring-fenced in anyway or re-allocated against specific activities. In simple terms, the receipts from Inheritance Tax are an income for Treasury, and are pooled with Income Tax, Corporation Tax and VAT  to finance the expenses Government incurs. However, Inheritance Tax is part of a wider Taxation System which uses levers to encourage and discourage behaviours and redistribute wealth.

Paying for Common Necessities

Governments often step in to provide funding for activities that either must be run centrally or are not financially motivating to private business.  Examples of central functions include a national pension and benefits system, a health service open to all, schooling up to tertiary level and the budgets for defense, transport, energy, firemen etc. There are a raft of quasi-private businesses which still require support to service the public: the Post Office, for example, still benefits from subsidies to enable it to provide service to the entire country regardless of whether it is economically profitable to serve an area. The university system, house-building and employers also receive substantial subsidies, tax allowances and grants.

Paying Debt

Most Governments carry some level of debt that must be paid off or at least have interest payments made. These expenses can be from spending too much on social services, fighting expensive wars or years of limited income because of a depression. For example, the Treasury estimates the UK National Debt at almost £1.4 trillion with a rising deficit, costing £60bn annually to service interest payments. This is now the fourth biggest item of expenditure for HM Government.

Influencing Behaviour

Taxes have evolved into a way for the Government to affect the decisions people make by making them more or less expensive through taxes. The Government can pass taxes that discourage people and businesses from engaging in behaviors that the Government does not want to promote.

These can range from adding extra taxes on products that pollute, such as gas-guzzling vehicles, to giving tax breaks to alternative products such as a tax credit for buying an electric car. Ideally, goods and services that have a negative social impact (cigarettes, alcohol, gambling, junk food etc.) will be more heavily taxed and their positive counterparts promoted through financial incentives (exercise, creativity, health foods, medical research etc.) and as many companies and people make decisions based on the expected costs and benefits, this can be an effective way to encourage the behaviors which have the optimal social benefit.

Encouraging Savings and Investment

Even though taxes reduce the amount of pay that people get to keep, taxes can actually increase savings by instituting tax breaks for people who put money aside in special savings accounts. Two examples in the UK are personal pensions and children’s ISAs which are both deductible from taxable income enabling people pay to incur smaller tax liabilities because they were “nudged” into making provision for the future.

Corporate investment in machinery and plant also benefits from allowances, helping them remain sustainably competitive.

Redistributing Wealth: who should win and who should lose?

Under a fair, progressive taxation system, increased incomes attract a higher percentage of taxes. For example, under a progressive system a person with an annual income of £30,000 may only pay a marginal tax rate while someone who makes £300,000 will have the burden of a higher rate tax rate. However, as the Government services are provided to all the richer members of society are clearly funding the poorer ones. In theory, VAT follows a similar pattern: richer people spend more and, therefore, create more receipts for Treasury and, likewise, Inheritance Tax (IHT) works on the principle that larger legacies will attract a greater inflow of funds to the Government bean-counters. So despite varying in its level of progressiveness, IHT fulfils the same function as the others fiscal tools.

IHT, however, brings something different to the “Zero Sum Game”: politicians throughout history have used IHT successfully to promote inter-generational competition and innovation whilst combating indolence and entitlement. Whilst conferring assets to heirs might seem intuitive this allows too few families to concentrate property ownership and, thus, denies the prospect to others. It creates a landed class that ultimately undermines the legitimacy of the very idea of property, that it is a reward for a life of service and contribution.

In response to the spectre of inequality most societies have developed a system for taxing property when it moves between generations. From the Stamp Duty that a young baron paid to the King when taking over his father's lands, through Adam Smith, Thomas Jefferson, Andrew Carnegie, Herbert Hoover, Theodore Roosevelt, Winston Churchill et al the principle of society taking a proper cut on such bequests has long been established. Churchill, for example, regarded IHT as a “corrective against the development of the idle rich'.

Andrew Carnegie, the Scottish industrialist / philanthropist and arguably an inspiration to Gordon Brown, advised ‘the parent who leaves his son enormous wealth generally deadens the talents and energies of the son and tempts him to lead a less useful and less worthy life than he otherwise would.’ IHT, then, is a good thing as it removes the disincentive to contribute to society. Moreover, there is evidence from modern Britain that the expectation of IHT encourages parents to spend money enhancing their children’s educational and social skills to equip them for a perfect storm of headwinds: austerity, globalised competition, environmental crises, digitalization, demographic changes, technological convergence etc. etc. etc.

However, for every proponent of IHT like Winston there’s a Whoopi Goldberg, who complains: “I’d like somebody to get rid of the death tax. That’s what I want. I don’t want to get taxed just because I died. I just don’t think it’s right. If I give something to my kid, I already paid the tax. Why should I have to pay it again because I died?”

In recent times the notion that taxing inherited property is immoral and should be materially reduced or abolished altogether has gained traction on both sides of the Atlantic, accelerated by the skilful language of the neoconservatives who labelled it “death tax”. Indeed, the Chancellor’s pre-election proposals confirm this direction of travel, and though may have been omitted from the Queen’s Speech earlier this week they are expected to be included in the new Finance Bill due for publication in July, and with 70 per cent of the take being paid by people inheriting estates of half a million pounds or less it will always be attractive to Middle England.

Taking a slightly different tack, the Labour politician (now Lord) Roy Jenkins derided IHT as the “voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue’. IHT’s “voluntary” nature being a reference to the various schemes devised by specialist tax consultants to avoid the intergenerational burdensome benefactors might have felt appropriate.

Ultimately, IHT is perceived by many as unfair: double taxation for the families who have worked hard, saving and building assets all their lives, and optional for those rich enough to protect their largesse. Like Whoopi there are many, on both sides of the pond, who vociferously support the view that there should be “no taxation without respiration”. Tacitly, this group includes the British Aristocracy no doubt emboldened by the Royal Family’s approach: In 2002 the Queen Mother is understood to have left her entire estate estimated at £50 million to her daughter Elizabeth II, including works of art, jewels, antiques and her thoroughbred racehorses. A “deal” made with John Major’s Government back in 1993 ensured that The Queen avoided IHT of an estimated £20 million on her mother's estate.

What’s more the view that this is an unfair imposition is playing well with cross-party Think Tanks, looking for creative ideas to hit the right notes with voters. It would be no surprise to see Osborne’s pledge to raise the IHT threshold pushed through very early in this Parliament. The threshold is currently fixed at £325,000 for individuals and IHT is charged at a rate of 40% on estate values in excess of the threshold (where no exemption applies). Any unused allowance can be transferred to a surviving spouse, which means married couples can collectively bequeath £650,000 tax-free.

The Institute for Fiscal Studies (IFS) argue that whilst Osborne’s raising of the threshold to £1 million would simultaneously appease hard-working middle-income families (possibly swing voters in marginal seats?) and continue to act as a disincentive for the potential young, idle and rich it would raise little revenue for the Treasury, and becomes excessively expensive to justify. They contend that, had the threshold been £1 million, the revenue raised by the Treasury in 2010-11 would have been just £800million, 70% lower than the £2.6 billion actually generated. Furthermore, the numbers paying the tax would have reduced from 2.8% of deaths to 0.7% of deaths. The IFS suggest certain alternatives to raising the threshold, such as scrapping IHT altogether or taxing what each recipient gets rather than what each donor passes on.

At the current threshold level, proceeds for the tax year 2013-14 were £3.42 billion and according to forecasts from the Office for Budget Responsibility the Treasury will raise approximately £5.8 billion during 2018-19 if the existing threshold is maintained. The numbers paying IHT are also forecast to increase from 2.6% of deaths in 2009-10 to 9.9% of deaths in 2018-19. This increase, a meaningful contribution to the Treasury’s tax take and, by inference, the policies we voted the Government in to deliver, is in part due to economic recovery and as the property boom ripples out from London through the regions.

There is a counter-argument to George Osborne’s, and the Tea Party lobby, that the tax take should be raised and the loopholes closed that let much property to be held offshore. The economic benefits are clear. More property would have to be sold on death to pay the tax, easing house-price inflation and giving people the chance to buy property that otherwise would not come on the market. Additionally, lowering inheritance tax does not stimulate innovation, entrepreneurship or high business start-ups. In direct contrast, the opposite appears to be true: easy access to unearned wealth negates the incentive to work and to innovate - one of the reasons why philanthropy is becoming an attractive alternative to the super wealthy.

Only time will tell whether the Chancellor’s long term plan advocates private property as the just reward for individual hard work and acknowledges that only a fair part should be passed on or, as many suggest, a way to maintain estates (and intergenerational advantages / inequality) in perpetuity.

For further information or legal advice, please contact law@blandy.co.uk or call 0118 951 6800.