Inheritance tax is a government cash cow, but politics may cause its downfall

© Reuters. Inheritance tax is a government cash cow, but politics may cause its downfall

Proactive Investors - The debate over the virtues of inheritance tax (IHT) is back in the public sphere, as reports emerged that Prime Minister Rishi Sukan plans to scrap what is roundly considered one of the most unpopular taxes in Britain.

The Sunday Times cited three sources stating that a “live discussion” is underway at Downing Street over the future of the tax.

“No 10 political advisers have been looking at abolishing inheritance tax as something that might go in the manifesto. It’s not something we can afford to do yet,” said one source.

With a make-or-break election on the horizon for the Tories, there is every chance that IHT will be a hot-button issue in parliamentary debates and Question Time roundtables.

Britain’s most hated tax

Due to its perceived double tax effect and confusing administration, IHT has been a constant source of division since replacing the transfer tax in 1986.

Former chancellor Philip Hammond asked the Office of Tax Simplification (OTS) to look into quirks in the IHT system way back in 2019.

Despite only 5% of estates paying IHT (that’s only around 30,000 estates in total), the OTS called it “uniquely unpopular”.

Part of that is down to the convoluted nature of the tax, which is charged at 40% on any part of your estate above the tax-free threshold.

As of September 2023, the tax-free threshold was £325,000. This threshold has not changed since 2009, despite average house prices nearly doubling in that same time period.

Over time, the demographics exposed to IHT have changed from the uber-wealthy to lower, yet still wealthy, rungs in the mid-to-upper classes.

It is therefore understandable why IHT is the most hated tax in Britain.

Estates can dodge IHT by giving their money away as gifts, but this, too, comes with complications.

The ‘seven-year rule’ stipulates that gifts given seven years before an inheritance is passed down are also exposed to the 40% IHT tax.

There are also limits on how much can be given away as gifts, namely £3,000 per year. However, gifts paid to spouses and civil partners, charities and political parties are not taxed, and there is a £5,000 wedding gift allowance to each child.

These gift allowances are also highly outdated, having been set in the 80s. Had the annual gift allowance kept pace with inflation, it would be well above £10,000.

Due to these layers of confusion, the OTS recommended a vast overhaul to make it easier to digest.

Unfortunately, the OTS has since been wound up and no recommendations were implemented.

IHT receipts climb

As such, IHT has continued to rake in big tax receipts for the government.

In the 2022/23 tax year, IHT receipts totalled £7.09 billion, up from £6.05 billion in the 2021/22 tax year.

Barring a dip following the global financial crisis, this number has steadily risen over the decades; in 2000/01, the government pulled in £2.22 billion in IHT receipts.

Nicholas Hyett, Investment Manager at Wealth Club, commented: “Our research suggests the combination of rising house prices and inflation will push up both the number of families paying inheritance tax and the amount they pay.”

The average IHT bill could top £275,000 by the end of the decade – Source: Wealth Club

Hyett suggested that, without changes to the way inheritance taxes are calculated, the number of people paying IHT could rise by 50% in a decade.

“With the UK’s most hated tax hitting a growing number of families you can see why there are calls to abolish the tax, and why the government are said to be giving it serious consideration,” he said.

IHT receipts could potentially exceed £9 billion in 2029, according to Wealth Club research, meaning that the government “will probably decide scrapping the tax altogether is too costly”.

As a compromise, Wealth Club is urging the government to raise the IHT threshold at least in line with inflation.

Given the amount of energy dedicated to debating IHT, is it worth just scrapping it and moving on?

On the one hand, £7.06 billion was barely half a percent of the total public sector tax receipts in the 2022/23 tax year.

On the other hand, handing out tax breaks to wealthy estates when the middle and working classes face the opposite could be bad optics for a Tory government facing an election wipeout.

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