What would be the effects of abolishing or reforming inheritance tax?

Inheritance taxes aim to raise revenue and reduce inequality of opportunity arising from differences in parental wealth. But current UK policy has little impact on social mobility. Scrapping the tax would benefit the wealthiest, while reforms could reduce unfairness and negative economic effects.

Inheritance tax policy is increasingly contentious. Inheritances are growing – both in absolute terms and relative to the lifetime economic resources of those who receive them. This makes the design of inheritance tax more important over time (Bourquin et al, 2020).

Calls to abolish or reform the tax have been frequent in the UK in recent months. A newspaper campaign launched last year to scrap the tax was backed by around 50 Conservative MPs (The Telegraph, 2023).

The tax currently raises around £7 billion a year in the UK. If it were to be abolished, around half of the gain would go to the wealthiest 1% of estates at death, and to those living in London and the South East. In contrast, there would be no direct effect on the more than 90% of people who do not pay any inheritance tax.

Similarly, other reforms – in particular, removing various special reliefs and exemptions from the tax – would affect only a minority of taxpayers. But such reforms have clearer economic rationales, removing sources of unfairness and economic distortion. Revenue from these changes could be used to reduce the inheritance tax rate or increase the threshold before inheritance tax is paid, while keeping revenues constant.

How does inheritance tax work?

Inheritance tax is levied on wealth, over a certain threshold, bequeathed at death or given away in the seven years before death. Any wealth passed on to a spouse or civil partner is not taxed; neither is wealth given to charity or to a political party.

The threshold at which inheritance tax applies in the UK is currently £325,000, so anything passed on below this limit is not subject to tax. There is an additional allowance of £175,000 if passing on a main property to children or grandchildren, which means that the effective threshold before transfers are subject to inheritance tax is £500,000 for most homeowners. Above this effective threshold, the tax rate is 40%.

Any unused proportion of these allowances can be passed on to a surviving spouse or civil partner, meaning the second partner in a couple to die, if passing on a property, can be subject to an effective threshold of £1 million.

Certain types of assets are not subject to inheritance tax. In particular, pension pots are not treated as part of an individual’s taxable wealth, and agricultural and business property can attract tax relief. These exemptions further push down the amount of wealth subject to inheritance tax.

As a result of these high effective thresholds, most people don’t pay inheritance tax – fewer than 4% of deaths resulted in inheritance tax in 2020/21 (HM Revenue and Customs, HMRC, 2023).

Inheritance tax is usually only payable on the death of the second partner in a couple, since the first member in a couple to die will usually pass on their wealth tax-free to their surviving partner. If that surviving partner ends with a taxable estate, we might consider both members of the couple to have been affected by inheritance tax.

But even when counting individuals as inheritance taxpayers if either they or their spouses or civil partners pay inheritance tax at death, fewer than one in ten people are inheritance taxpayers.

This means that revenues from the tax are small in the overall context of government finances. The tax brings in around £7 billion each year, which is less than 1% of annual government spending.

What would be the effect of abolishing inheritance tax?

There are some reasons to think that abolishing inheritance tax might be a popular political move. Some evidence seems to indicate that the tax is unpopular. For example, only one-fifth of people described inheritance tax as ‘fair’ in a recent YouGov poll, compared with around 60% saying that national insurance contributions are fair (Ansell, 2023).

But research has shown that most people would not prioritise inheritance tax when deciding which tax to cut. Further, most people would prefer to spend the money that abolishing inheritance tax would cost – £7 billion in 2022/23, equal to the amount of revenue raised – in other ways (Demos, 2023). Interpreting public opinion on this issue is not straightforward.

Inheritances are set to rise in value over time, as a result of the increasing levels of wealth held by those at older ages. This means that revenues from inheritance tax are also projected to rise over time, and so in turn would the cost of abolishing the tax (Sturrock, 2023).

By 2032/33, revenues – and so the cost of abolishing the tax – are set to increase by more than double to £15 billion (Advani and Sturrock, 2023). As with any tax cut, raising taxes, cutting spending elsewhere or increasing borrowing in order to pay for the cut would be necessary.

The wealthiest 5% of people, those who have more than £1 million at death, would capture 83% of the fiscal benefit from abolishing inheritance tax in 2024/25 (Advani and Sturrock, 2023). Around half of the gain would go to estates in London and the South East. More than 90% of people would not benefit, since neither they nor their partners pay inheritance tax.

How could the structure of inheritance tax be improved?

If retained, the structure of inheritance tax could be improved. The preferential treatment currently given to pension pots, business and agricultural assets, and main residences passed to direct descendants creates inequality between decedents depending on their ability to hold their wealth in these forms.

For example, the fact that pension pots are not subject to inheritance tax creates an incentive to use them for bequests, while funding retirement through other forms of wealth (Adam et al, 2022). Indeed, this approach is increasingly suggested by wealth management and pensions professionals (Standard Life).

These exemptions also mean that wealth is not directed to its most productive or efficient uses, but may instead be held in some forms because of tax considerations. For example, agricultural property relief encourages investment in agricultural land as a tax avoidance mechanism.

As such, the proportion of agricultural land bought by farmers fell from 60% in 2011 to 40% in 2017, indicating that buying land to pass it on tax-free may be becoming increasingly popular (Office for Budget Responsibility, OBR, 2019).

Largely as a result of these reliefs, the very largest estates, those worth over £7.5 million, pay a lower average tax rate than estates of between £2 million and £7.5 million (HMRC, 2023).

As a result, there is a strong case both in terms of fairness and economic efficiency for eliminating, or at least curtailing, these special exemptions.

What would be the effect of reducing or capping the special treatment of some types of assets?

Abolishing or capping some of these reliefs could allow the government to reduce the headline rate of inheritance tax from 40% (or to increase the threshold before inheritance tax is payable) in a revenue-neutral way. Alternatively, it would raise additional revenue, which could be spent in other ways.

Abolishing business relief could increase annual revenue by up to £1.4 billion, which is around a 20% increase in the revenue raised by inheritance tax with its current structure. This change would largely affect those who are wealthiest at death – 90% of business wealth passed on at death is held in estates worth over £2 million.

This £1.4 billion could allow the threshold before inheritance tax is charged to be raised to £415,000 in a revenue-neutral way. Alternatively, it could allow the rate of inheritance tax to be lowered to 34% (Advani and Sturrock, 2023). This amount could, of course, be used in other ways, such as cutting other taxes or increasing public spending.

Treating pension pots as taxable would raise a smaller amount of money – revenue from inheritance tax would increase by around £200 million if 80% of pension pots were included in estates. But this number is set to grow rapidly over time, as a result of the growing importance of defined contribution pension pots in overall wealth (Cribb and Karjalainen, 2023).

Combining many of the reforms discussed – eliminating the additional exemption for residential property passed to direct descendants, including pensions, in the value of taxable estates, and capping business relief – would increase annual revenue by around £4.5 billion.

This would allow the threshold before inheritance tax is charged to be raised to more than half a million pounds – £525,000 – in a revenue-neutral way. Alternatively, it would enable the rate to be lowered to 25%.

There is uncertainty around these figures because they would depend on how people react to reforms and whether they are able to use other ways to avoid inheritance tax. Implementing a coherent package of reforms would likely be more effective than curtailing some reliefs but leaving other avoidance channels open.

Would reforms to inheritance tax affect social mobility?

One of the main rationales for having an inheritance tax in the first place is to reduce inequalities between those who have more and less wealthy parents.

As it stands, a child of the wealthiest fifth of parents to pass away in 2024/25 will inherit around £380,000 on average. This compares with less than £2,000 received by a child of the least wealthy fifth (Advani and Sturrock, 2023).

Crucially, only around £40,000 of that £380,000 will be taxed, on average, which means that inheritance tax reduces this inequality by about a tenth. So while inheritances play an increasing role in expanding wealth gaps, inheritance tax does not play a large role in reducing those effects.

Differences in inheritances also represent only a minority of the wealth gaps between those with richer and poorer parents. By the time people inherit (typically in their late 50s or early 60s), the children of wealthier parents are already much better off than the children of poorer parents.

By their early 50s, the children of the wealthiest fifth of parents have around £830,000 in wealth on average, while the children of the least wealthy fifth have around £180,000.

These wealth differences are a result of multiple factors: for one thing, these children tend to have had more opportunities, in terms of education and high-paying jobs. Children of wealthier parents are also more likely to have received gifts from their parents at earlier points in life (Boileau and Sturrock, 2023).

Around half of these gifts tend to be used for buying homes, which can be very important for future wealth accumulation (Boileau and Sturrock, 2023). Gifts received in early adulthood will rarely be subject to inheritance tax, since they are generally given more than seven years before death.

For these reasons, inheritance tax in its current form has a minimal impact on social mobility and would continue to do so even following the reforms set out above. For inheritance tax to make a meaningful difference to social mobility, there would need to be a larger-scale reform that significantly lowered exemption thresholds, and brought a greater share of lifetime gifts into the scope of the tax.

Conclusion

Gains from abolishing inheritance tax would largely accrue to the wealthiest 5% of the population at death, and to those living in London and the South East. The lost revenues would have to be made up through raising other taxes, cutting spending or borrowing more. Although of modest size now, this revenue loss would grow quickly over time.

Reforming the tax by eliminating or curtailing its special exemptions could allow the threshold before tax is payable to be raised, or the rate to be lowered. These reforms would reduce the unfairness and distortions in the current structure of inheritance tax.

These changes are unlikely to affect social mobility dramatically because most inheritances would still remain untaxed. In order for inheritance tax to have substantial effects on social mobility, a larger-scale change would be necessary, such as substantially reducing the tax-free threshold and bringing a greater share of lifetime gifts into the scope of the tax.