If inheritance tax is to be retained, it urgently needs to be improved, argues new report co-authored by CAGE's Dr Arun Advani

Each generation of older people is holding more and more wealth. Inherited wealth is becoming increasingly important as a result. If non-spousal inheritances passed on next year were to be equally shared between all 25-year-olds, each would receive around £120,000.

As inheritances grow in importance, so too will inheritance tax revenues. Our new analysisLink opens in a new window suggests this growth will be much stronger than official forecasts, increasing revenues from around £7 billion in the current year to around £15 billion in a decade’s time. Scrapping inheritance tax would therefore come with a fiscal cost that grows over time.

If inheritance tax is to be retained, it urgently needs to be improved. The current system suffers from several problems which are costly, inequitable and inefficient. And as inheritances grow, these problems become more prevalent. There are several clear steps the government could take to make the system better. These could raise additional revenue, or could be combined with a lower inheritance tax rate or higher threshold as part of a revenue-neutral reform.

Even with these reforms, inheritance tax will not have much impact on inequalities in wealth or on intergenerational social mobility: only a small share of estates are affected by the tax; and by the time inheritances arrive, wealth inequalities by parental background are already well entrenched and hard to undo.

These are among the findings of Reforming inheritance tax, by Arun Advani and David Sturrock, published today as a pre-released chapter of the 2023 IFS Green Budget, produced in association with Citi and with funding from the Nuffield Foundation.

Other findings include:

• The most recent HMRC statistics show less than 4% of estates paid inheritance tax in 2020–21. However, the rapid growth in wealth among older individuals means this number is set to rise to over 7% by 2032–33.
• The number of people affected by inheritance tax will be still larger. One in eight people (12%) will have inheritance tax due either on their death or their partner’s death by 2032–33.
• This varies dramatically between the different regions of the country: in London, around 23% of people (or their surviving spouse or civil partner) will pay inheritance tax, almost twice the national average and five times higher than in the North East.
• The current cost of abolishing inheritance tax would be £7 billion. Around half (47%) of the benefit would go to those with estates of £2.1 million or more at death, who make up the top 1% of estates and would benefit from an average tax cut of around £1.1 million. The 90% or so of estates not paying inheritance tax would not be directly affected by such a reform.
• Reforms to inheritance tax that remove poorly justified reliefs could raise up to £4.5 billion, though this amount would be reduced if the wealthy responded by reducing the size of their estates.
• These reforms would raise revenue from the largest estates. Estates worth more than £5 million would go from paying an average effective tax rate – after accounting for tax reliefs – of 19% under the current regime, to 38%. The additional revenues would allow the tax-free amount (‘nil-rate band’) to be raised from £325,000 to £525,000, meaning the average effective tax rate would fall slightly for estates worth less than £2 million. Alternatively, the reforms would allow the tax rate to be cut from 40% to 25% while being revenue-neutral.
• Inheritance tax as currently designed has only a small impact on the distribution of inheritances received. Next year, the wealthiest fifth of donors will bequeath an average of £380,000 per child, and pay inheritance tax of around 10% of this amount. By contrast, the least wealthy fifth of parents will leave less than £2,000 per child.
• By the time inheritances are received, wealth inequality is already substantial. By ages 50–54, children of the wealthiest fifth of parents have accumulated an average of £830,000 in wealth, while children of the least wealthy fifth have an average of £180,000.

David Sturrock, a Senior Research Economist at IFS, said: ‘There are reasonable arguments for and against an inheritance tax. But as inheritances grow in size, it’s increasingly important that we address problems in the current system. The government should abolish the special treatment given to business assets, certain types of shares, agricultural assets, pensions and homes passed to direct descendants. These exemptions and reliefs open up channels to avoid inheritance tax. This is costly, unfair and distorts economic decisions. Reforming them could raise as much as £4.5 billion in additional revenue.’

Arun Advani, an Associate Professor at the University of Warwick and Research Fellow at IFS, said: ‘While inheritances and therefore inheritance tax revenues are set to grow, inheritance tax remains small and comes too little too late to reduce inequalities between those with the wealthiest parents and the rest. While it’s conceivable that a more expansive inheritance tax could be introduced, those concerned with social mobility need to look earlier in life than when parents die.’

Mark Franks, Director of Welfare at the Nuffield Foundation, said: ‘Inheritance tax is paid after death and by only a small proportion of the population, who are largely the wealthiest members of society. Like all taxes, it supports vital public services. Abolishing it or scaling it back would mean either cutting such services, raising other taxes or increasing the national debt. Yet, the current design of inheritance tax compromises both confidence in it and its ability to generate revenue effectively. Through practical reforms, it is possible to craft a more just and efficient system.’

• The research has been covered in The Guardian (27 September)