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Picture this: the government commissions an official report on a high-profile tax and the result is a comprehensive report, about as damning as you can get: it calls the structure unfair, crucial deductions outdated and demands reform.
Six years later, absolutely nothing has been done to solve this problem.
Except that there is no need to imagine this scenario, because it is what actually happened with the inheritance tax.
Accumulation: Inheritance tax was originally conceived as a levy on the estates of the very rich, but has increasingly become a tax on the wealthy middle class who own family homes in the south of England.
This exemplifies the abject failure of the British tax system over the past two decades.
Successive Finance Ministers have known about bad taxes that damage public confidence and instead of fixing them they have chosen not only to ignore the problem but often to actively make it worse.
The Conservatives made a lot of noise about improving inheritance tax and even hinted at scrapping it. Aside from George Osborne’s tinkering with the clumsy home-based exemption, they instead ignored the issue.
Conservative finance ministers were prepared to sit back and allow inheritance tax to become more and more of a tax raid on the affluent middle classes rather than the levy on the very rich it was intended to be. We now start in a bad position when faced with a Labour Party apparently keen to tax wealth.
In January 2018, the then Chancellor of the Exchequer Philip Hammond asked the Office of Tax Simplification to conduct a review of inheritance tax with the aim of simplifying it for both government and taxpayers.
The OTS returned with the first part of its review in late 2018, followed by the final part in 2019.
As I mentioned earlier, the results of the review were far from complimentary.
It painted a picture of a total disaster of a tax which, despite being paid by only a small percentage of estates, manages to create an administrative nightmare for many more whose loved ones have died, cementing its reputation as Britain’s most hated tax.
In November 2018, the OTS said: ‘Although inheritance tax is payable on less than 5 per cent of the estates of the 570,000 people who die in the UK each year, around half of families have to complete the forms.
‘Many also told us that their relatives had been worried about inheritance tax during their lifetime, even though it would not affect them.’
Inheritance tax is levied at a rate of 40 per cent on estates exceeding the individual nil-rate band of £325,000, with an additional £175,000 tax-free for those who pass on their own home to their direct descendants.
You can transfer your unused allowances to your spouse, meaning married couples and civil partners have a combined allowance of £1 million.
A cornerstone of the estate tax is to limit the amount that people whose estates would be subject to it can give away before their gifts become caught in the inheritance tax net.
Once they exceed these gift limits, they must survive for another seven years for the gift to be free of estate tax.
The OTS highlighted in detail how outdated these limits are and that they had not been increased since inheritance tax was introduced in its current form in 1986.
The frozen principal gift limit means you can only gift £3000 per year before you end up with a potential inheritance tax liability.
An exemption applies for weddings: a parent can donate £5,000 or a grandparent £2,500.
Alternatively, you can make unlimited small gifts worth up to £250, but you can only make one per individual recipient.
There is an IHT exemption for making regular gifts from surplus income, but this is a murky area and you cannot use it to give away your savings.
The rules on donations create some truly bizarre potential scenarios for anyone unlucky enough to die within seven years.
- Your estate could become subject to inheritance tax if:
- Buy your 18 year old son a £5,000 second hand Ford Fiesta
- Share your daughter or son’s wedding (the average cost of which is estimated at £20,000)
- You’ve already given away your £3,000 this year and bought your grandson a school laptop.
- Take the family on a great vacation
Once upon a time: Inheritance tax gift limits haven’t changed since the 1980s
Despite all these restrictive rules, the truly wealthy pay a lower effective rate of inheritance tax than the merely wealthy.
In fact, I imagine these things happen all the time and go unnoticed without any inheritance tax being charged, even if the donor dies within seven years.
However, in theory, the tax authorities could pursue an estate that exceeds the inheritance tax threshold by charging 40 percent on any of the above points.
One area where people are most at risk of receiving an IHT bill is if the bank of mum and dad (or grandparents) helped with the deposit on a house, which often runs into tens of thousands of pounds.
One of the most striking elements of the OTS report was that, despite all these restrictive rules, the really rich pay a lower effective rate of inheritance tax than the merely rich.
Standard exemptions of up to £1 million per couple mean the total effective rate of inheritance tax on estates (the amount paid versus its value) is much lower than the headline rate of 40 per cent.
As people become caught in the IHT net, the effective rate rises steadily, from 5 per cent at the low end, to around 20 per cent for estates between £2m and £3m, where it remains stable until around £7m.
But after that it starts to fall and when you get to estates of more than £10m the effective rate of inheritance tax is 10 per cent.
This is where having pockets deep enough to do some serious inheritance tax planning really pays off and exemptions such as transfers of businesses and agricultural land start to be used by the wealthy, rather than the businessmen or farmers for whom they were designed.
In its second report, the OTS made 11 recommendations. The most important to most people were those related to living donations, which recommended a new, simpler general allowance for personal donations at a higher level, along with reducing the seven-year rule to five.
My personal view is that inheritance tax could be made even simpler, simply by reducing the IHT rate to a much more acceptable level of 20 per cent, and the tax take could remain the same as avoiding it becomes less profitable.
This is Money readers disagree: in a poll of 5,321 people voting, just 11 per cent were in favour of cutting the rate, compared with 26 per cent who wanted to raise the threshold and 49 per cent who said they should abolish it altogether.
Whatever your opinion of inheritance tax, you would think that after such a damning report on a tax that far exceeds its weight in terms of attention and disruption, something would have been done.
Instead, the Conservatives sat on the OTS report for so long that it managed to outlive the Office of Tax Simplification itself, which was dismissed by Kwasi Kwarteng and Liz Truss.
As with many of our problematic tax cheats, it is a shame the Tories never acted.
Especially since for some strange reason our new Labour government seems to want to kill off economic optimism with some tax increases.
Perhaps we’ll be in for a surprise in October. Perhaps Rachel Reeves won’t carry out a lousy inheritance tax raid that would only make a bad tax worse, but instead will increase gift allowances to suit modern life and make it simpler and better.
Although I’m not sure I can see that happening.
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