IEA Blog

The Conservatives have abandoned their manifesto commitment to raise the Inheritance Tax threshold as part of the coalition deal with the Liberal Democrats. This his highly regrettable.

Inheritance Tax is clearly unjust in the sense that it represents triple taxation. Tax is paid on the initial income, then on savings and then again after death, creating significant economic distortions. One result is the small army of tax advisers employed to minimise exposure to death duties; another is that resources are allocated in order to avoid tax rather to achieve the highest returns. Perhaps most importantly, the tax reduces incentives to save rather than consume, thus lowering investment and hampering the production of wealth.

Inheritance Tax raises about £3.5 billion per annum for the Treasury – a tiny proportion of the overall tax take. The Conservative plans to raise the threshold would therefore have cost relatively little. Indeed, given its impact on investment and allocative efficiency, it is probable that inheritance tax actually reduces overall tax revenues in the long term.

The Liberal Democrats’ alternative policy of raising personal allowances to benefit the low paid is worthwhile in order to improve work incentives by reducing the horrendous marginal withdrawal rates produced by benefits and tax credits. Nevertheless, given the fiscal crisis, the measure will have to be funded by tax rises elsewhere. If, as the reversal on inheritance tax suggests, this means higher taxes for the relatively wealthy, it may represent a transfer from those with low time preferences (entrepreneurs and savers) to those with high time preferences (low-income spenders). Accordingly, the economic benefits of this realignment of the tax system are far from clear.

The impact of Inheritance Tax is explained in Euthanasia for Death Duties by Barry Bracewell-Milnes.

The Economist has repeatedly criticised the Conservative Party’s proposal to permit married couples to pool their income tax allowances. The plan would benefit single-breadwinner families, who, under the present system, are effectively waiving the Personal Allowance of the non-working partner. The magazine deemed the proposal both paternalistic, for trying to “tempt couples down the aisle” and regressive: “most of the poorest families would not benefit. [...] of the 3.9m children living in poverty only 11% would stand to gain.”

The first criticism is fair. In a free society, government should have no role in promoting or discouraging particular family structures. (Through the “couple penalty” in the benefits system, it currently does the latter.) But this is not necessarily a reason to dismiss the plan. At least for some people, it amounts to a tax cut, and as the late Milton Friedman put it: “I am in favour of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible.” Like Goethe’s Mephistopheles, the Tories want the right thing for the wrong reason.

In a more indirect way, this may also apply to the second point The Economist raises. Their 3.9m-figure refers to children living in households with an income below 60% of median household income. True, most of those falling below this poverty line do not pay income tax, and those who do are the ones not far below. But this does not mean that raising the Personal Allowance would only reach the not-so-poor among the “poor”.

As the Institute for Fiscal Studies shows, those with the lowest incomes are generally not the ones with the lowest living standards. Plotting income against Material Deprivation (MD), a consumption-based measure of poverty, they find a roughly arch-shaped relationship: starting in the middle of the income distribution and moving downwards, MD-poverty increases. But towards the very bottom, MD-poverty falls again. Very far below the poverty line, living standards are generally higher than in closer proximity to it, or just above. The reasons probably include short-term income fluctuations and misreporting.

Therefore, to those who could really do with a bit of extra income, raising the Personal Allowance might do more good than the Conservatives realise, and this is without even mentioning dynamic effects. The real criticism of the Tory tax plan should be: why so little, and why only for some?

The UK still has a higher proportion of children living in workless households than any other member state of the EU-27. This is the result of an unfortunate combination of two circumstances: first, the UK has a high overall rate of economic inactivity; second, households with children are overrepresented among the inactive.

A governmental PR department would probably present it this way: “Ten years ago, in a benign economic climate, 2.2 million children lived in households with no member in gainful employment. Today, in a severe recession, this figure is down to 1.8 million.” But it is also true that after ten years of extensive and costly policy efforts to raise employment rates, especially among lone parents, the UK is still at the bottom of the pack.  

It is a bit strange that this fact is not really among the flagship arguments of the anti-child-poverty advocacy community. Instead, they emphasise that more than half of all children in relative poverty live in “working poor” households.  

This statement is true when looking at snapshots of relative low income, but it overlooks the dynamics. Those who are in employment exit relative low income much more frequently than those who are not – which is hardly surprising. The chances of experiencing a pay rise or finding a better-paid position are higher inside the labour market than outside. Work continues to be the most promising route out of poverty and low-pay.

Therefore, in the longer run, child poverty should be understood and approached in very different ways than is done today. But as a first-aid measure, we should consider a substantial increase in the personal tax allowance, and likewise for National Insurance contributions.

For example, Tom Clougherty at the Adam Smith Institute proposes a near-doubling of the tax-free allowance to £12,000 per person. This would decrease tax revenues by £18.9bn, but it could well be a good investment. It would make work, even in low-skilled jobs, more attractive to those currently outside the labour market. To those half-way inside, it would boost incentives to go further, by disentangling tax liability and tax credit withdrawal to some extent. Old-fashioned economic incentives could, once again, prove a more powerful force than well-intentioned government projects.