Why UK chancellor should avoid inheritance tax sugar rush in budget

Since the summer, there have been rumours that the government is looking to cut inheritance tax. The prospect of an early election has only heightened speculation that this is coming in the March budget. While commentators and pundits argue over the question of whether or not a cut is coming, they miss the more important question: how would an inheritance tax cut be made?

When he stands up on 6 March, Jeremy Hunt will have two options for how he could make such a cut. The first, reported to be popular on the right of the party, is simply to cut the headline rate.

Halving it to 20% would cost about £5bn, and would provide a short-term sugar rush – a big, bold, headline-grabbing move that might sound good now but would ultimately need to be paid for. Deferring the pain might be politically sensible – the current polls suggest finding the money later won’t be Hunt’s problem – but would damage any claims the Conservatives might want to make about fiscal responsibility, unless paired with specific spending cuts, which would rather blunt the electoral benefits.

The benefits would also be extremely concentrated: four-fifths of the gain would go to millionaires, and the top 5% would get £180,000 each. Unsurprisingly, the majority of the benefit would go to those in London and the south-east, so many constituencies would see little gain, even in Conservative seats.

The more responsible alternative would be to reform inheritance tax by closing loopholes to pay for a lower headline rate or a higher wealth threshold after which it is paid. The biggest of these loopholes is the unlimited amount of farmland, private businesses and AIM shares that can be passed on entirely tax-free.

These tax breaks are the key reason that HMRC’s own figures show the average rate of inheritance tax paid by estates worth more than £10m was just 17%, lower than the rate paid by estates worth £1.5-£2m (20%) – just half of the headline rate of 40%. And these figures are before accounting for the far greater use of trusts by the wealthiest.

While there are some social arguments for wanting to protect small family farms and family businesses, the current tax breaks have perverse effects. Uncapped relief for agricultural land leads farms to be snapped up by the very wealthy. Such policies can lead to local farmers being priced out.

The tax break for private businesses is both badly targeted and smacks of using a sledgehammer to crack a nut. Four in every five pounds of the relief – totalling more than £1bn – applies to AIM shares, where the deceased is just an arm’s-length investor. Even among businesses where the deceased actually ran the organisation, most of the tax break goes to a small number of individuals with extremely large businesses, not to the many who run small plumbing or corner store businesses. About 90% of business wealth passed on comes from an estate worth more than £2m.

A happy medium might be to cap these reliefs at £1m per couple, on top of the current £1m that a couple with a house would typically have. This protects genuinely small farms and businesses, while ensuring that wealthier individuals actually pay. Doing this, alongside tidying up the treatment of pensions in inheritance tax, would allow a revenue-neutral cut in inheritance tax from 40% to 30% for estates worth less than £2m. A related reform that stopped capital gains tax from being wiped out at death would allow a revenue-neutral cut to 20% rather than 30%.

The number of direct beneficiaries from any reform to inheritance tax would be small. Even accounting for growing wealth among the generations coming to the end of their life, only one in 10 people will have inheritance tax paid on either their death or that of their spouse/civil partner. Choosing reform, rather than a straight cut, would benefit all but the wealthiest 1%, who would lose access to the concessions that allow them to reduce their tax rate.

Reform would make the system fairer and deliver a large reduction in the rate that affects most of those who pay inheritance tax. For a chancellor keen to deal with immediate political concerns and to leave a legacy, the current mess of inheritance tax provides a real opportunity.

• Arun Advani is an associate professor of economics at the University of Warwick and a research fellow at the Institute for Fiscal Studies.