The Ethics and Economics of Inheritance Tax

In the run up to the budget, with Ireland digging itself into more than €400,000,000 of extra debt every week, it’s unsurprising that there’s a lot of disagreement on how to bridge the gap between tax revenue and government spending. Some favour huge tax hikes, some want massive spending cuts, some are looking for both, and there are even a few who don’t want to have to deal with either, and hope that the whole thing will just sort itself out somehow. While I would more usually align myself on the side of spending cuts, there are a few avenues open for the government to increase tax revenue without pushing the economy further into recession, and I believe these should be fully exploited. In particular, there’s one form of tax of which there has been barely a whisper of discussion on of late, and that’s inheritance tax.

In Ireland, tax on inheritances comes in the form of the Capital Acquisitions Tax (CAT). This tax, which also covers gifts, was increased from a nominal rate of 20% to 22% in the April budget, but due to a range of exemptions and reductions that cover pretty much anything anyone would ever be likely to inherit, the actual effective rate will top out at 2% even on the largest inheritances, and in the vast majority of cases will be zero.

The threshold for CAT (where the beneficiary is a child, which covers most cases) is just over €520,000, with the tax levied at a rate of 22% on values over that. On their own, this threshold and rate would result in a situation where no tax on inheritance is paid in the majority of cases, and only a very small amount is paid by anyone other than the very wealthy. However, there are three reductions and exemptions that are applied that affect this situation massively. Firstly, residential property is completely exempt from CAT, regardless of value. In addition, reliefs are applied to agricultural and business property, in each case reducing their value by 90% when calculating CAT. What’s more, this reduction is applied before the threshold, which means the actual rate of CAT on both is 0% on values up to €5,200,000, and 2.2% on values over this.

To see the effect of this, consider the following example. Two people each come to own a farm with a value of €10 million. The first has inherited the farm from his parents, which means, after applying the relief, he pays €105,334 in tax on it, which is just over 1% of the overall value. The second person wasn’t quite so lucky as to be born into such a wealthy family, and buys the farm with her own income, which she has saved over a number of years. While working to save up all this money, she was paying income tax which, at a top effective marginal rate of 54%, meant that for every €1 she earned that would go towards the farm, she could keep 46 cent of it. Hence, in order to save the €10 million to buy the farm, she would have to actually earn €21,739,130 and pay €11,739,130 in income tax. This is ignoring stamp duty, or any other tax that would be applied on the actual purchase of the farm.

In both of these cases the person involved ends up with a farm worth €10 million, the difference being whether this wealth has been inherited or earned. In a just society one might expect that the taxation system would favour those who work for what they have over those who are lucky enough to inherit it. Our taxation system not only does the opposite, but favours those who inherit wealth to an astonishing degree; in the above example the person who actually worked for the farm had to pay well over 100 times as much tax as the person who inherited it. This notion of fairness isn’t merely philosophical, either. By not taxing inheritances to any significant degree, the government needs higher rates of VAT and income tax to make up the shortfall. People who work for their wealth are quite literally paying extra to give the children of wealthy parents the luxury of an almost tax-free inheritance.

Fairness aside, the current scenario simply doesn’t make any economic sense either. Almost all of the ways in which a government can raise revenue have unwelcome side effects. Setting corporation tax too high discourages foreign direct investment. A high rate of VAT discourages spending, which hurts businesses. Excessive income tax discourages people from seeking out higher-paid jobs, and can discourage them from working altogether if social welfare is generous enough. Comparatively, no matter how high you set inheritance tax, there are virtually no unwelcome side effects. The only possible side effect that you could attribute to an inheritance tax would be that it could discourage dying, which, if it somehow managed to do so, would be a quite welcome one indeed!

For a government, any tax which can be raised without hurting the economy should be a holy grail, especially in times like these. Bringing in a reasonable level of inheritance tax would save the government from having to raise other taxes or cut spending, and could hence help bring the deficit in line with minimal effect on the economy. Quite how much revenue an increased inheritance tax would raise is a complex question, and I hope to write a new post soon with a series of detailed estimates on what the answer might be under different circumstances

In the meantime, consider this; the government raised €292 million last year from CAT on inheritances. This is despite the fact that the largest component of inheritances (residential property) was completely exempt, and the next two largest (farm and business property) were taxed to an almost negligible degree. Even modest reform of inheritance tax should allow the government to bring in many times that figure, and this is hardly a time in which any revenue-raising technique can be ignored.