Listen to Adam Smith: inheritance tax is good

Inheritance tax is one levy that makes good economic sense

17 October 2007

3:44 PM

17 October 2007

3:44 PM

Politics trumps economics. That’s the best summary of the Tory and Labour competition to pander to those who until now have been threatened with paying to the Treasury a portion of the money they receive for just ‘being there’.

Let’s de-emotionalise this issue. An inheritance tax is not a death duty. The slogan ‘No taxation without respiration’ is too clever by half. Even a Chancellor of the Exchequer as powerful as the previous occupant of the office could not get a corpse to sign a cheque. It is a tax paid by the recipient of this income, the inheritor, the lucky winner in the sperm lottery.

Nor, finally, is it a tax on a lifetime of thrift. In most cases the wealth being taxed results from a rise in the value of houses — not something brought about by the acumen and hard work of the owner, but by a decade of low interest rates and economic growth, or the good fortune of having a public amenity plunked down in the neighbourhood.

That out of the way, let’s consider why the rush to appease a few voters in a few marginals is bad economic policy.

Barry Bracewell-Milnes, a student and an opponent of these taxes, concedes that ‘Inheritance without taxation weakens the beneficiary’s incentive to work.’ Surveys by the Economic and Social Research Council show that only a very small minority of people say they work for ‘enjoyment’; most work for what ESRC researchers call ‘mainly instrumental reasons’ — to keep a roof over their head and food on the table. Studies by the Policy Studies Institute and the London School of Economics support this conclusion: 70 per cent of the men and half the women questioned say the main reason they work is to ‘earn money for necessities’.


So it should come as no surprise that researchers at America’s Syracuse University find (with appropriate caveats), ‘An inheritance received by a family reduces the probability that both spouses will continue to work, and increases the probability that both will retire.’ In short, Andrew Carnegie, the great Scottish philanthropist and a special Gordon Brown hero, had it right — ‘The parent who leaves his son enormous wealth generally deadens the talents and energies of the son and tempts him to lead a less useful and less worthy life than he otherwise would.’ Leave inheritances untaxed, and many of the young inheritors will exit the productive workforce, not a good thing for an economy needing to encourage hard work in an increasingly competitive world.

We know, too, that inheritance taxes encourage parents to spend money enhancing their children’s educational and social skills. Unable to leave a tax-free financial package, parents are more likely to pour some of their wealth into what University of Chicago economist Casey Mulligan calls ‘educational and health expenditures, financial gifts, or time spent teaching or nurturing them [their children]’. It is a social misfortune that such an inheritance is not more widely available — but that’s a policy discussion for another day. What is important here is that inheritance taxes encourage parents to invest in skills during their children’s formative years.

Then there is the practical question: where will the money come from to replace the revenues lost when the take from inheritance taxes is reduced? Since the Tories have promised, cross their hearts and hope to die, that they will spend as much as the Labour wastrels, it won’t come from reductions in government spending. No, it will come from pensioners, whose incomes will now be capped sooner than originally planned; employees who have invested in Save As You Earn (SAYE) schemes; higher taxes on farmers selling their farms; the military, which forfeits any prospect of a real increase in the funds available to defend the realm; small businessmen who had been encouraged by the last Chancellor to risk their meagre capital and ample sweat equity in the hope of selling out and paying only a 10 per cent capital gains tax; non-doms (of which I am one) who will pay £30,000 per year in addition to the taxes on the money they earn and spend in Britain; and hedge-fund operators who have been pretending that their ordinary incomes are capital gains, but who will still be allowed that pretence, their tax raised to 18 per cent from 10 per cent, but not to the 40 per cent that others pay on such incomes.

The non-doms and the hedge-fund operators are reasonable targets, if equity is all there is to consider. But these financial types are the most mobile of the assets located in Britain. Not all will flee, but some will, and others eyeing Britain as a site for new businesses will now know it is less worthwhile than it once was to brave the mean streets of London by taking up residence in a town with one of the highest costs of doing business in the world.

But if it is equity that the Labour taxmen are after, why penalise pensioners (again) and small businessmen (again), and employee-savers, and all the other innocent bystanders? All to benefit a handful of taxpayers who happen to be concentrated in key marginals.

Which brings us to the final objection to this forgiveness of taxes on inheritance, which in the end is no different from any other income the beneficiary might receive — except that it is not earned by the sweat of his brow or the whirring of his brain. The tax cuts could have been better concentrated on lowering the marginal tax rate faced by all earners. Reduce taxes on the pay for that extra work, and you will get more of it; reduce taxes on the profits from risk-taking, and entrepreneurs will take more chances and create more jobs. Reduce the taxes on recipients of inheritances, on the other hand, and they will work less and be less likely to start up new businesses. Worse still, and perhaps most important, to abandon the laudable goal of trying to make opportunity more equal for all in order to favour the beneficiaries of perhaps the 6 per cent of estates that pay inheritance taxes is a terrible policy trade-off.

At least to an economist, whose policy role should be to tell politicians the cost of their decisions, and then leave it to them to decide whether a policy is worth its cost. Inheritance taxes make good economic sense, but against the economic advantages must be set the limitation they impose on the freedom of people to dispose of their lawfully earned wealth as they see fit.

In my view, that reduction in freedom — the cost of retaining inheritance taxes — is outweighed by the benefits: the economic advantages, especially when compared with other taxes, and their contribution to the drive for greater equality of opportunity. Which makes it too bad that politics trumped economics, since the result is neither greater overall fairness, nor the increased stimulus to economic growth that alternative tax cuts would provide.

Messrs Darling and Osborne would do all of us a favour if they would whip out their undoubtedly dog-eared copies of The Wealth of Nations. To meet the criteria of ‘evident justice and utility’, Adam Smith supported a tax on wealth inherited by children ‘who have got families of their own, and are supported by funds separate and independent of their father’. Which is why the Economist classifies Smith as one of the political economists ‘broadly in favour’ of the estate tax. Pity that two Scots, both hailing from Kirkcaldy, differ on this policy question.

Irwin Stelzer is director of economic policy studies at the Hudson Institute and a columnist for the Sunday Times.

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Show comments
  • HJ

    I agree with much of Irwin Stelzer’s argument, but he is surely wrong to say that inheritance tax, in the form it is currently levied in the UK, is not a death duty. He claims it is paid by the inheritor – as if there is and could be, only one inheritor.

    In fact, inheritance tax is paid not on the amount that an individual inherits, it is paid on the size of the estate of the deceased. So the same amount of tax is paid whether or not the estate is split amongst many people or just left to one. So tax may be deducted even if individuals are receiving very modest amounts.

    The correct apporach, surely, is to abolish inheritance tax and to require the individual inheritors to pay capital gains tax on inherited wealth. This would encourage people to spread money around in their will.

    But, of course, the real purpose of inheritance tax is to feed the insatiable demands of the state.

  • cuffleyburgers

    There is no doubt that some sort of inheritance tax is one of the less damaging of the multiple forms of taxation we are faced with.

    And your argument would be perfect if the object of the taxation were the beneficiary and not the estate itself.

    Then it could be perceived as fair.

    As it is, and with the limits not increased in line with house price inflation, it was clearly just the usual squalid Labour money grubbing exercise of bash the middle classes.

  • Mark Kasozimusoke

    Dr Stelzer is quite correct about weighing up the merits of providing tax relief and stimulating people to seek employment. However the most recent thresholds for inheritance tax were becoming very close to objectively small amounts of money in comparison to the rising cost of living(especially in South East England where a two bedroomed hovel can cost around £200,000). The figure of only 6% is much quoted but how many years would it have taken for that percentage to have got well into double figures? HJ makes an interesting alternative suggestion. If governments are to retain low thresholds for inheritance tax then as Stelzer points out they should be offering lower, flatter taxes elsewhere. None of the main parties seem committed to flattening tax even for those on low income. Surely a libertarian approach should be to limit the size of the State. Neither George Osborne or Vincent Cable seem to be offering robust alternatives to Brown’s persistent theft of GDP. Will any of these leading politicians break rank and offer us some original “free” market policies?

    • isthisreallife2

      The “free” market is the problem. When it comes to housing, supply has failed to rise to meet increasing demand hence driving up prices. In theory the free market should have delivered an increased supply but property developers have held off from building and instead are hoarding land as the more they restrict supply the more they profit. So we have a kind of market failure – and this means the government has to step in to correct this market failure. First step should be a massive state housebuilding program. Then a land tax.

  • Gavin Kennedy

    Quoting Adam Smith on the benefits or otherwise of inheritance tax is not helpful when the context is left unexplained.

    In Wealth Of Nations, Book V, ii.h.4: p 859, he discusses inheritance tax in his usual manner with a history of such taxes since Roman times.

    He distinguishes between a tax on inheritance when the children live at home and concludes such a tax would be ‘cruel and oppressive’. Again he quotes Roman law and Scotch law for cases where the children are independent and says inheritance would be ‘a real addition to their fortune’ and ‘might…perhaps, without more inconveniency than what attends all duties of this kind, be liable to some tax’. Certainly not 40 per cent (Augustus set it at 5 per cent).

    Of course, he was not writing when icnome tax on labour can be 40 per cent (it was zero), plus VAT at 17.5 per cent on consumption, plus local council tax, plus, plus, plus.

    I would not call on Adam Smith as evidence of a ringing endorsement of inheritance tax.

  • Ben Philips

    Sorry Irwin – I don’t buy this. Several points: first, even allowing for your theoretical arguments about the desirability of active employment, surely we should be encouraging, through whatever means we can, individuals and families to become self-sufficient. That way we no longer look to the state to keep us in old age, but through what we and our parents have contributed to the family pot. You want a smaller state? Me too. Then abolish IHT and allow families to fend for themselves. And if the unworthy beneficiary blows it all that’s his look-out.

    You suggest that rises in house prices are an unwarranted benefit in kind to the next generation. But even if we do enjoy a windfall on the property of a deceased, it will only buy us an equivalent somewhere else. And with so many struggling to get onto the property ladder, a leg-up from a departed grand-parent could help the third generation.

    Second: the imposition of IHT cuts right across the family. If I’ve worked hard and I wish to pass the proceeds of my work onto my children and grand-children, that’s my decision. The state should not act as arbiter on what I do with my money. It should allow me the freedom to pass it on untouched by yet further government interference.

    Third: by removing every justifiable tax grievance on individuals and families we may indeed encourage risk-taking and entrepreneurship from the next generation. I myself stand to inherit a sizeable estate; it is acting as a spur for me to establish a legacy in my own right and not to live off what others have provided for me.

    And finally we should use the exemption as an encouragement for philanthropy. Freed from the threat of the taxman, we can safely open the door and start giving, safe in the knowledge that this is our decision made for the best of all reasons: pure altruism.

  • David

    I don’t care if IHT makes economic sense or not. We own our property and should be free to give that property to anyone we like, tax free, as a gift upon our death.

    And I question the argument that IHT is good for the economy. Surely IHT discourages people from building up wealth to hand to future generations, as nearly half will be lost in tax? People resent working for the taxman, particularly when older, so they stop. And not all those who inherit fit your lazy stereotype of the ‘dim wit son’ who blows the family silver. Many people make a lot of their inheritance, turning small family businesses into far bigger ones. It is often the second or third generation that makes it big, as ‘the first million is the hardest’. With IHT, these businesses are lost.

  • Chris

    I suspect, if being objective, the concept of inheritance tax is not necessarily bad. However making it fair for all concerned is or should be a worthy goal.

    The lottery concept of housing valuation does not consider all the issues. Many so-called working and middle class family home owners have spent years of penury paying off mortgages resulting in a lifetime of minimal disposable income, foregoing holidays, new clothes, cinemas, theatres and eating-out. Compare this with either the rich or even renters who seem to have plenty of money for such leisure activities. So seems fair that savers should not be penalised for this gain which does come in the main through sacrifice. A nation of homeowners…and all that!

    Perhaps a fairer way would be to add an exclusion on a primary residence from the inheritance tax equation and only levy remaining assets. At the same time close all the loopholes on family trusts etc. which are really just for the benefit of the really wealthy to avoid tax. I am sure the economics would be greatly improved too!

    • isthisreallife2

      “years of penury paying off mortgages resulting in a lifetime of minimal disposable income, foregoing holidays, new clothes, cinemas, theatres and eating-out.Compare this with either the rich or even renters who seem to have plenty of money for such leisure activities. ”

      This is just factually inaccurate. Renting is more expensive than paying off a mortgage – this is well known. Many of todays young who are lucky enough to be given money by their parents to raise a deposit for a house therefore have an unfair advantage over those who cannot raise it and are locked out of ownership and forced to spend more to have a roof over their head through no fault of their own.

  • Richard Tesh

    I totally disagree. I do not consider we are part of the 6% most wealthy in the country and do not think we live in a marginal seat, yet I believe IHT is potentially the most distorting of all the taxes imposed.

    Taking IHT into account my marginal rate of tax is in excess of 70%, a figure that is readily verifiable. The thrust of the argument does means that when the house is paid for, the kids educated and on the property ladder whilst the pension has been secured, why work when you keep less than 30%? It is as easy for the retired to emigrate and take their money away as it is for the non doms.

    Furthermore, capital gains tax is now 18% (unless amended) whereas IHT is 40%. So the home is tax at a greater rate than any other capital gain whilst cash and equities, which have already been taxed once, are taxed a second (or more) time.

    I now spend a significant proportion of my time and energy finding various ways to avoid IHT. It is a real pleasure to consume a bottle of “duty free” knowing that the real cost is only 60% of what I have paid as the Revenue will not be able to steal it back off me.

  • Peter Taber

    The first glaring flaw in Stelzer’s argument is the implication that the State has first claim to all wealth.

    His glib assertion that most wealth is the result of appreciated house prices is unsubstantiated, but who cares? The fact that a family bought a house, then paid their mortgage and taxes over the course of a lifetime hardly disqualifies the family from keeping their putative gains. This is especially true if the property passes from one generation to another. And surely it would be unfair to tax the part of the increase that relates to inflationary government schemes that have eroded purchasing power by debasing the currency.

    Then there is his complaint that an inheritance increases the possibility that one person in a family might drop out of the labor force is, first of all, none of his business. But, isn’t there an argument to be made that we’d be better off if someone was home watching the kids?

    Stelzer’s house of cards rests on the assumtion that a government bureaucrat knows better of how to direct the disposition of a nation’s wealth than its citizens. I thought we got past the idea of central planning with the fall of the Berlin Wall, but I guess not. Some bad ideas, zombie like, still wander the streets and clutter the pages of the popular media.

  • Alan Hill

    Very good Mr Stelzer but we all know that politicians do what is good for their poll ratings not what is good for the economy.

  • Tadeusz Stanek

    Is it The Spectator or am I reading the Morning Star or the Guardian? Arguments spurious. Between father and son, no taxman need call. Family is writ in blood, sweat, and tears; economy in ink (if at all).

    • isthisreallife2

      Any moral justification? Did the son earn it? Meanwhile, the youth of today will grind out a living and have no hope of ever buying!

  • Steve

    ‘An inheritance received by a family reduces the probability that both spouses will continue to work, and increases the probability that both will retire.’

    Of course it does. But this is only one of the many pieces of evidence that could be assembled. What about those that inherit and, hence, cease relying on state aid. Or those that inherit after retirement (an increasing trend) and thus counteract the great pensions theft. Think also about the alternative uses of the money – upward pressure on house prices, more luxury cars etc.

    Frankly all this article demonstrates is that you select evidence that most aligns with your preconceptions.

  • Gene Robison

    Stelzer is mad as a hatter.

  • JackM

    So, according to the author, one of the enormous negative effects on society of receiving inheritance is that is takes people out of the labor market. Well, if that is such a hugely destructive problem, then we should end welfare because all those layabouts waiting for free money from the government should be out working instead. I know, it’s ridiculous.

    Irwin, the problems with your “argument” is that you only care about social engineering and you don’t seem put off by the negative impact of double taxation (or treble etc).
    And you seem to imply that the money REALLY belongs to the government anyway, and it is for them to decide how much of THEIR money (that you temporarily have in your accounts) to let you have. Yuck.

  • jfrancishill

    Wealth inherited most often in
    later years will be invested for
    support of latter years. Said
    wealth generates more economic
    health than it would in the
    taxman’s purse.

  • wolf terner

    It is obvious someone, like the author of this piece, lacks basic knowledge about inheritied monies. Money that is double taxed through inheritance is money wasted by government. It effectively removes that money from the sector that all employed people would earn in their daily jobs.It is money redirected to pet political projects which directs taxed money to limited individuals. Money that is spent by those that inherit it, whether that inheritor works or not is still spent in the public sector. It is taxed, taxed through the purchase of goods necessary to sustain that individual. It is invested by that idividual into businesses that are again taxed by government. And after several generations, with more family members to divided up the inherited monies guess who will eventually have to go to work. Which suggests that the families of the rich keep up the gene pool selection so as to compete in the eventual open market for employees. Market crashes are also great equalizers of wealth.

  • Philip Ogilvie

    With interest rates are as low as they are now, a 10% capital tax set in 1980, say, is like a 20 – 30% tax today, in terms of the number of years investment income needed to recover the loss caused. At 40%, a capital tax is highly confiscatory and unacceptable on legacies of under 300,000 pounds PER RECIPIENT. Looked at another way, the setting of a flat rate inheritance tax by the Conservatives when previously the rate had been tapered, has been a wonderful poison pill to get Labour with.

  • Knott Byinnit

    LOL, it’s OK to tax my children because, “in most cases”, I didn’t earn their inheritance by digging ditches, etc.

    Well, isn’t that logical?

    I might as well throw out my umbrella because,”in most cases”, when I walk outside I won’t get rained on, hmm?

    Besides, only evil, fat-cat entrepreneurs carry umbrellas, n’est-ce pas? Why, we should get the government to take their umbrellas and give them to the needy! Rich people don’t care if the poor have no umbrellas. I wish I could find a politician to vote for who would do something about all the hoarded umbrellas in the fat-cat foyers of all these fat-cat mansions!

  • isthisreallife2

    Some of these arguments are valid but the article doesnt tackle the glaring wealth inequality and shortage of housing stock today – and this matters. House prices are out of reach for the next generation and lowering inheritance tax will exert further upward pressure on house prices and rents. This will further concentrate the wealth of the rich and lock out more people from property ownership. This is quite simply unsustainable on almost every level.