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Fiscal Drag 2023 – Here’s Why Inheritance Tax Is Soaring In the UK

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Inheritance tax is a contentious topic that continues to stir debates among policymakers and taxpayers in the UK. As of 2023, there has been a notable surge in inheritance tax, leaving many families grappling with higher tax bills upon the passing of their loved ones. 

This phenomenon is often attributed to fiscal drag, a term used to describe the impact of inflation and economic growth on tax thresholds. Let’s delve into the concept of fiscal drag and explore the reasons behind the soaring inheritance tax in the UK.

Understanding The Fiscal Drag

Fiscal drag, also known as bracket creep, occurs when inflation and economic growth push individuals into higher tax brackets. In a progressive tax system like the UK, higher-income earners pay a higher percentage of their income in taxes. 

However, when income thresholds for tax brackets fail to keep pace with inflation, individuals may find themselves in higher tax brackets despite experiencing only modest real income growth. As a result, they end up paying more in taxes without any real increase in their purchasing power.

The Impact on Inheritance Tax

Inheritance tax is a tax levied on the estate (property, money, and possessions) of a deceased person before it is distributed to their beneficiaries. As of 2023, the UK’s inheritance tax threshold stands at £325,000 per individual, with an additional “main residence” allowance of £175,000 for those leaving their main home to direct descendants. Any value above these thresholds is subject to a 40% inheritance tax rate.

With fiscal drag in effect, the value of assets, particularly property, tends to increase over time due to inflation and rising property prices. 

As a result, more estates are crossing the inheritance tax threshold, subjecting them to the 40% tax rate. This phenomenon is particularly significant in the UK, where property prices have experienced substantial growth over the years. 

In addition to the impact of inflation, fiscal drag can also be exacerbated by policies and thresholds that fail to keep pace with economic growth and rising property values. If the government does not regularly adjust the inheritance tax thresholds to reflect these changes, more and more estates will be subject to higher inheritance tax liabilities.

Potential Solutions and Mitigations

To address the issue of fiscal drag and soaring inheritance tax, several potential solutions and mitigations have been proposed. Here’s this inheritance tax advice summarised for easy reading:

Regular Threshold Adjustments

The government could implement a system of regular threshold adjustments to keep pace with inflation and rising property values. By indexing the inheritance tax thresholds to inflation or average property price growth, fiscal drag could be mitigated.

However, as Isaac Delestre, an economist at the IFS, explains, the longer the governmental bodies take to make this decision, the more painful it will be, for both the economy and the common man, in the future. 

Increased Thresholds

Raising the inheritance tax thresholds significantly could help reduce the number of estates affected by the tax. However, this must be balanced with the need for government revenue to fund public services.

Still, the chance of having increased thresholds is still very low, and past decisions made by the people in power explains that hypothesis. Rishi Sunak extended the threshold freeze until the 2025-26 tax year, and chancellor Jeremy Hunt has further increased this threshold freeze to the tax year 2027-28.

As it still stands, there’s no saying how long this freeze lasts, and one can only hope it’s lifted before it makes a major impact on the economy.

Main Residence Allowance Reform

The “main residence” allowance, currently set at £175,000, could be reevaluated to better align with the real estate market. A higher allowance may alleviate the burden for individuals leaving valuable properties to their descendants.

Lifetime Gifting

Encouraging more lifetime gifting could reduce the value of estates subject to inheritance tax. By giving assets away during their lifetime, individuals can utilise the annual gift exemption and potentially reduce their tax liability.

Bottom Line

Fiscal drag has become a significant factor in the soaring inheritance tax in the UK, leaving many families facing higher tax bills on their loved ones’ estates. As assets, particularly property, increase in value over time due to inflation and economic growth, more estates are crossing the inheritance tax thresholds. To address this issue, the government must consider regular threshold adjustments, increased allowances, and potential reforms to the inheritance tax system.

As the fiscal landscape evolves, taxpayers and policymakers must work together to strike a balance between fiscal responsibility and ensuring a fair and equitable tax system. By understanding the implications of fiscal drag and exploring viable solutions, the UK can better navigate the challenges of inheritance tax and achieve a system that meets the needs of its citizens and contributes to a stable economy.

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