Rachel Reeves urged to consider an inheritance tax raid on pension pots which could raise up to £2 billion a year - as Chancellor faces pressure to meet public spending targets

Chancellor Rachel Reeves has been urged to consider an inheritance tax (IHT) raid on pension pots that could raise up to £2 billion a year as she faces pressure to meet public spending targets.

The Institute for Fiscal Studies (IFS), a leading economic think-tank, suggested that unspent cash in defined contribution funds should no longer be exempt from the death tax.

And it would align the government with recent recommendations by the International Monetary Fund (IMF) in a report on the UK.

It came as a separate IMF update yesterday on the global economy urged governments to stick to commitments to balance the books but warned that the prospect of continuing high interest rates could make that task harder.

Labour has pledged to keep to the previous government's targets on bringing down debt.

But during the election campaign, economists complained that neither party was being realistic about the hard choices that would be needed - either in the form of spending cuts or tax hikes.

Income tax, VAT and corporation tax rises have been ruled out raising speculation that Ms Reeves could target other areas such as pensions or capital gains tax.

The IMF has already recommended in a recent 'Article IV' report on the UK that the government should consider 'broadening the base of VAT and inheritance tax, while reforming capital gains and property taxation'. 

That could include 'removing unnecessary reliefs' for inheritance tax, it said.

And the fund's chief economist Pierre-Olivier Gourinchas yesterday noted that while it was 'too early' to assess Labour's economic plans, some of them were 'consistent with some of the recommendations that we have made in our most recent Article IV'.

David Sturrock, an economist at the IFS, put the case for the suggested inheritance tax raid in comments first reported by the Telegraph.

He said: 'The current system gives an incentive to hold onto pension wealth and use other assets to fund retirement.' 

That creates a 'perverse situation' where the tax treatment of pension pots means that they are used to build up inheritances rather than pay for retirement, he argued.

The government would gain only 'modest' revenues from the change - of around £200m - for now, Mr Sturrock said.

'But the importance of this special treatment is set to grow quickly because more and more people will arrive at retirement with wealth in DC pension pots over time and the sums involved will be larger,' he added.

'In the coming decade or so, we estimate that the revenues raised by bringing pension pots into the scope of IHT would be in the range of £1bn to £2bn.' 

But there are fears that the tax raid could leave some facing double taxation.

Currently, if the pension pot owner dies under the age of 75, money can be withdrawn without being subject to inheritance tax or income tax.

If they die after turning 75, withdrawals by the heir are taxed as income.

It is the latter group that could face a double tax hit if IHT is also applied.

Adam Smith, former chief of staff to the previous chancellor Jeremy Hunt, told the Telegraph that the reform had been recommended by Treasury officials in the past.

And Sir Steve, now a partner at consultants LCP, said: 'Any review of pension tax relief is likely to look at the favourable tax treatment of pensions when someone dies.

'The government may look at ending the way in which wealth held in ISAs [individual savings accounts] counts as part of an estate but pensions do not.' 

Ms Reeves yesterday said she recognised the 'scale of the challenge' facing the economy as IMF forecasts showed the UK was still some way off achieving Labour's growth goals.

The Fund expects Britain's gross domestic product (GDP) to climb by 0.7 per cent this year and 1.5 per cent in 2025.

Next year's outlook puts the UK on course to outpace Germany, France and Italy but still falling short of expansion in the US and Canada.

It underlines the difficulty Labour will face in achieving its goal of beating all of those countries with its pledge to achieve the highest sustained growth in the G7 group of advanced nations.

The forecast came as the IMF also dampened the hopes of millions of borrowers worldwide by warning that stubborn inflation may mean interest rates need to remain 'higher for even longer'.

That could also make it harder for governments to balance the books - but the IMF urged them to stick to plans to bring down debt, raising the spectre of higher taxes.

Ms Reeves said: 'I am under no illusion to the scale of the challenge facing the economy and the inheritance this new government faces.

'That is why we are already taking the tough decisions to fix the foundations of our economy, so we can rebuild Britain and make every part of our country better off.'