The complexity of the tax system is under fresh fire ahead of the Budget as figures reveal 775,000 people are paying more tax on each extra pound that they earn than someone whose income runs into millions. The perverse situation arises due to the introduction – and subsequent withdrawal – at certain levels of income of various allowances. Successive governments have added to and tweaked these arrangements, creating numerous marginal tax rates. Next month’s Budget will see Philip Hammond, the Chancellor, come under intense pressure as he seeks to appease core Tory voters as well as attempting to compete with Labour’s colossal spending promises. Tax and policy experts are urging Mr Hammond to radically simplify the system so that workers on modest incomes do not find, as now, that the tax man takes a bigger share of extra earnings. The research – conducted by Royal London, the mutual insurer – estimates that at least three quarters of a million people are paying tax rates well over the 45pc top rate. Affected groups pay these higher rates because as their incomes rise they begin to lose tax, pension and child benefit allowances. “Most people would agree that as people earn more they should pay a higher rate of tax,” said Royal London’s Sir Steve Webb. “A series of complex changes which have been bolted on to the tax system over recent years means this is no longer true. There are hundreds of thousands of people who pay more tax on each extra pound that they earn than a millionaire. This is not a sensible tax system.”
Who loses out? Britain’s tax system is based on “marginal” rates. The first £11,500 a year is free of income tax (though National Insurance, which pays for state pensions and other benefits, kicks in at £8,164). Earnings up to £45,000 attract 20pc tax, the next band up to £150,000 is 40pc, and income above that 45pc. But for a family with two children, where one person earns between £50,000 and £60,000 a year, the tax rate can be as high as 59.9pc. This is because of rules, in force since 2013, that negate child benefit once at least one half of a couple earns over £50,000. Earning £51,000, for instance, would result in a £179 loss of child benefit. Added to normal income tax and National Insurance rates, the extra £1,000 would result in £599 of “tax”. Royal London estimates 375,000 people fall into this trap. The next group identified are those earning between £100,000 and £123,000. The “personal allowance” of tax-free income drops away by 50p for every £1 earned over £100,000. So earning £1,000 over that threshold results in an extra £200 of income tax. The effective tax rate is 62pc and is thought to be paid by 250,000. Restrictions on the amount you can save into a pension each year have created the next group, estimated to be 150,000 strong. Since April 2016 the “annual allowance” on pension contributions is tapered from £40,000 a year, down to £10,000, for incomes over £150,000. Like the personal allowance, the pensions limit drops by 50p for every £1 over the limit. Many in this group will be paying top-rate tax, so the annual allowance cut means an extra 22.5pc of tax is paid. Taken together, the tax rate is 69.5pc. Sarah Ghaffari, of the Institute of Chartered Accountants, added that there were dozens of other instances where tax rules were nonsensical. She pointed out that earning just £1 over the higher-rate threshold could result in a “10,000pc tax rate” because the tax-free allowance on savings drops from £1,000 to £500 for higher-rate payers. “Complicated tax rules divert us from running businesses and getting on with our real lives,” said Danby Bloch, a tax expert. “Complexity favours the rich who can afford to take expensive advice, adds to the cost of every transaction and only discourages us from saving. It makes us resent paying taxes and in the long run it almost certainly makes us less honest.” A spokesman for HMRC said: "The tax paid per pound has to reflect a wide range of personal circumstances, not only income. Increases to the personal allowance have taken four million out of income tax altogether over the last parliament alone."
If you have 2 children your effective income tax rate between income of £50,000 and £60,000 is 60%, if you have 3/4 children your tax rate could be as high as 75%!
Meaning you see 25p in every £1 you earn. Between £100,000 and £123,000 your tax rate jumps to over 60%.
When/if your income exceeds £150,000, the taper of the annual pension allowance begins which causes further complications.
All of these tax traps can be avoided with some good strategic planning.