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14 July 2018

Personal Taxation

Tag(s): Politics & Economics
What is the top rate of income tax in the UK? Most people would probably answer 40%. Some might say 45%.  My answer, over 70%, and this is not on top earners. Britain’s system of taxation is in a mess with a huge range of anomalies, particularly in personal taxation. Over three quarters of a million people pay more tax on each extra pound that they earn than someone whose income runs into millions.

This perverse situation arises from the introduction – and subsequent withdrawal – at certain levels of income of various allowances. Successive Chancellors have added to and fiddled with these arrangements creating numerous marginal tax rates.

If you go to the Government’s own website on income tax you will see what appears to be a relatively simple structure.

Income Tax rates and bands

The table shows the tax rates you pay in each band if you have a standard Personal Allowance of £11,850.
Band Taxable income Tax rate
Personal Allowance Up to £11,850 0%
Basic rate £11,851 to £46,350 20%
Higher rate £46,351 to £150,000 40%
Additional rate over £150,000 45%
So that seems straightforward. But child benefit is withdrawn at £50,000 p.a., and so the marginal rate of income tax on the extra earnings from £50,000 to £60,000 is over 70% for those who have four children or more. At £100,000 the personal allowance is withdrawn, and so the marginal rate of income tax on earnings from £100,000 to £123,000 is 62%. As the above table shows the so-called Additional rate of 45% starts at £150,000 but also at this level of income up to £210,000 the Pensions annual allowance tapers so that actual marginal rates at this level again reach nearly 70%.

The water is further muddied by the artificial distinction between Income Tax and National Insurance. National Insurance (NI) is a tax system paid by workers and employees for funding state benefits. It was introduced by the National Insurance Act 1911 and greatly expanded by the Labour government in 1948. It has, of course, been amended in numerous ways by subsequent governments. Intended as a contributory form of insurance against illness and unemployment, as it has been expanded it has provided retirement pensions and other benefits.

Citizens pay NI contributions to become eligible for State Pensions and other benefits. Anyone 16 years old and above is mandated to pay NI provided the employee earns more than £162 per week or the individual is self-employed and makes a profit of £6,205 p.a.or more. 

NI contributes a significant part of the government’s revenue (21.5% of the total collected by HMRC). The structure of NI was modified to remove the fixed upper contribution limits with a much lower rate paid by employees on income above a certain level, currently £46,356 p.a.

Employees pay 12% on income above £8,424 p.a. up to £46,356 p.a. and thereafter 2%.  Please note that while the personal allowance for income tax is £11,850 for NI it is £8,424. While the original intention may have been to create a new form of government funding for insurance against illness and unemployment, the effect on the individual is the same. We have no choice but to declare our income and pay both income tax and NI on it. Thus the basic rate of combined tax is 32% not 20%, the marginal rate of tax at £46,356 is 42% not 40% and at the other examples I gave of particularly harsh rates of tax, the person with 4 children earning £50,000 has a marginal rate of combined tax of 71.5%, while the additional income between £100,000 and £123,000 carries a combined rate of tax of 64%.

According to 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 tax and in the long run it almost certainly makes us less honest.’[i]

And, of course, the state is not content with just taxing us and our employers on our income. Once we have paid our tax and start to pay for goods and services it will tax us on most of these at 20% Value Added Tax on the transaction. If we are able to put away some money for savings and investments it will tax us on the interest and the capital gains. The Local Government taxes us on our home every year with so-called Council Tax. This tax is calculated somewhat inefficiently on the value of the property, neither on our ability to pay nor on the amount to which we use the services funded by this tax. And then when we finally ‘shuffle off this mortal coil’ the state will come after our heirs to tax everything over £325,000 at 40%.

So what can be done? Introduce flat taxes. Estonia was the first country in Europe to introduce a flat rate of income tax at 21% and it was hugely successful. Its neighbours Latvia and Lithuania quickly followed with similar results and these examples have been imitated by other former Communist countries including Russia. The social democrats in Western Europe resist the idea because they believe if they have a single rate of tax then the rich will pay less and the poor will pay more.  But in a well-designed system of flat taxes everyone will pay a lower rate of tax but the government will collect more money.

We already know from long experience that when we reduce the higher rates of tax the rich pay more in total taxes. They no longer see the need to employ expensive accountants to avoid tax or set up off shore trusts or even move their domicile overseas and pay no tax at all. Between 1980 and 2007, the US cut the rate of taxes at all income levels. As a result the top 1% went from paying 19.5% of all taxes to 40%. In Britain, when the top rate of tax was lowered from 83% to 40 % between 1979 and 2010, the top 1% went from paying 11% of all taxes to 27%.

But these changes were accompanied by further complications of the system. Tolley’s tax guide was 2,529 pages when Gordon Brown became Chancellor, an already intimidating prospect. Today it is a truly horrifying 20,000 pages.

And with such complexity comes an obstacle to economic growth. Many of these anomalies are the result of feeding special interests. That inevitably results in distortions to economic activity and barriers to new entrants. Even small companies have to hire accountants to help them with a daunting array of government demands for VAT returns as well as income tax and other regulatory requirements. This is all time and money that could have been invested in growing their businesses.

Even HMRC would benefit as with a flat rate of tax they could simply apply that to the total pay roll in their PAYE return without needing to know every individual’s details. That would free up resources to spend on chasing the real tax cheats and crack down on the accountancy  and law firms who themselves get rich on peddling tax avoidance schemes. In a well-argued article on the subject the leading MEP, Daniel Hannan says:

‘The problem with flat taxes is not economic but political. The idea that lower tax rates can lead to higher tax revenues is counterintuitive.

People tend to start with an assumption and then fit the facts to their prejudice. If you start from the assumption that lower taxes must mean lower revenues, then a candidate who argues the opposite, however sound his logic, may strike you as a shill for oligarchs. Or you might be tempted to back wealth taxes on grounds of envy or egalitarianism, even at the cost of general prosperity. A YouGov poll in 2015 showed that a majority of Labour voters would back a higher top rate tax even if they thought it meant less money for the Treasury.

This lingering resentfulness makes it difficult for democratic governments to go all the way.’[ii]

Another example of how democracy does not always reach the right answer.

[i] ‘Tax Trap: 775,000 pay top rate of 70% ‘ Sam Brodbeck The Sunday Telegraph 15 October 2017
[ii] ‘Flat taxes get more money from the rich’. Daniel Hannan The Sunday Telegraph 13 May 2018

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