Today is the start of the new tax year in the UK and to
celebrate the Institute for Fiscal Studies recently published a nice little
piece outlining the impact of the inflation indexation of tax thresholds (here).
As the IFS points out, the UK routinely uprates the cash value of tax
thresholds in line with inflation, unlike many other countries. This process
dates back to 1977 when two backbench MPs introduced a process forcing the
government to automatically uprate thresholds in what became known as the
Rooker-Wise Amendment. This makes a lot of sense: Without such indexation as
wages rise in line with inflation, so ever more people at the lower end of the
income scale would be dragged into higher tax brackets.
But the IFS notes that across many tax categories this
automatic uprating has not taken place for a number of years. Two of the most
interesting examples are fuel duties which have not increased in cash terms
since April 2010 whilst working-age benefits have been frozen since 2015-16. At
a time when governments around the world are trying to curb vehicle emissions
it does seem rather odd that the UK is not taking the opportunity to take the
moral high ground by raising emissions taxes. Consumer prices have risen by 16%
since the start of 2011 which would add around 10p to a litre of diesel (7.5%).
Obviously, drivers will not complain that the real value of fuel taxes has
declined over the last 9 years but it does seem at odds with the government’s
self-professed green credentials. We can view this move in one of two ways: It
is an overtly political move to curry favour with motorists or it is an attempt
to reduce the regressive effect of such taxes.
Being charitable, we should perhaps assume the latter option
in an effort to redress the effect of a freeze in the cash value of working age
benefits, which obviously means a decline in real terms. But as the IFS put it,
“the government might believe that
benefits should be more or less generous, but the extent of any change in
generosity should be thought through and justified, not the arbitrary and
accidental result of what the rate of inflation turns out to be.”
The IFS has also identified a growing trend of instances
where thresholds are maintained in cash terms and only uprated when the
government believes it to be necessary. Most of these instances really only
affect those at the upper end of the income scale and whilst the vast majority
of taxpayers will not shed any tears for the better paid members of society,
they do illustrate how arbitrary manipulation of tax thresholds can result in
some strange outcomes which may impact on work incentives.
One such is the £100k threshold at which the personal tax
allowance is progressively withdrawn. Anyone earning below this amount is
entitled to a £12.5k tax-free allowance but for every £2 of income above £100k
the tax free amount is reduced by £1. One result of this is that those earning
between £100k and £123.7k are taxed at a marginal rate of 60% (i.e. they keep
just 40p out of every £1 they earn thanks to the allowance taper). Yet more
bizarre is that those earning between £123.7k and £150k are once again subject
to a lower marginal tax rate of 40% (above £150k the marginal income tax
rate rises to 45%). “Oh dear, how sad, never mind” you may say. But there are
now 968,000 taxpayers’ earning more than £100k – an increase of more than half
since 2007-08, who have been dragged into the net due to the failure to index
the threshold.
That said, higher taxes on the better off in society have
been used to fund an extension of the zero-tax threshold for the less well
paid. In fiscal year 2007-08 (the last year before the financial crisis) those
earning £10,000 paid an average tax rate of 13.1% (income tax plus National
Insurance Contributions). The government’s stated policy of taking the lower
paid out of the tax system altogether means that someone earning this amount
today pays an average tax rate of only 1.6%. As the chart suggests, the average
tax schedule has clearly shifted to the right compared to 2007-08, illustrating
the reduction in tax liability of the less well paid. The curve is also lower
than it was in 2007-08 for incomes below £100k, so most people pay less tax, but
it rises sharply thereafter, and those earning £120k are paying more.
But the true marginal tax rate is not merely made up of the
amount levied on income – we have to account for the withdrawal of social
welfare entitlements, and those lower down the income scale are in the line of
fire. For example, those earning more than £50k per year have to pay back some
of their Child Benefit in the form of extra income tax. If they earn between
£50k and £60k and have one child, they face a marginal income tax rate of 51%
but if they have three children their marginal income tax rate is 65%. Again,
this threshold has remained unchanged for some years which means an increasing
number of people are likely to run into this problem.
However, one of the more bizarre quirks is the reduction in
the pension annual allowance for high-income individuals. The first £40k of
pension contributions is free from income tax but those whose income (excluding
pension contributions) exceeds £110k face a tapering in their tax free pension
allowance. Without going through the details (they are outlined in the IFS
paper), the upshot is that someone earning £150k (including pension
contributions) can put £40k into their pension without incurring extra taxation
but someone whose total income (including pension contributions) is £210k finds
that their tax free allowance is reduced to only £10k. More bizarre still is
that the likes of senior doctors, whose generous defined benefit pension
schemes result in contributions exceeding £40k, can end up facing marginal tax
rates of more than 100%. I was recently made aware of instances where such
doctors are not prepared to work beyond a certain point because they pay more
tax than they earn (obviously, they could offer their time for free but they
could equally well enjoy an evening at home if they are not getting paid for
it).
Although some of the examples highlighted here are extreme cases,
they illustrate how an ill-designed tax system can result in high marginal tax
rates that act as a disincentive to work. And the more people are dragged into
the tax net due to the absence of indexation, the greater is this effect. A
good tax system should meet five basic conditions: fairness, adequacy,
simplicity, transparency, and administrative ease. A lack of inflation
indexation undermines all of them.