Frozen tax thresholds pull more into tax traps

A growing number of top rate tax payers

With the start of a new tax year, attention naturally turns to making the most of allowances and minimising tax bills where possible.

For higher earners, keeping the total tax paid as low as possible can be hard work.

An increasing number of people are now subject to the highest rate of income tax at 45% on some of their earnings, with the loss of personal tax allowance also suffered.

In the year before the top income tax threshold of £150,000 was announced in 2008, around 319,000 taxpayers in the UK had incomes above that level.

Fast forward to today, and now 428,000 taxpayers fall into the top rate of tax.

It’s problematic because the threshold has remained unchanged at £150,000 since it was announced initially. The limit has been frozen, but average earnings have risen, pushing more taxpayers into the top rate.

Double whammy: Losing your personal allowance 

Another tax change announced at the same time as the top rate of income tax was the withdrawal of the income tax personal allowance on earnings above £100,000.

This tax policy had the consequence of creating a marginal rate of income tax at 60% for some higher earners.

Ahead of the 2008 announcement, there were 647,000 taxpayers in the UK with earnings above £100,000. Today, there are 986,000 taxpayers in this position.

If each threshold had been increased each year in line with price inflation, they would stand at £120,000 for the withdrawal of personal allowance and £180,000 for the top rate of income tax.

Newly published analysis from the Institute of Fiscal Studies has shown these are just two examples of the consequences of tax thresholds not being escalated in line with inflation.

It means that a growing number of taxpayers are being pulled into higher tax bands in an unplanned and opaque way.

Loss of Child Benefit creates 65% marginal rate of tax

Another example is the £50,000 threshold at which child benefit starts to be withdrawn, through the High Income Child Benefit Charge. This tax charge creates a 65% marginal rate of income tax for people with parents or the partners of parents with three children, with earnings between £50,000 and £60,000 a year.

It’s set to affect one in five families with children in the 2019/20 tax year, compared with one in eight families when first introduced.

The IFS highlights several other areas of tax where frozen thresholds mean more people are paying tax than ever before.

Inheritance Tax impact

The nil rate band for inheritance tax has been frozen at £325,000 from 2009/10. However, the introduction of the residence nil rate band has done something to soften this for homeowners who pass on their estates to direct descendants.

The VAT registration threshold has been frozen at £85,000 since April 2017, and the last Budget announced that it would remain frozen until April 2022.

This frozen threshold is especially relevant as we see the introduction of Making Tax Digital for VAT reporting.

Higher earners limitations on pension contributions: watch out if you’re still accruing

Looking at pensions, the £110,000 and £150,000 thresholds at which the annual limit on tax-privileged pension saving starts to be reduced are fixed in nominal terms.

According to the IFS, these pension saving thresholds can create very high marginal tax rates and, as the thresholds are frozen from year to year, they are gradually affecting more people.

It’s especially problematic for some members of generous but inflexible public sector pension schemes. Limits on how much benefit can be accrued each year in these schemes mean a salary increase can leave someone considerably worse off.

The IFS gives the example of someone with earnings (excluding pension contributions) of more than £110,000 a year, with the value of pension contributions exceeding £40,000 a year, which can happen in these generous public sector schemes.

Such a scenario has been highlighted recently by the British Medical Association, as some doctors have been worse off as a result of pay rises or accepting overtime.

Stuart Adam, a Senior Research Economist at IFS, said: “Some might struggle to shed a tear for the plight of high earners with good pensions. But nobody’s interests are served by encouraging them to work less in order to keep their income below an arbitrary threshold. And as these thresholds are frozen while incomes rise, these pernicious incentives become relevant to an ever-wider group of people.”

Paul Johnson, IFS Director, said: “By freezing the thresholds at which child benefit is withdrawn, the personal allowance is withdrawn and the top rate of income tax applies, recent governments have, rather stealthily, increased the tax rates on high earners and the number of people facing high marginal rates of tax. If government thinks there is a case for more high-income people to pay more tax, it should be upfront about that view.”

If you’re concerned about the impact changes in tax legislation will have upon your financials, get in touch.