The 62 per cent income tax trap..

Paying tax is a necessary part of earning income and being part of a society. That is accepted.

But while you may have thought that the top rate of tax is 45 per cent, there are hundreds of thousands of people paying 62 per cent due to an odd quirk in the system.

This is having a demoralising effect on workers. They question the point of working hard if only 38% is going to be safe from the tax man. Many experienced professionals are turning down pay rises or leaving work completely.

The anomaly has arisen because of the gradual removal of the £12,500 tax-free personal allowance by £1 for every £2 if you earn over £100,000. This means the effective tax rate can be as high as 62 per cent once National Insurance contributions are taken into account. 

If you earn between £125,000 and £150,000, you will still pay income tax at 40 per cent but have no personal allowance. You will then pay the top rate of 45 per cent on any earnings over £150,000. 

The quirk is currently thought to be affecting approximately 360,000 tax payers but due to the strong growth in wages, this figure is set to increase. Not surprisingly, there are many more people earning over £100,000 than in 2010 when the policy was first introduced. In addition, the threshold has remained at £100,000 while the personal allowance has increased which has meant a greater number of people are caught in the trap.

Some people are careful to ensure they don’t earn more than £100,000. In their view, it’s pointless. Contractors may actually turn down work so as not to tip over the threshold. Some may decide to retire early and leave the workforce altogether and others may opt to pay a large amount into their pension to keep their net income under the limit.

While the quirk may be generating an additional £4bn for the Treasury, it is ironically having a negative impact on the economy. With a significant number of higher rate taxpayers being dis-incentivised from working, it is actually costing the economy more money than it is generating.

There have been indications the government may look at making tax cuts in the future to stimulate the economy. The Institute for Fiscal Studies (IFS) think-tank has proposed that the tapering of the personal allowance should be abolished in line with Boris Johnson’s promise to raise the point at which the higher rate of income tax kicks in from £50,000 to £80,000. 

The IFS also recommended eliminating the 40 per cent tax income band so that we would revert to having just a two tier system, with the 45 per cent rate starting earlier at earnings of £80,0000 or more. They did, though, suggest the implementation costs could be offset if the starting point for the higher rate of income tax was £75,000 of earnings rather than the proposed £80,000. 

There is much still to be evaluated but the current tax system is clearly causing disillusionment among taxpayers and having a disproportionately negative effect on the economy.

If you would like to discuss the tax rates and allowances in relation to your own financial planning, do get in touch with us.

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