Millions snared by income tax traps
Changes to headline rates of tax — or politicians’ promises not to raise them — tend to elicit the biggest reaction from the public when it comes to fiscal reforms. But more subtle nuances in the tax regime can impose heavy and unexpected burdens on certain groups.
“You always have winners and losers where changes are made. It’s inevitable,” says Patrick Stevens, tax policy director at the Chartered Institute of Taxation.
A number of “tax traps” lie at faultlines in the tax and benefits system, where the government has decided that a tax relief should not be universally extended. Some are removed gradually, others abruptly.
While the process of “tapering” reliefs introduces anomalies in what is otherwise a progressive income tax regime, the latter creates cliff edges where taxpayers can face sharp increases to their marginal rate for earning just a little more than a given threshold.
FT Money has identified four of the most distorting effects of tax policy — anomalies that affect millions of taxpayers across the income spectrum.
Personal allowance tapering
Among higher earners, arguably the most egregious quirk in the tax system is the tapering of the tax-free personal allowance on annual income above £100,000.
For every £2 earned above this threshold, £1 of relief is taken away. Income earned in 2015-16 between £100,000 and £121,200 will therefore effectively face an additional tax rate of 20 per cent.
Combined with the higher income tax rate of 40 per cent levied on income above £42,385, “it isn’t anything more or less than an effective marginal income tax rate of 60 per cent,” says Paul Johnson, director of the IFS.
Patricia Mock, a tax director at Deloitte, says the 60 per cent rate — which has never been officially recognised as such — affects ever more taxpayers as wage inflation takes a higher proportion of salaries above £100,000. Official figures show the number affected rose from 588,000 in 2010-11 to a projected 791,000 in 2014-15.
In addition to this process of “fiscal drag”, the 60 per cent band has widened in proportion to the tax-free personal allowance, which rose from £6,475 in 2010-11 to £10,600 this year.
“Frankly, it is another way of putting tax up for higher income people without raising the headline rates,” says Mr Stevens.
Dermot Callinan, UK head of private client advisory at KPMG, says that while the tapering of the allowance has influenced tax planning since its introduction in 2010, opportunities to significantly reduce liabilities have been curtailed by anti-avoidance measures and tighter reliefs.
“It does encourage people to look closely at the timing of their bonus, if they are in a position to do so, and at their personal pension contributions,” says Mr Callinan.
Taxpayers facing a marginal tax rate of 60 per cent can divert an extra £1,000 to their pension pot at a net cost of only £400.
However, with annual and lifetime pension allowances reduced significantly during the course of the last parliament — falling to their current respective levels of £40,000 and £1.25m — fewer higher earners in this position have been able to squirrel away money tax-efficiently into their pensions.
Further cuts to pensions tax relief are promised.
Before their election success, the Conservatives pledged to taper the annual pensions allowance for additional rate taxpayers — those earning over £150,000 a year — to fund an extension of the inheritance tax threshold.
Like the tapering of the income tax allowance, £1 of pension relief will be taken away for every £2 earned above £150,000 under the proposals. Those earning £210,000 or more a year will be allowed to save only £10,000 tax-free into their pensions each year.
After the reforms come into effect, additional rate taxpayers who continue to put their income into a pension would face a marginal income tax rate of 67.5 per cent.
“It makes no coherent sense why someone earning £150,000 should be able to put in £40,000 [a year] to their pension before tax, yet someone earning £210,000 should only put in only £10,000,” says Mr Johnson.
Nimesh Shah, a partner at accountants Blick Rothenberg, says that while the cost of the proposal — up to £13,500 in lost pensions tax relief — may not pose a great financial cost to the highest income taxpayers who will be affected, it is nonetheless seen by many of his clients as unfair.
“Where people lose a universal allowance that everyone else is entitled to, it is quite emotive even to the very wealthy,” he said.
Mr Johnson said that few taxpayers — already facing a marginal income tax rate of 45 per cent — would ultimately end up paying an effective rate of 67.5 per cent, because many would simply reduce their pension contributions.
Further curtailment of pension reliefs is expected to encourage additional rate taxpayers — who number 332,000 this year, according to HMRC estimates — to divert surplus income from pensions to more tax-efficient investments.
As ministers ramp up the counter-avoidance efforts, with punitive financial penalties for taxpayers involved in arrangements disputed by HMRC, venture capital schemes that enjoy formal government support are in favour.
Investments made via the enterprise investment scheme and venture capital trusts were close to record highs in 2013-14. Although investors qualify for significant tax breaks, including upfront income tax relief of 30 per cent, these are in place partly to reflect the inherently higher risks associated with investments in smaller companies.
Child benefit tapering
Further down the income ladder, the tapering of another tax relief affects a much larger group of taxpayers.
Since 2013, households with one annual income of between £50,000 and £60,000 have only partially qualified for child benefit. Where one parent earns more than £60,000, the couple does not qualify for any child benefit.
“You can have a couple with two incomes of £49,999 that receives the benefit in full, but a couple with one income of £60,000 that receives none at all,” says Paul Aplin, chair of the technical committee at the Institute of Chartered Accountants of England and Wales, which scrutinises tax policy.
Complicating matters for higher earners with children, the benefit continues to be paid in full but they must repay the relevant amount via self-assessment.
The introduction of the high income child benefit tax charge (HICBC), initially forecast to affect 1.5m families, forced an estimated half a million taxpayers into self-assessment for the first time.
Chas Roy-Chowdhury, head of tax at the Association of Chartered Certified Accountants, says he has spoken to many professional parents who did not know they needed to self-assess because of the changes, however.
“The difficulty is that it is a moving group facing clawback [of the benefit] . . . With large fines for not filing returns, it is rich pickings for the Revenue.”
Repayment of child benefit — currently £20.50 a week for the eldest child and £13.55 for each one subsequent — means that income between £50,000 and £60,000 is effectively subject to higher taxation. The rate depends on the number of children a taxpayer has.
While someone with one child faces an effective marginal rate of 51 per cent — excluding national insurance contributions at an additional 2 per cent — after the HICBC is taken into account, this rises with each subsequent child, breaching 100 per cent with the eighth child.
For parents of two or three children, the effective tax rate on income earned in this band is 58 per cent and 65 per cent respectively.
Ms Mock said that separated couples should bear in mind that the HICBC will still apply to a partner earning over £50,000, even if they do not live with the children.
Given that the charge is based on adjusted net income, a taxpayer with income just above £50,000 could, for example, make additional pension contributions to take themselves below the HICBC threshold.
Another option is to give to charity via gift aid. For every £100 donated, a taxpayer’s adjusted net income is lowered by £125.
The most recent peculiarity in the personal tax system — and “most absurd”, according to Mr Aplin — was introduced only this year. “Every time there’s a new relief, there’s another weird effect.”
Unlike reliefs that are tapered to exclude higher earners, however, a new tax break for married couples is removed altogether for couples with one salary of more than £42,385.
Where one spouse or civil partner earns less than £10,600, one-tenth of their remaining personal tax-free allowance can be transferred to their partner, so long as they are not a higher rate taxpayer. In the current tax year, it can be worth anything up to £212 to qualifying couples.
Given that the relief ends at a cliff edge, someone who earns £1 more to take them into the higher rate tax bracket can lose their entire transferable allowance. Unless they receive a pay rise of more than £212, they could be worse off after tax.
“It is a small, but ludicrous relief,” said Mr Johnson. “Its removal at a cliff edge, the cheapest option in fiscal terms, seems to introduce a complexity with very limited benefit.”
Mr Roy-Chowdhury says the anomalies thrown up by the removal of the transferable allowance and child benefit compromise the principle of equality of treatment for taxpayers.
“We should have an income tax system where an economic unit can pool their resources,” he said, adding that many capital taxes and reliefs — such as private residence relief — remain on this historical basis.
“If the Conservatives are serious about family and marriage, why should income tax reliefs and allowances not be transferable for all taxpayers?”
Calls for reform
The combined effect of removing these reliefs leaves a series of counterintuitive peaks in the income tax regime.
Rather than progressively increasing with earnings levels to a peak of 45 per cent, as headline rates would suggest, marginal effective rates of income tax in fact breach 60 per cent at £100,000 and would again at £150,000 if pensions tax relief is curtailed.
In spite of calls for reform, the last government not only avoided changes to smooth the rollercoaster income tax regime but introduced new complexities. Fuelled by a political desire to restrict reliefs to prevent tax avoidance and to correct their perceived misallocation, the tax code continues to expand.
“Ten years ago, the volumes stacked up went up to my ankles,” says Mr Shah. “Now they reach up to my knees.”
Office of Tax Simplification
With a mandate to identify areas of the tax code ripe for reform, the Office of Tax Simplification was established as an independent advisory body in 2010.
John Whiting, its tax director, says the role of the OTS — which makes recommendations to the government — is to ask whether the tax regime could be made more straightforward.
The government is not obliged to adopt its advice, however. Of the 60 “big picture” recommendations made by the OTS since its inception, only nine had been fully implemented by March, with a further seven partially so. Most of its proposals, such as the merger of income tax and national insurance contributions, remain untouched.
In the past five years, the tax code has also lengthened considerably. Tina Riches, national tax partner at accountants Smith & Williamson, says there are three factors: “swaths” of legislation to counter tax avoidance; new taxes such as the annual tax on enveloped dwellings; and “continual tweaking” of the regime.
“The OTS must feel like it is holding the tide back with a broom,” says Mr Aplin. “Despite its valiant efforts, the volume of tax legislation has been growing faster than it can deal with.”
Mr Whiting says that ultimately it is ministers who decide tax policy, and there are invariably difficult political and fiscal decisions associated with implementing the body’s proposals. “Nobody said tax simplification is easy, otherwise it would have been done years ago.”
He adds that it is important, however, that reform remains on the agenda. “Let’s be clear: there is a dividend in simplification for both HMRC and taxpayers.”