Income Tax: From 3.5% to 14% in 36 Years
Cast you mind back to the early 1990s, if you can. John Major was Prime Minister and his successor as Chancellor, Norman Lamont, ran a distinctly different income tax strategy from the current incumbents of 10 and 11 Downing Street. Just how different was highlighted in recent research published by the Institute for Fiscal Studies (IFS).
Then to now…and beyond
In 1991/92, basic rate income tax – then at 25% – was the top rate of tax paid by 96.5% of UK adults. The remaining select 3.5% paid higher rate tax (at 40%, as it is now outside Scotland). Up until the end of the 2000s, the starting point for higher rate tax generally followed inflation. However, in that period earnings outpaced prices, with the result that there was a steady rise in the numbers dragged into higher rate tax.
Matters worsened in the 2010s, with both freezes in the higher rate threshold and the introduction of additional rate tax on incomes over £150,000. The freezes stopped after 2015/16, only to reappear in the 2021 Budget. The Chancellor at the time, Rishi Sunak, fixed the higher rate threshold (again outside Scotland) at £50,270 through to 5 April 2026. At the time inflation was not projected to rise to the dizzy heights of 2% until 2025, meaning the impact of the freeze was expected to be limited.
In March 2023, Mr Sunak’s next but two successor as Chancellor, Jeremy Hunt announced:
a further two-year extension to the higher rate threshold freeze (outside Scotland), meaning it would run up to and including 2027/28; and
a reduction in the threshold for additional rate tax (45% outside Scotland) from £150,000 to £125,140 (a move Scotland followed).
The result
The IFS used data from the Office for Budget Responsibility (OBR) to calculate the impact of the Sunak and Hunt freezes combined with inflation at a level which was almost inconceivable just over two years ago. By April 2028, 14% of all adults and about one in five of all taxpayers will face a marginal rate of tax of 40% or more. The graph below shows the unhappy trend. In terms of tax increases, the IFS calculates that the threshold freezes will represent the single most significant tax increase since the rate of VAT was raised from 8% to 15% in 1979.
That only one number has changed – the additional rate threshold – makes the size of this tax increase difficult to believe…until you remember inflation. In effect, the Treasury has delegated tax policy to the soaring Consumer Prices Index (CPI).
Source: HMRC, OBR
What can you do?
If you pay tax at more than basic rate already, or are likely to in the next five years, there are a range of factors to discuss with your financial adviser:
What is your marginal rate of tax – the tax you pay on the next £1 of income? It may not be either of the ‘advertised’ rates of 40% (42% in Scotland, 33.75% on dividends) or 45% (47% in Scotland, 39.35% on dividends). The labyrinthine structure of the UK tax system with tapered allowances and cliff edge eligibility thresholds can create much higher marginal tax rates. For example, if your income is between £100,000 and £125,140 your marginal tax rate could well be as high as 60% (63% in Scotland).
Are your investments held in the optimum framework, given your marginal tax rate? You may have been dragged into a higher tax band because of the threshold freezes, in which case the way you hold your investments may need to be revised. Remember too that the dividend allowance has been halved to £1,000 this tax year and will halve again in 2024/25. You could soon be a dividend taxpayer, if you are not already.
Can you take advantage of independent taxation? Married couples and civil partners are taxed individually, so it might make sense to transfer investments if you each have different marginal tax rates.
Can you restructure your income? For instance, if you are a private company director you may be able to choose between dividends and salary and save tax.
Are you making the most of the tax reliefs available on pensions and venture capital investments? The rules in both areas changed (yet again) in 2023/24, creating some new opportunities.
It is still relatively early in the tax year, so there is time to take action that can have an impact on your 2023/24 tax bill. But the longer you delay, the more you will experience the chill of threshold freezes. Call us today to arrange for an income tax planning review.
This article was prepared by Chris Green, our Head of Financial Planning. We always appreciate your feedback. If you have enjoyed this article or have any specific topics you would like to see addressed in future newsletters, please email us at FPTeam@city-asset.co.uk.