Think 45p taxpayers have it hard? The tax system crushes incentives at all levels
Ahead of next week’s Budget, two former chancellors and 160 Tory MPs are calling for the 45 per cent income tax rate to be reduced to 40 per cent. But for all the political capital devoted to explaining the disincentive effects of a 45 per cent rate, the reality is that many people across the income scale face marginal rates much higher than this. In fact, the 45 per cent band is not even the top marginal tax rate created by the income tax system.
A “marginal tax rate” is best thought of as the proportion of money that is taken from you on the next £1 of income you earn. It’s important because it represents a good proxy of your financial incentive to earn more income – whether through working more hours, investing in your own human capital, seeking promotion, or arranging your affairs such that more of your earnings are declared as income.
With that definition, it’s clear that our income tax bands are only a small part of the story. Most of us also pay employees’ national insurance contributions (NICs) too. This is another tax on income. Including this means that, rather than the marginal tax bands being 0, 20, 40 and 45 per cent – for income tax alone – the bands are in fact 0, 12, 32, 42 and 47 per cent (with the 12 per cent band occurring because employees’ NICs kick in at a lower level than income tax).
For many, marginal tax rates are much higher still. Those receiving tax credits see these withdrawn as their income rises. This creates an additional 41 per cent marginal tax rate until the credits are withdrawn entirely. A single-earner family with three children faces a combined marginal tax rate of 73 per cent (with income tax and NICs) on up to about £40,000 of earned income.
The withdrawal of child benefit for families with one earner on between £50,000 and £60,000 causes higher marginal tax rates too (of 10.8 per cent for one child and 7.1 per cent thereafter). A family with three children faces an extra marginal tax rate of 25 per cent on top of the combined 42 per cent income tax and NICs rates across this income range.
Finally, those earning over £100,000 a year see their personal income tax allowance removed at a rate of 50p for each extra £1 earned – adding 20 per cent to the 42 per cent income tax and NICs marginal rate faced by someone earning up to £121,200.
Things are worse still for others. Those at the bottom face withdrawal of other benefits, and many face an extra 9 per cent on their marginal rate from student loan repayments. This analysis ignores employers’ NICs too – at least part of which is likely to be borne by employees. With such high marginal tax rates across large parts of the income spectrum, is it any wonder our productivity growth performance is so poor? Are there really good financial incentives for advancement?
The truth is, the incentive arguments we hear in favour of cutting the 45 per cent income tax rate – that it will encourage work, human capital investment, and lead to more declared income – can be applied right down the income scale. The difference is cutting the top rate might not cost much revenue compared to cuts for others, because top rate payers are likely to be more responsive to changes in tax rates. But the key economic insight that incentives matter is a powerful one.
By all means cut the top rate further, but politicians should not forget the much broader case for pro-growth tax and benefit reform which lowers marginal rates and removes the anomalies outlined above. This could significantly improve economic outcomes.