Marginal rates of income tax
Income Tax rates are not applied to an individual’s entire income, but rather separately applied to different income brackets. For example, the first £12,570 that people earn is free from Income Tax; if someone earns more than £12,570 they still pay nothing on that first portion of their income, the tax rate is only applied to income in excess of that threshold.
Headline tax rates are not, therefore, total or average rates, but rather marginal rates. The marginal tax rate that an individual faces is the proportion they would pay on the next £1 they earn. A marginal rate of 20%, for example, means that if someone earns an additional £1 on top of their existing income they would pay 20p in tax. The current bands and marginal rates of Income Tax are listed below:
The apparent picture: nominal rates of Income Tax
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Source: HMRC [1].
(Tax bands and rates are correct for the 2022-23 Financial Year throughout.)
High effective marginal rates
Just quoting nominal rates of Income Tax paints a somewhat rosy picture which does not adequately reflect the experiences of people across the income distribution. Additional taxes on income mean Income Tax is only part of the story, while at various points quirks of the tax and benefits systems result in much higher effective marginal rates.
Personal Allowance withdrawal
The Personal Allowance, which exempts people from paying any Income Tax on the first £12,570 they earn, is withdrawn for people earning more than £100,000. For every £2 that someone earns in excess of £100,000 they lose £1 of their Allowance which is instead taxed at the 40% Higher rate [2]. This means that, in effect, the marginal rate of Income Tax is 60% between £100,000 and £125,140, since for every additional £2 they earn they pay an extra 40p in Income Tax due to the withdrawal of their Personal Allowance in addition to the 80p that they would paying anyway at the Higher rate. After reaching £125,140 their Personal Allowance has been reduced to zero and the marginal rate returns to 40% until they hit the Additional rate threshold.
While the Personal Allowance has increased over recent years, this £100,000 threshold has remained fixed. As a result, more and more people are subject to this especially high marginal rate as wages increase and the size of the band is widened in line with the rising Allowance, leaving more than a million people affected [3]. An Institute for Fiscal Studies (IFS) report found evidence of noticeable “bunching” of salaries just below the £100,000 threshold, suggesting that the withdrawal of the Personal Allowance discourages people from entering that income bracket to a noticeable extent [4].
National Insurance and student loans: extra taxes on work
When assessing how income from employment in the UK it is unfortunately inadequate to just look at Income Tax because other taxes on work exist, defined as separate taxes but in reality having the same effect; Income Tax is not the only income tax. While National Insurance (NI) contributions have different bands and rates and an additional function – a person’s NI record determines their eligibility for certain benefits, most notably the state pension [5] - they are really just a supplementary income tax in practice. Employees on Pay As You Earn (PAYE) have both Income Tax and NI contributions deducted from their wages in the same way.
Most employees pay Class 1A NI rates: zero on the first £823/month (£9,876/year), 13.25% on income between £823-£4,189/month (£9,876-£50,268/year) and 3.25% on any additional income in excess of £4,189/month. These rates ought to be added to Income Tax rates when assessing the effective marginal tax rates that workers face. Once this is taken into account we can see that workers making £9,876-£12,570/year are already paying a marginal rate of 13.25% despite being under the threshold for paying any Income Tax, Basic rate taxpayers are really paying a rate of 33.25% rather than 20%, and Higher and Additional rate taxpayers are paying an extra 3.25% on top of their Income Tax rates.
Employers also have to make NI contributions for their employees, paying 13.8% for any employee they pay more than £758/month (£9,096/year). While this does not directly come out of an employees’ paycheque, it nevertheless also functions as a tax on employment given that it raises the cost of employing someone to 115.05% of their nominal wage above the threshold. If employers’ NI did not exist businesses would face lower labour costs and/or could afford to pay their employees higher wages.
Student loan repayments are another charge that may as well be considered a supplementary income tax as they are taken out of salaries alongside Income Tax and NI contributions [6]. University leavers with outstanding student debt are charged 9% of their income over a threshold of £1,682/month (£20,184/year) if they hold are on a Plan 1 (pre-2012) repayment plan or £2,274/month (£27,288/year) if they are on Plan 2. This means that the effective marginal tax rate of anyone with outstanding student debt earning more than their respective threshold is 9% higher still. A Basic rate taxpayer making student loan repayments facing almost the same marginal rate after accounting for the repayments and NI contributions (42.25%) as a Higher rate taxpayer with no student debt (43.25%).
It is worse still for anyone who has taken advantage of the recent availability of postgraduate loans as these are not simply added on to their total of outstanding student debt, but rather repaid separately at a rate of 6% on income over the above thresholds. This means that a Basic rate taxpayer making undergraduate and postgraduate student loan repayments faces the same effective marginal rate as an Additional rate taxpayer with no student debt (48.25%).
Universal Credit
A common feature of many benefits intended to support low-income individuals and families is that they are means-tested such that as someone’s income increases the amount of support that they are entitled to is progressively reduced. The logic of this is understandable both economically and politically: means-tested benefits are, in theory, more efficient as money is concentrated where it is needed and not ‘wasted’ on people who are in less need; furthermore, the media and the public tend to have a very dim view of such inefficient welfare spending. However, if the rate at which benefits are withdrawn is too steep this can, in practice, discourage people receiving benefits from working more – or at all.
Universal Credit (UC) is now the primary benefit for supporting people on low incomes in the UK. UC is subject to a taper rate: for every £1 a claimant earns from work their UC payment is reduced by 55p, which is itself more generous than the previous rate of 63p.. Claimants with children or young dependents and/or who have a disability or health condition which limits how much they can work are given a “work allowance” which lets them earn a certain amount before the taper rate is applied. For all intents and purposes the taper rate functions like a 55% marginal rate of tax; for every additional £1 a claimant earns on paper their total disposable income is increased by only 45p after accounting for their reduced UC payment.
For a single claimant with no work allowance this means that their UC payment will be reduced to zero before they reach an income from employment of £8,000. Couples receive a higher allowance, though less than if they were able to each claim separately, and families with children receive a work allowance guaranteeing them a higher minimum income. However, this also means that they could still be claiming UC at income levels which put them over the threshold of paying taxes (UC claimants are not exempted from Income Tax or NI). Claimants who are subject to the UC taper rate and who are also paying Income Tax and making NI contributions face an effective marginal tax rate of up to 88.25%! The Institute for Government estimated in 2016 that the implementation of UC would lead to effective marginal rates of more than 50% hitting 6.6 million people, rates of more than 70% hitting 700,000 of those, and of more than 90% for a particularly unfortunate 100,000 people [8], though this was before the reduction of the taper rate to 55%.
The real picture: effective marginal rates of taxes and transfers on income from employment for selected groups
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Sources: HMRC [9, 10], DWP [11, 12]; student loan repayments are for a Plan 2 undergraduate loan, Class 1 employees’ NI.
High tax rates act as a disincentive to work.
The overall effect of these features (or bugs) is a tax and benefits system which generally imposes high effective marginal tax rates on most people, inconsistently ranging from moderately high to very high rates at various points. Perversely, the highest effective marginal rates are levied upon some of the most vulnerable (low-income families) and some of the most productive (graduates and many high-earners) members of society. Instead of encouraging such people to work more and keep the proceeds of their employment, the existing systems do precisely the opposite.
High marginal tax rates can act as a disincentive to work in a few ways: high “participation tax rates” can discourage people from working at all if they do not gain enough to justify the loss of free time; people in work can also be discouraged from working more hours or working harder to try and increase their income if the potential gains are relatively small [13].
As should be fairly obvious from the issues with Universal Credit document above, the highest participation tax rates are faced by low-income individuals, especially households with children and/or disabilities, who stand to find that most of the income they gain from finding employment is cancelled out by a corresponding reduction in their benefit payments. For people in such situations being reluctant to work is a perfectly rational perspective: why sacrifice time that could be spend caring for loved ones or simply at leisure if the rewards for doing so are so small?
The highest effective marginal tax rates, which might disincentivise people who are in work from choosing to work more or work harder, are generally faced by people earning high incomes as Income Tax rates progressively increase, though some Universal Credit claimants can still have their benefit payments being tapered while paying taxes which leads to the highest of all marginal rates. These people might be content with being in employment but unwilling to take another job, increase their hours, or make an effort to try and get a promotion and a raise because, again, the potential reward does not seem to justify the added work that would be required.
An academic study of effective tax rates across Europe found similar results across most countries showing these problems are hardly unique to the UK; in fact, the UK has a lower participation tax rate than most EU countries. Their survey of UK taxpayers confirms that people facing a high participation tax rate (disincentive to work at all) are predominantly people on low-incomes and who have low levels of education while high effective marginal tax rates (disincentive to work more/harder) have a U-shaped incidence: high for low and high income and education levels, low in between [14].
A 2011 OECD survey of empirical evidence found that the groups whose labour participation decisions are especially sensitive to changes in the taxation of employment include low-income workers and single parents who stand to lose benefit income if they work, second earners who may similarly lose benefits which are calculated at the household rather than individual level, and older workers who may be encouraged to retire once they are entitled to a pension rather than do heavily taxed work; meanwhile high marginal rates for highly-skilled and mobile workers may encourage them to work less or even move to a different tax jurisdiction [15].
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A 2018 literature review showed that most economic studies of labour participation found that higher participation tax rates reduce the supply of labour, with an average elasticity of 0.38 (i.e. a 1% rise in the participation tax rate reduces labour force participation by 0.38%), with the highest elasticities found among women and older workers [16].
Work creates wealth but is taxed more.
Successive governments have tried to improve labour market efficiency and encourage more people to work: from New Labour’s new deal for the unemployed [17] to the introduction of Universal Credit which was heralded as a reform to “make work pay”[18]. While these reforms have improved the circumstances faced by many, all the issues described above show there is still some way to go before the UK’s tax and benefits systems can truly be described as efficient and not a hindrance to work.
Besides efficiency, the high marginal tax rates faced by workers also raise questions of equitability and fairness. Work is integral to the creation of wealth and yet employment is perhaps the most heavily taxed activity in the UK. The rates of tax applied to, for instance, capital gains [19] and corporate profits [20] are much lower than even the nominal rates of Income Tax, let alone the much higher effective rates that workers really face.
Taxes on wealth often raise fears of capital flight and disincentivising investment [21] and it is undoubtedly true that it is generally easier for capital to avoid taxation than for labour to do so. Even relatively mobile workers find it easier to send some money abroad than to up sticks and move themselves and their families; low-income workers with limited resources are often straightforwardly unable to move and frequently have little choice but to work to get by even in the face of high marginal rates, especially if any benefits they receive are conditional upon either working or actively job-seeking. However, employment being a more captive and thus practical source of revenue does not neuter the issues of fairness and equality. In any case, if the level of taxation of wealth produces concerns over inefficiency, then the much higher level of taxation of work should setting off alarm bells!
Policy: aggregate and adjust tax rates.
The current tax and benefits system is a byzantine web of different rates and allowances which produces highly inconsistent and in many places inefficient taxation of income earned from employment. Successive piecemeal reforms have achieved some gains but have not changed this fundamental structure. A comprehensive, holistic review of the whole system is needed in order to make substantial improvements.
For a start, the various taxes and charges which purport to be different things but are really all just taxes on earnings ought to be brought together. While the proposal of merging Income Tax and National Insurance into a single tax will be fully considered in the entry on National Insurance, it can at least be said here that for the purpose of evaluating real tax burdens they should be considered as one. The fact that that in 2000 the Basic rate of Income Tax was 22% and employees’ National Insurance contributions were 10%, whereas today they are 20% and 12% respectively, makes no difference for most worker [22]. What matters is the overall tax burden, not what each slice is called.
The simplest way to address the anomaly of the 60% rate of Income Tax created by the withdrawal of the Personal Allowance would be to remove the taper, extending the Personal Allowance to all taxpayers regardless of their income. In isolation this would be a costly and controversial measure; the IFS estimates that this would cost around £4 billion in tax revenue and would obviously exclusively benefit high-income households [23]. However, in combination with over tax reforms it would contribute a significant rationalisation; for example, extending the Personal Allowance to all while simultaneously lowering the Additional rate threshold would result in a much lower net cost while still benefiting those who would otherwise be stuck with a marginal rate of more than 60%.
The Universal Credit taper rate poses another obvious problem which would, unfortunately, also be costly and likely controversial to solve. Reducing the taper rate would increase claimants’ incentive to work and boost their disposable incomes, but would of course also mean more people receiving higher payments, including those with significant incomes from work. According to analysis by the Joseph Rowntree Foundation, reducing the UC taper rate by just 2.25% would cost £1 billion, though it would also raise about 200,000 people over the poverty line.24 According to the DWP’s own estimates, the 2017 reduction in the taper rate from 65% to 63% already cost about £700 million/year[25]. Raising work allowances would carry a similar cost and could exacerbate issue of extremely high marginal rates for UC claimants who earn enough to pay taxes, while raising tax thresholds further would also be very costly; the IFS estimates that raising the threshold for National Insurance contributions to £12,500, in line with the Personal Allowance, would cost £17 billion [26].
A radical alternative to means-tested welfare would be for the government to just pay everyone a benefit, regardless of their income or circumstances. Many people have proposed replacing the current benefits system with a Universal Basic Income (UBI) to do just that. While a UBI might lower the incentive to work on average by giving everyone a guaranteed income whether or not they are employed or even looking for work, at the lower end of the income distribution it would dramatically reduce the participation tax rate or disincentive to work at all since recipients would not lose any of their benefit by working, they would only be subject to taxes on their employment income [27]. A UBI would of course be very expensive, providing just £400/month (approximately the same as Universal Credit payments for single adults over 25) to every working-age adult in the UK would cost more than £200 billion/year [28], or more than one-fifth of the Government’s current budget [29]. Welfare spending on working-age people was just under £100 billion as of 2018 [30] so such a scheme would undoubtedly require a huge increase in spending.
Student loan repayments being administered as a supplementary income tax for graduates is another distortion that would be expensive to unwind. The Labour Party’s proposals in recent elections to abolish tuition fees and instead fund universities through general taxation would greatly reduce the burden of student loan repayments, but would also cost an estimated £8 billion/year [31].
It is clear that more equitable taxation of work without excessively high marginal rates would require accepting some eye-watering expenses and losses of revenue, however this is more reason to do it as part of a general rebalancing of the tax system. The present advantage enjoyed by the wealthy who pay less tax on the proceeds from their assets than most workers do on their wages should be addressed by any serious review and offers potential to raise revenues to compensate for tax reductions elsewhere. For example, the IPPR has estimated that taxing capital gains at the same rate as income from employment and abolishing the separate reliefs could raise £18 billion/year [32], while Labour proposals to reverse recent cuts to Corporation Tax expected to raise £24 billion [33]. It is clear that the wealthy could afford to bear a greater share of tax burdens and in doing so allow workers to be taxed at more reasonable rates.
2https://www.gov.uk/income-tax-rates/income-over-100000
3https://www.ft.com/content/4ee32fd8-d16d-11e4-98a4-00144feab7de
5https://www.gov.uk/state-pension/eligibility
6https://www.gov.uk/repaying-your-student-loan/how-you-repay
7https://commonslibrary.parliament.uk/research-briefings/sn07096/; https://www.ons.gov.uk/peoplepopulationandcommunity/personalandhouseholdfinances/incomeandwealth/bulletins/householddisposableincomeandinequality/financialyearending2020provisional (relative poverty line is 60% of median household disposable income)
9https://www.gov.uk/national-insurance/how-much-you-pay
10https://www.gov.uk/repaying-your-student-loan/what-you-pay
11https://www.gov.uk/universal-credit/what-youll-get
13https://www.sciencedirect.com/topics/economics-econometrics-and-finance/tax-rate
14https://www.iser.essex.ac.uk/research/publications/working-papers/euromod/em19-19.pdf
16http://ratio.se/app/uploads/2018/10/jl_jn_taxes_benefits_and_labour_force_participation_313.pdf
17https://www.ifs.org.uk/economic_review/fp193.pdf
18https://www.gov.uk/government/news/universal-credit-makes-work-pay
19https://www.gov.uk/capital-gains-tax/rates
20https://www.gov.uk/corporation-tax-rates
21https://www.cato.org/publications/tax-budget-bulletin/taxing-wealth-capital-income
24https://www.jrf.org.uk/report/comparing-investment-universal-credit-work-allowances-and-taper-rate
25https://www.legislation.gov.uk/uksi/2017/348/pdfs/uksiem_20170348_en.pdf
26https://www.ifs.org.uk/publications/14388
28https://www.ft.com/content/927d28e0-6847-11ea-a6ac-9122541af204; https://www.ethnicity-facts-figures.service.gov.uk/uk-population-by-ethnicity/demographics/working-age-population/latest (£200 billion/year figure based on working-age adults being approximately two-thirds of the overall population, adjusting other estimates to match)
31https://wonkhe.com/blogs/the-costs-of-labours-tuition-fee-pledge/
