Income tax: How it really works, what you pay – and who forks out probably the most

For most people, income tax makes up the largest portion of the taxes they will pay over their lifetimes.

It is also the UK Government’s biggest tax source of revenue, accounting for 25 per cent of UK tax receipts last year, according to official figures.

In theory, our income tax system is simple and progressive. As people earn more they pay a higher rate by stepping up three bands: 20 per cent, 40 per cent and 45 per cent. 

In reality, things are more complicated and some get caught by a tax trap that means they pay a 60 per cent rate.

We explain what you need to know about income tax, who pays what, how so-called fiscal drag is making us all pay more – and why the top 10 per cent of earners end up paying more than half of total receipts.

What is income tax?

Income tax is a progressive tax system, meaning that the more you earn the higher the rate.

Income tax is charged on earnings from employment and self-employment, but also state and private pension income, rental income, and savings interest.

You may also have to pay income tax on some state benefits, including Bereavement Allowance, Carer’s Allowance and Jobseeker’s Allowance.

You don’t usually have to pay income tax on all your taxable income, because most people qualify for one or more allowances. 

The main one is the tax-free personal allowance but there are also specific allowances for private pension income, savings interest and other elements.

Income tax rates and the personal allowance

The highest rate of income tax you pay will depend on your earnings and the tax band you fall into.

The official tax rates for England, Wales and Northern Ireland are 20 per cent, 40 per cent and 45 per cent. (Scotland has different rates of 19, 20, 21, 42 and 47 per cent).

These are charged above the personal allowance of £12,570, which is the amount of income people can earn tax-free.

Not every gets a personal allowance though. For those who earn more than £100,000, the personal allowance is reduced by £1 for every £2 earned over the limit, until it is removed entirely at £125,140. 

Tax bands 

• The personal allowance means most will not pay any tax on the first £12,570
• Basic rate income tax at 20 per cent is then paid between £12,571 and £50,270
• Higher rate income tax at 40 per cent rate is paid between £50,271 and £125,140
• Additional rate income tax at 45 per cent is paid on income above £125,141

How tax bands work 

The amount of tax you pay will depend on how much income falls within each tax band. You won’t pay income tax at the same rate on all your income, but rather on the amount in each bracket.

For example, if you earn £52,000 a year:

You will not pay any tax on the first £12,570

You will pay 20 per cent income tax on your earnings up to £50,270, so the next £37,700 of your income.

You will pay the 40 per cent on the final £1,730 above the higher tax threshold  of £50,270.

How income tax is paid

Most working people are employees and pay income tax through PAYE – pay as you earn – which is the system employers use to deduct income tax and national insurance contributions before they pay wages. 

PAYE is also used by employers paying defined benefit pensions.

Your tax code will tell your employer how much to deduct. The standard tax code uses the personal allowance to provide a tax-free amount, but people’s tax codes change to take into account taxable benefits or the removal of the personal allowance. You can check your tax code on your payslip.

Britain’s 4.2million self-employed, about 13 per cent of working people according to the ONS, need to file a self-assessment tax return to pay their income tax.

Employees and pensioners with additional income, for example from rental properties, private pensions, or needing to pay tax on savings interest, also need to fill in a self-assessment tax return to pay the right amount of tax. 

Self-assessment is also used by higher earners claiming tax relief on pension contributions, those paying the child benefit high income charge, and all those with taxable income above £150,000.

The 60% tax trap

Calculating tax should be relatively straightforward, but it becomes a lot more complicated for those earning six figures.

This is the level at which the 60 per cent tax trap kicks in: England, Wales and Northern Ireland’s unofficial highest rate of tax, levied between £100,000 and £125,140. 

This is a marginal tax rate, the percentage of tax you’ll pay on the next pound you earn.

It is triggered by £1 of the personal allowance being removed for every £2 of income above £100,000.

This means every £1 earned between £100,000 and £125,140 loses 50p – ie half – of its tax-free status.

The effect bumps up the tax rate by half, turning official 40 per cent income tax into an effective 60 per cent rate.

This warps the tax system and means that income tax rates start at 20 per cent, rise to 40 per cent, then hit 60 per cent between £100,000 and £125,140, before dropping to 45 per cent above that.

Child benefit and other high marginal rates

There are other instances of high marginal income tax rates where removing benefits affects the system, such as the child benefit tax trap.

The Government claws back child benefit from families where the highest earner has an income above £60,000, and withdraws it completely when they earn over £80,000.

This is based on individual income rather than household income, so the higher earner in a couple triggers and is responsible for paying the charge.

Under the £60,000 to £80,000 child benefit removal bracket introduced in the March 2024 Budget, the marginal tax rate created for a parent with one child is 49 per cent, while for a parent with two children it is 53 per cent and 58 per cent for a parent with three children.

Graduates will also need to think about any student loan repayments, which can add an additional 9 per cent to their income tax rate. 

The biggest tax vs benefits cliff edge is the 30 hours per week childcare scheme, where after £100,000 all free hours are lost. 

Critics argue that high marginal tax rates act as a disincentive to work, which in turn leads to lost economic growth and tax revenue.

Frozen thresholds, fiscal drag and stealth tax

The freeze on income tax thresholds has created a colossal stealth tax raid in recent years and raked in large sums for the Treasury.

For tax allowances and thresholds to maintain their real value, or affect a consistent proportion of the working population, they need to rise with inflation or wage growth.

If they do not increase with inflation, then the amount people can earn tax-free, or at lower rate tax bands, falls behind the rising cost of living.

Meanwhile, if the allowances and thresholds don’t rise with wages, then they start to target a different slice of the working population.

This process is known as fiscal drag and as wages tend to rise over time, it means that more low earners are caught in the tax net and the number of taxpayers in higher rate bands increases.

Fiscal drag has hit low and high earners in the UK over recent years.

The frozen basic rate threshold, currently £12,570, drags more people into paying income tax and means that the real value – adjusted for inflation – of the tax-free allowance has been diminished.

Stalling the higher rate threshold at £50,270 has shifted more people and a greater slice of earnings into the 40 per cent bracket.

Meanwhile, the £100,000 threshold at which the personal allowance starts to be taken away has not been increased after its introduction 15 years ago. If it had risen in line with inflation, it would be £153,000 now.

Fiscal drag was affecting the additional rate level, which was stuck at £150,000 for many years, but it was then actually cut to £125,140 in April 2023, creating many more 45p taxpayers.

A report by the IFS found that by the 2027/28 tax year 8.9million taxpayers will pay higher rate taxes, compared to 7.4million now and 3.2million when the Conservatives came to power in 2010.

The think tank said frozen thresholds were the equivalent to adding 6p per pound to both the basic and higher rates of income tax.

Pensioners are also stung by frozen thresholds, in large part thanks to the triple lock, which ensures that the state pension rises in line with inflation, earnings or 2.5 per cent. 

The freeze on the personal allowance means that many pensioners receiving the full state pension with some private pension income on top could be liable to pay income tax.

The stealth tax freeze to thresholds also hits savers, dragging more of people’s savings interest, dividend income and capital gains into tax.

Who pays the most tax?

Income tax is progressive, so higher earners pay more but the effects of fiscal drag mean that tax receipts have become increasingly heavily weighted towards those with bigger incomes.

A House of Commons Library report in May 2024 highlighted this, stating: ‘Income tax payments are concentrated amongst those with the largest incomes. The 10 per cent of income taxpayers with the largest incomes contribute over 60 per cent of income tax receipts.’

According to the IFS, the top 1 per cent of income taxpayers accounted for 28 per cent of all income tax paid.

What other tax allowances are there? 

There are a number of other income tax allowances that can be claimed.

Under Marriage Allowance, you can transfer £1,260 of your personal allowance to your spouse or civil partner. The lower earner must normally have an income below the standard personal allowance to benefit from this.

The Blind Person’s Allowance is an extra £3,070 in the current tax year, added to the personal allowance.

The trading allowance means the first £1,000 of income from self-employment isn’t taxed.

Those with rental income also have a £1,000 tax-free allowance, unless they use the Rent a Room scheme.

The personal savings allowance is the total amount of interest you can earn from your savings before paying tax: it is £1,000 for basic rate taxpayers, £500 for higher rate taxpayers and zero for additional rate taxpayers.