The freeze on income tax thresholds has created a huge stealth tax raid in recent years.
While it boosts the Treasury’s coffers, it means more people than ever are being dragged into higher tax bands. This is something that the Chancellor Rachel Reeves could make even worse in today’s Spring Statement.
Recent figures from HMRC show that the number of higher-rate taxpayers ballooned 15 per cent between the 2021/22 and 2022/23 tax years, due to fiscal drag.
With the income tax thresholds set to stay in place until 2030, more people are at risk of paying more tax.
Meanwhile and increasing numbers are earning more than £100,000 and falling into the 60 per cent tax trap, where the removal of their tax-free personal allowance creates a sky-high marginal rate.
This Is Money and MailOnline’s tax calculator below shows you the rate of tax you pay, how close you are to the next bracket, and what your marginal rate and average rate are.
Your marginal rate is the income tax rate you will pay on the next pound that you earn. Your average rate is the income tax rate you pay across all income at a certain level, this is lower than headline and marginal rates, as 40 per cent and 45 per cent taxpayers will earn a chunk of money that is taxed at 20 per cent.
Stealth tax: More people than ever are being dragged into higher rate tax bands
What are the income 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
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 (your personal allowance)
- 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.
What is fiscal drag and is it hitting you?
Tax allowances and thresholds need to rise with inflation or wage growth to maintain their real value.
If they don’t, then the amount people can earn tax-free, or at lower rate tax bands, falls behind the rising cost of living.
And if those 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.
Both low and high earners are affected by fiscal drag.
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.
Keeping the higher rate threshold at £50,270 also means more people have to pay more of their salary 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 cut to £125,140 in April 2023, creating many more 45p taxpayers.
Pensioners are also stung by frozen thresholds, in large part due 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 are now 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 the tax bracket.
The 60% tax trap
Calculating tax should be relatively straightforward, but for those earning six figures it’s slightly more complicated.
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.
Every £1 earned between £100,000 and £125,140 loses 50p – ie half – of its tax-free status.
This bumps up the tax rate by half, turning the 40 per cent income tax into an effective 60 per cent rate.
Child benefit and other high marginal rates
The 60 per cent tax trap isn’t the only instance of a marginal tax rate. There are other examples 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.
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