A nasty stealth tax

It has become common, in recent decades, for Chancellors to promise (in one way or another) not to raise certain tax rates, only to bring in (with much less fanfare) other effective tax rises. We have got used to the freezing of allowances and tax bands in recent years (which brings a greater proportion of your income within the charge to tax and, potentially, within higher tax bands) but there have been many other examples. George Osborne restricted tax relief on the finance costs of residential landlords, often increasing their tax bills significantly, while, in 2016, he changed the method of taxing dividends and, in the process, effectively raised dividend tax rates by about 7.5 percentage points.

Prior to that, Alistair Darling had introduced the phasing out of the personal tax-free allowance (which is currently £12,570) as someone’s ‘adjusted’ income rises above £100,000. The effect of this is currently that, over a range of income up to £125,140, the individual suffers a marginal rate of tax of 60%, before it drops down to 45%, the official top rate. (Note that, for Scottish taxpayers and those with dividend income in this band, the same effect applies, but the marginal tax rate will differ from 60%.)

The £100,000 starting threshold for this abatement has not changed since these rules were introduced 16 years ago, at which point the figure represented over 4 x average earnings. Now, it is more like 2.5 x average earnings, so many more people are affected by it. When you add 2% Employee NICs and a 9% student loan repayment rate, the marginal rate for many individuals now reaches 71%.

The childcare cliff edge
The introduction of the ‘Tax-free Childcare’ scheme a few years ago has made the situation worse for many families. This support (£2,000 p.a. per child or £4,000 p.a. for a child with a disability) has a hard cut-off at £100,000 of income. Above this level, no support is given.

This produces anomalous results. For example, a family with three children loses £6,000 of support if either parent earns even one pound above £100,000. Thus, they could be worse off if they get a promotion and their salary rises from, say, just under £100,000 to £115,000.

Labour market evidence shows that many people are choosing to work fewer hours or decline overtime, where their extra income is going to be hit for these high tax rates. What can you do about it if you, or your staff, are affected by this problem? Here are some suggestions.

1. Owner-managers of companies have the option of controlling salary and dividend levels to keep income below £100,000, as long as this level of income will meet their personal spending needs.
2. For employees and employers, options include:
• Increasing pension contributions to reduce adjusted income. This is less attractive if the individual needs the cash now, but still preferable to paying high marginal rates.
• Making charitable contributions, which can reduce adjusted income.
• Negotiating a different remuneration package, to including benefits that are lightly taxed (e.g. electric vehicles) or untaxed (e.g. additional training).
• Deferring income into a new tax year.
• Using tax advantaged share schemes, which can reduce current tax liabilities while providing long-term incentives.

Individuals caught in this tax trap must understand their position clearly, while their employers need to be flexible in how they structure remuneration packages.

We can help you analyse the tax effect of working extra hours if you think you are likely to be affected by these high marginal rates, as well as helping employers decide on tax-efficient remuneration strategies, so please get in touch with the JRW Hogg & Thorburn team.