Beware the stealth tax trick! It can be worse than a tax hike

From tax cuts for everyone to sneaky tax hikes for years to come, it’s been quite six weeks for our financial outlook.

On September 23, Kwasi Kwarteng rolled out his shock and awe mini-Budget and while he managed to shoot himself in the foot with his 45p tax cut overshadowing an income tax cut for everyone, he did present us with a base rate cut from 20p to 19p .

With Kwasi and his boss Liz Truss gone, Chancellor Jeremy Hunt and Prime Minister Rishi Sunak are eager to show the world that they are the sensible adults in the room.

That meant not only shredding those short-lived tax breaks, but some targeted pitch-rolling ahead of the November 17 autumn statement about plugging a so-called £50bn black hole with stealth tax hikes.

This doesn’t qualify them as particularly subtle, but they do include the classic stealth tax move of freezing income tax thresholds so that more people get dragged in.

Threats of a capital gains tax and a dividend tax hike are also circulating and likely to spark more anger, but it’s the stealth income tax raid that would affect more people.

You can see why Chancellors like it. Even when it’s obvious that it’s happening, stealth taxation sounds so much tastier than a tax hike, but it’s often worse.

And it’s worth noting that even as he handed out tax cuts left right and center, Kwasi also pulled this trick.

His cut in the base income tax rate would have put an extra penny of every pound earned in the pockets of taxpayers, but freezing the thresholds at which tax rates kick in offered the opportunity to recoup more from their wage increases.

The most anyone could save from the proposed 19p base rate cut was £375 (split across the £37,500 base rate band), but if your pay rise is bumped up by a higher tax rate it could quickly cost more than that.

If you don’t increase the personal deduction with inflation or pay and subtract more of people’s income into the base tax rate, they’ll pay 20 percent on an extra pound earned.

Meanwhile, if you don’t raise the higher tax threshold, people will lose 40 percent on every extra pound earned above it (though that’s instead of 20 percent).

This is what is known as a tax impediment and it can often surprise people how powerful the effect can be on the amount of their earnings they are allowed to keep.

For example, it has now dragged a record 7.7 million people into the 40 percent tax bracket.

Meanwhile, as I will explain later, it has also pushed more people into the most inconvenient parts of our tax system, where the loss of child support of more than £50,000, or the personal deduction of more than £100,000, can lead to an effectively marginal tax rate of 60 euros per year. cent.

How stealth taxes eat your pay rise

Here’s how the numbers work with someone getting a 5 percent pay raise, the current average according to the most recent ONS numbers.

If someone equals the higher tax threshold of £50,270 and gets a 5 percent pay rise, his salary will increase by £2,315.50.

If the higher tax threshold goes up by 5 percent in line with the average wage, they pay only 20 percent income tax, handing them over £502.60.

But if the threshold is frozen, their entire pay rise will go into the 40 percent tax bracket and they will hand over £1,005.40.

This is the difference between keeping £2,010 or £1,508 of that pay increase.

And the problem with long-term tax barriers is that as the effect grows over the years, wages are (hopefully) steadily increasing, adding increases to previous increases, but frozen thresholds eat them further.

The silver lining is that at least the personal allowance has increased in real terms over the past 12 years, from £6,475 in 2010 to £12,570 now.

This has more than kept pace with consumer price index inflation – if it had risen in line with that, it would have been £8,961.

But that does illustrate that 41 percent of the seemingly generous increase in personal allowance is simply due to the rise in the cost of living.

The tax threshold for a higher rate has also risen, from £43,875 in 2010, but it has not kept pace with inflation. If the tax level of 40p had increased with the cost of living it would come out not at £50,270 but at £60,724.

But 40 per cent isn’t really Britain’s top tax rate, nor is the 45 per cent charged to the highest earners above £150,000, instead that dubious credit goes to the effective rates caused by tax fraud policies for those who pay less. to deserve.

The abolition of child support for households where either parent earns more than £50,000 means an effective marginal tax rate of 51 per cent if they have one child, or 59 per cent if they have two children.

Meanwhile, abolishing the personal deduction above £100,000 at the rate of 50 pence for every additional pound earned raises the effective marginal income tax rate to 60 percent.

Once the personal allowance is just above £125,000, the marginal rate falls back to 40 per cent before rising to 45 per cent above £150,000.

If the level at which child support is abolished since the system was introduced in 2013, had risen in line with inflation, it would be £62,500 instead of £50,000.

But top marks for tax barriers go to the £100,000 personal deduction removal threshold, which, had it risen in line with inflation since Alistair Darling conceived the idea in 2019, would now be £142,000.

You can see why Chancellors love this squeak – and the bad news is that Rishi and Jeremy are rumored to now want to freeze tax thresholds until 2028.