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When George Harrison wrote the song Taxman he was complaining about a marginal tax rate of 95%. The introduction of an additional tax rate of 50% from 6 April 2010 for people earning in excess of GBP150,000 is nowhere as bad as that suffered by the Beatles, but some people may find themselves with an even higher marginal tax rate despite their income being well below GBP150,000.
The personal allowance trap
For 2011-12 the personal allowance of GBP7,475 is gradually reduced to nil where a person's income exceeds GBP100,000. The reduction is GBP1 for every GBP2 that income exceeds the threshold. Therefore, a person with income of GBP114,950 or more is not entitled to any personal allowance (GBP114,950 - GBP100,000 = GBP14,950/2 = GBP7,475). The effect of the reduction is that where a person's income is between GBP100,000 and GBP114,950 their effective marginal rate of income tax is 60% (the higher rate of 40% plus a further 20% due to the withdrawal of the personal allowance). Most people will also be paying national insurance contributions at the rate of 2%.
Directors and employees may be able to reduce the impact of this 60% marginal rate by:
In addition, there are various ways of reducing taxable profits, thus also saving national insurance contributions (2%) as well as income tax (60%). For example, a bonus could be paid to employees, and this has the attraction of not having to be paid until nine months after the end of the accounting period. Alternatively, the amount of tax saving might make it attractive to incur capital expenditure qualifying for the 100% annual investment allowance. To be effective expenditure must be made before the end of the accounting period.
The loss of tax credits
Although not strictly taxes, the working tax credit and the child tax credit are calculated using virtually the same definition of income as for income tax. The tax credit award for 2011-12 is based on a person's income for 2010-11, and any increase in the current year is ignored unless it is more than GBP10,000. Therefore, a pay rise or increase in profits of, say, GBP1,000 will not impact on a tax credits claim until the following tax year. However, the marginal tax rate applicable to the additional income can then be very high.
Most tax credits are clawed back at the rate of 41% above an income threshold which is currently GBP6,420. This applies to a couples' income rather than on an individual basis. The 41% rate of claw-back means that many families will have a marginal tax rate of 73%, and some with higher incomes will have a marginal rate of 83%.
Example of 73% marginal rate
Alex, a single person with no children, works 40 hours per week and earned GBP10,000 during 2010-11. For 2011-12 he is entitled to a maximum working tax credit claim of GBP2,710, but this is reduced to GBP1,242 (GBP2,710 - GBP1,468 (GBP10,000 - GBP6,420 = GBP3,580 at 41%)) as his income exceeds the threshold of GBP6,420. If Alex had received a pay increase of GBP1,000 for 2010-11, then his tax credit claim would instead have been reduced to GBP832 (GBP2,710 - GBP1,878 (GBP11,000 - GBP6,420 = GBP4,580 at 41%)). He has therefore lost tax credits of GBP410 (GBP1,242 - GBP832), and will also pay income tax of GBP200 (GBP1,000 at 20%) and national insurance of GBP120 (GBP1,000 at 12%) on the additional earnings. This is a total of GBP730 (GBP410 + GBP200 + GBP120), and thus a marginal tax rate of 73%.
Realistically, there is probably little that a person with this level of income can do to reduce the impact of the 73% marginal tax rate. However, they might consider it not worthwhile having the additional income of GBP1,000 if it involved extra responsibilities (for an employee) or more work (for a self-employed person).
Example of 83% marginal rate
Zoe, a single parent with two children, works 35 hours per week and earned GBP45,000 during 2010-11. She pays GBP300 per week for child care. For 2011-12 Zoe is entitled to maximum tax credits (including the family element of the child tax credit - this is clawed back at the rate of 41% once income exceeds GBP40,000) of GBP21,235, but this is reduced to GBP5,417 (GBP21,235 - GBP15,818 (GBP45,000 - GBP6,420 = GBP38,580 at 41%)). Zoe is a higher rate taxpayer, so if she had received a pay increase of GBP1,000 for 2010-11, then her tax credit claim would have been reduced by GBP410 (as for Alex), and she will also pay income tax of GBP400 (GBP1,000 at 40%) and national insurance of GBP20 (GBP1,000 at 2%) on the additional earnings. This is a total of GBP830 (GBP410 + GBP400 + GBP20), and thus a marginal rate of 83%.
A person subject to the tax credit 83% tax rate has virtually the same options as a person subject to the personal allowance trap. However, it is possible to effectively obtain even more tax relief. For example, assuming that Zoe's income is the same in 2011-12, she could have made a gross personal pension contribution of GBP1,000 in that year. Her revised income for tax credit purposes would then have been GBP45,000 (GBP46,000 - GBP1,000) since this is less than the 2010-11 income figure of GBP46,000. The pension contribution preserves tax credits of GBP410, saves income tax of GBP400, but also preserves tax credits of GBP410 for 2012-13 (as the claim for this year will be based on the income for 2011-12). The total saving is GBP1,220 (GBP410 + GBP400 + GBP410), or 122% of the actual pension contribution. The same principle applies to capital expenditure for a self-employed person, and means that tax relief of 124% (122% plus 2% national insurance) may be available.
These examples are two extremes of the tax credit system, and many people will fall in between. They will therefore earn substantially more than Alex, but still be subject to a marginal rate of 73%. The maximum saving for such people by making a GBP1,000 gross pension contribution is GBP1,020 (GBP410 + GBP200 + GBP410) or 102%. The saving on capital expenditure by a self-employed person will be GBP1,110 (GBP1,020 plus national insurance of GBP90 (GBP1,000 at 9%)), or 111%.
From 6 April 2012 an income disregard of GBP2,500 will be introduced whereby a fall in income of less than this amount will have no impact on the tax credits award. Therefore, such tax planning as outlined above will only be effective for amounts in excess of GBP2,500.
VAT registration
Is there a situation when the effective marginal tax rate on additional income is more than 100%? The answer is yes for some self-employed people who are forced to register for VAT where their income just exceeds the registration limit of GBP73,000, and they are unable to pass on the cost of registration to customers. In such circumstances the output VAT payable becomes an additional cost for the business.
Example
Michael is a hairdresser who pays income tax at the higher rate of 40%. His turnover for the year ended 5 April 2012 would have been GBP71,000, but he decided to forego three weeks of his holiday during April 2011 as he needed to save up for the deposit on a new house. His turnover therefore increased to GBP76,000 (an additional GBP5,000). To keep things simple assume that VAT registration was necessary from 6 April 2011, that it was not possible to apply for exception from registration, and that no additional costs were incurred as a result of the increase in turnover. The GBP5,000 of additional income therefore represents profit. The relevant flat rate of VAT (after the 1% discount for the first 12 months of using the scheme) is 12%.
A hairdresser will not normally be in a position to pass on the cost of VAT registration to customers by putting up prices, and will often have very little input VAT that can be recovered. If Michael uses the flat rate VAT scheme then the output VAT payable for the year ended 5 April 2012 will be GBP9,120 (GBP76,000 at 12%). This will be deducted from his turnover, so the profit for the year ended 5 April 2012 will be reduced by GBP4,120 (GBP9,120 - GBP5,000). Michael's income tax liability will therefore be reduced by GBP1,648 (GBP4,120 at 40%) and his national insurance contributions by GBP82 (GBP4,120 at 2%). The net tax cost of making an additional profit of GBP5,000 is therefore GBP7,390 (GBP9,120 - GBP1,648 - 82), which is a tax rate of 148%. This rate would have been even higher if Michael had paid income tax at the basic rate of 20%.
Unless such a move is a stepping stone to much higher income and profits in the future, it is obviously not beneficial for Michael to do the extra work. For such a person approaching the VAT registration limit it is better to simply do less work by taking more holiday, or instead working in part-time employment where any additional income will not count towards the VAT registration limit. Since registration is based on turnover rather than profit, there is no other practical way of avoiding registration.
Conclusion
Marginal rates of tax can be surprisingly high at quite low levels of income, but careful advance planning may often mitigate the effects. Unfortunately, many people will not become aware of the problem until they file their self-assessment tax returns, and then it will be too late to take any action.
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Marginal tax rates in 2010-11
By David Harrowven
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one hour of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
When George Harrison wrote the song Taxman he was complaining about a marginal tax rate of 95%. The introduction of an additional tax rate of 50% from 6 April 2010 for people earning in excess of GBP150,000 is nowhere as bad as that suffered by the Beatles, but some people may find themselves with an even higher marginal tax rate despite their income being well below GBP150,000.
The personal allowance trap
For 2011-12 the personal allowance of GBP7,475 is gradually reduced to nil where a person's income exceeds GBP100,000. The reduction is GBP1 for every GBP2 that income exceeds the threshold. Therefore, a person with income of GBP114,950 or more is not entitled to any personal allowance (GBP114,950 - GBP100,000 = GBP14,950/2 = GBP7,475). The effect of the reduction is that where a person's income is between GBP100,000 and GBP114,950 their effective marginal rate of income tax is 60% (the higher rate of 40% plus a further 20% due to the withdrawal of the personal allowance). Most people will also be paying national insurance contributions at the rate of 2%.
Directors and employees may be able to reduce the impact of this 60% marginal rate by:
- Making a contribution into a personal pension scheme. For example, a person with income of GBP110,000 will receive tax relief of 60% on a pension contribution of GBP10,000, so the actual net cost would only be GBP4,000. A pension contribution might be particularly attractive for someone approaching retirement as upon retirement 25% of the pension fund can be taken as a tax-free lump sum. This would leave in the region of GBP7,500 invested at a net cost of GBP1,500 (GBP10,000 less 60% tax relief and the 25% returned as a lump sum). To be effective for 2011-12 a pension contribution must be paid by 5 April 2012.
- Paying a gift aid donation to charity since the cost of a GBP1,000 donation is only GBP400. To be effective for 2011-12 a donation must be paid before the self assessment tax return for that year is submitted, since a claim can be made for a donation to be treated as paid in the previous tax year.
- Making full use of tax free investments such as individual savings accounts to turn taxable investment income into exempt income. To be effective, investments should be in place before the start of the tax year.
- Having bonuses paid in a different tax year. For example, an employee with a salary of GBP100,000, and who regularly receives a bonus of GBP15,000, would preserve their personal allowance for 2011-12 if the receipt of that year's bonus was delayed until 2012-13.
- Opting for additional holiday entitlement or shorter working hours instead of a pay rise.
In addition, there are various ways of reducing taxable profits, thus also saving national insurance contributions (2%) as well as income tax (60%). For example, a bonus could be paid to employees, and this has the attraction of not having to be paid until nine months after the end of the accounting period. Alternatively, the amount of tax saving might make it attractive to incur capital expenditure qualifying for the 100% annual investment allowance. To be effective expenditure must be made before the end of the accounting period.
The loss of tax credits
Although not strictly taxes, the working tax credit and the child tax credit are calculated using virtually the same definition of income as for income tax. The tax credit award for 2011-12 is based on a person's income for 2010-11, and any increase in the current year is ignored unless it is more than GBP10,000. Therefore, a pay rise or increase in profits of, say, GBP1,000 will not impact on a tax credits claim until the following tax year. However, the marginal tax rate applicable to the additional income can then be very high.
Most tax credits are clawed back at the rate of 41% above an income threshold which is currently GBP6,420. This applies to a couples' income rather than on an individual basis. The 41% rate of claw-back means that many families will have a marginal tax rate of 73%, and some with higher incomes will have a marginal rate of 83%.
Example of 73% marginal rate
Alex, a single person with no children, works 40 hours per week and earned GBP10,000 during 2010-11. For 2011-12 he is entitled to a maximum working tax credit claim of GBP2,710, but this is reduced to GBP1,242 (GBP2,710 - GBP1,468 (GBP10,000 - GBP6,420 = GBP3,580 at 41%)) as his income exceeds the threshold of GBP6,420. If Alex had received a pay increase of GBP1,000 for 2010-11, then his tax credit claim would instead have been reduced to GBP832 (GBP2,710 - GBP1,878 (GBP11,000 - GBP6,420 = GBP4,580 at 41%)). He has therefore lost tax credits of GBP410 (GBP1,242 - GBP832), and will also pay income tax of GBP200 (GBP1,000 at 20%) and national insurance of GBP120 (GBP1,000 at 12%) on the additional earnings. This is a total of GBP730 (GBP410 + GBP200 + GBP120), and thus a marginal tax rate of 73%.
Realistically, there is probably little that a person with this level of income can do to reduce the impact of the 73% marginal tax rate. However, they might consider it not worthwhile having the additional income of GBP1,000 if it involved extra responsibilities (for an employee) or more work (for a self-employed person).
Example of 83% marginal rate
Zoe, a single parent with two children, works 35 hours per week and earned GBP45,000 during 2010-11. She pays GBP300 per week for child care. For 2011-12 Zoe is entitled to maximum tax credits (including the family element of the child tax credit - this is clawed back at the rate of 41% once income exceeds GBP40,000) of GBP21,235, but this is reduced to GBP5,417 (GBP21,235 - GBP15,818 (GBP45,000 - GBP6,420 = GBP38,580 at 41%)). Zoe is a higher rate taxpayer, so if she had received a pay increase of GBP1,000 for 2010-11, then her tax credit claim would have been reduced by GBP410 (as for Alex), and she will also pay income tax of GBP400 (GBP1,000 at 40%) and national insurance of GBP20 (GBP1,000 at 2%) on the additional earnings. This is a total of GBP830 (GBP410 + GBP400 + GBP20), and thus a marginal rate of 83%.
A person subject to the tax credit 83% tax rate has virtually the same options as a person subject to the personal allowance trap. However, it is possible to effectively obtain even more tax relief. For example, assuming that Zoe's income is the same in 2011-12, she could have made a gross personal pension contribution of GBP1,000 in that year. Her revised income for tax credit purposes would then have been GBP45,000 (GBP46,000 - GBP1,000) since this is less than the 2010-11 income figure of GBP46,000. The pension contribution preserves tax credits of GBP410, saves income tax of GBP400, but also preserves tax credits of GBP410 for 2012-13 (as the claim for this year will be based on the income for 2011-12). The total saving is GBP1,220 (GBP410 + GBP400 + GBP410), or 122% of the actual pension contribution. The same principle applies to capital expenditure for a self-employed person, and means that tax relief of 124% (122% plus 2% national insurance) may be available.
These examples are two extremes of the tax credit system, and many people will fall in between. They will therefore earn substantially more than Alex, but still be subject to a marginal rate of 73%. The maximum saving for such people by making a GBP1,000 gross pension contribution is GBP1,020 (GBP410 + GBP200 + GBP410) or 102%. The saving on capital expenditure by a self-employed person will be GBP1,110 (GBP1,020 plus national insurance of GBP90 (GBP1,000 at 9%)), or 111%.
From 6 April 2012 an income disregard of GBP2,500 will be introduced whereby a fall in income of less than this amount will have no impact on the tax credits award. Therefore, such tax planning as outlined above will only be effective for amounts in excess of GBP2,500.
VAT registration
Is there a situation when the effective marginal tax rate on additional income is more than 100%? The answer is yes for some self-employed people who are forced to register for VAT where their income just exceeds the registration limit of GBP73,000, and they are unable to pass on the cost of registration to customers. In such circumstances the output VAT payable becomes an additional cost for the business.
Example
Michael is a hairdresser who pays income tax at the higher rate of 40%. His turnover for the year ended 5 April 2012 would have been GBP71,000, but he decided to forego three weeks of his holiday during April 2011 as he needed to save up for the deposit on a new house. His turnover therefore increased to GBP76,000 (an additional GBP5,000). To keep things simple assume that VAT registration was necessary from 6 April 2011, that it was not possible to apply for exception from registration, and that no additional costs were incurred as a result of the increase in turnover. The GBP5,000 of additional income therefore represents profit. The relevant flat rate of VAT (after the 1% discount for the first 12 months of using the scheme) is 12%.
A hairdresser will not normally be in a position to pass on the cost of VAT registration to customers by putting up prices, and will often have very little input VAT that can be recovered. If Michael uses the flat rate VAT scheme then the output VAT payable for the year ended 5 April 2012 will be GBP9,120 (GBP76,000 at 12%). This will be deducted from his turnover, so the profit for the year ended 5 April 2012 will be reduced by GBP4,120 (GBP9,120 - GBP5,000). Michael's income tax liability will therefore be reduced by GBP1,648 (GBP4,120 at 40%) and his national insurance contributions by GBP82 (GBP4,120 at 2%). The net tax cost of making an additional profit of GBP5,000 is therefore GBP7,390 (GBP9,120 - GBP1,648 - 82), which is a tax rate of 148%. This rate would have been even higher if Michael had paid income tax at the basic rate of 20%.
Unless such a move is a stepping stone to much higher income and profits in the future, it is obviously not beneficial for Michael to do the extra work. For such a person approaching the VAT registration limit it is better to simply do less work by taking more holiday, or instead working in part-time employment where any additional income will not count towards the VAT registration limit. Since registration is based on turnover rather than profit, there is no other practical way of avoiding registration.
Conclusion
Marginal rates of tax can be surprisingly high at quite low levels of income, but careful advance planning may often mitigate the effects. Unfortunately, many people will not become aware of the problem until they file their self-assessment tax returns, and then it will be too late to take any action.