By Harry Fone, grassroots campaign manager at the TaxPayers’ Alliance
Income tax wasn’t introduced until the end of the 18th century; and at that time, it was supposed to be temporary! It was created to fund the Napoleonic wars, but over 200 years later, it is still with us. A lot has changed since the single rate of 10 per cent rate in 1799.
In England, Wales and Northern Ireland, income tax is levied at three different rates; ranging from 20 to 45 per cent. Additionally, many people benefit from the “Personal Allowance”, meaning they don’t pay income tax until their earnings meet a certain threshold. For 2021-22 this is set at £12,570, and will remain at this level until 2026 following chancellor Rishi Sunak’s recent Budget - as will the thresholds for the other tax bands.
While not technically a tax rise, thanks to fiscal drag (meaning thresholds remain the same while people are moved into them by inflation), millions will pay more tax in the coming years.
Of course, since 2010, the Personal Allowance almost doubled from £6,475. Successive chancellors have increased this, which has been a boon to many Brits and something the TaxPayers’ Alliance has very much welcomed. But after all, it also means more people not paying tax - with the remaining burden left on those who do pay. Given Rishi’s announcement of a freeze, has the time of taking people out of tax come to an end?
I spoke with the TPA’s chief executive, John O’Connell, and research fellow, Rory Meakin, to get their expert insight and what the future for income tax should be.
Harry Fone: At the budget, Rishi announced he will be freezing income tax thresholds - is this bad news for taxpayers?
John O’Connell: Any tax hike is bad news for taxpayers. Freezing thresholds has long been used as a way to claw in lots of money for the exchequer with relatively little pain for politicians, as it's not always obvious to taxpayers it's happening. PAYE can have a numbing effect: money is taken out of your pay for you by someone else, so it's understandable that when you open a payslip, you focus on the net number. It's what ends up in your bank, after all. The theory goes that tax is more painful when you have to write the cheque yourself, and watch your bank balance drop as a result.
From the Treasury's perspective, they are presumably worried that big increases in the personal allowance in the coalition years have narrowed the tax base - that they're relying on too small a number of taxpayers to contribute income tax, which is the big ticket item for receipts. Tax wonks often argue that a broad base is best, leaving room for lower and, crucially, simpler taxes. If taxes are too complicated, or the tax system is used to "pull levers'' for preferred sectors or interests, then the tax base will narrow even further.
Rory Meakin: The economic disaster brought about by the pandemic means that now is a terrible time for any tax rise, including freezing thresholds. Income tax thresholds will be frozen next year and that's too soon to start raising taxes, even if you accept that's the right way to balance the books. But ignoring that timing issue, there are two reasons why the freeze is a bad idea.
The first is that thresholds should be indexed (linked to earnings growth), not tinkered with from year to year, so that there's maximum predictability in tax. The second is that the personal allowance is at roughly the right level in relation to earnings. Someone earning the minimum wage working full time earns around £15,000 a year. The government shouldn't be taxing people on such low incomes, only to hand it back again in benefits. Much better to let people earn and keep their own money.
HF: So is the personal allowance too low, too high or just right?
JO: It's very hard to say. The big uplifts in the personal allowance came after years of fiscal drag. So perhaps the Osborne-era uplifts were a necessary corrective. There is rightly a lot of focus on the earnings required to start paying the 20p rate of income tax, but fiscal drag has had a more damaging economic impact on the number of people paying the 40p rate. In 1991, one worker in every 15 paid the higher rate of income tax - it's now one in six. The higher rate of tax is supposed to be for the best paid workers in the country, but instead it's fairly commonplace.
RM: The personal allowance is about right, or possibly a little too low. Once it's high enough to ensure those on the lowest incomes aren't taxed, then the priority should be reducing the rate. The principles behind the 'broaden the base, lower the rate' mantra are sound, but only once it doesn't mean taxing low incomes only to hand the money back again, diminishing the dignity of earned income to expand the ‘fealty’ of a handout.
That principle of not taxing the lowest incomes naturally means that the level should also rise in line with incomes. That would keep income taxes at a constant share of economic output, meaning politicians would have to explicitly raise rates or cut the allowance if they wanted to increase receipts faster than the economy was growing.
HF: You mention broadening the tax base, and that a ‘broad base is best’. What are some of the benefits and indeed downsides of doing so?
JO: It makes intuitive sense for a couple of reasons. One of those is attaching value to public services: the theory goes that if someone doesn't pay income tax then they will view public services as 'free' as opposed to zero cost at the point of use. This may also mean that service users care less about them - for instance, not bothering to show up for GP appointments. Missed GP appointments cost over £200 million a year, but if you don't pay any income tax then you don't carry the cost burden.
Another reason becomes apparent when the TPA is out on an action day. Almost always, someone will say to one of our activists "I don't pay tax". After a chat, they explain they don't pay income tax. Then we explain to them that they do pay tax more generally: when they drive, when they fill up the car, when they turn on the heating, when they get on a plane to go on holiday, when they buy a pint after work, when they buy something in the shops. If people think that they don't pay tax, why would people care about the economic damage of high taxes; when they think that "only the rich" pay tax?
RM: The quid pro quo of raising taxes on people with low incomes is that welfare would have to be increased. Beyond the fundamental problems of discouraging work and self-reliance, it's debatable whether increasing the government’s share of people's incomes in that manner will make us feel more or less connected to tax and spending.
HF: For all that said, income tax was supposed to be temporary. Is it still fit for purpose? How would you improve it?
JO: After the Budget, the chancellor tweeted about his freeports policy, saying that the zones would have "lower taxes to encourage job creation". Rory rightly pointed out "if lower taxes encourage job creation, what do higher taxes encourage?" Higher income taxes suppress the incentive to earn more money.
But it's the biggest source of revenue for the Treasury, bringing in £194 billion in 2019-20. So it's not going anywhere. Making it fit for purpose - well that would involve abolishing national insurance, after having wrapped it into income tax in stages.
RM: Income tax is too messy and complicated, but the problem is much wider than that. It's with taxes on income in general rather than income tax specifically. Both employee and employer national insurance, capital gains tax, corporation tax and inheritance tax are all taxes on income. They all need to be rethought from first principles, which the TPA did with its landmark Single Income Tax project and report, with a far simpler, more transparent and less distortionary replacement.
The biggest problems with income tax lie with how it works at higher incomes. But for those on lower incomes, national insurance (really just another pair of income taxes with a frankly deceitful name) is the more pressing concern.
In conclusion
As John and Rory explain, the freezing of tax thresholds is detrimental to taxpayers - especially when you also consider the sustained tax burden is at a 70-year high. Linking the Personal Allowance and thresholds with wage growth would help to avoid fiscal drag and ensure a better deal for millions.
As with many taxes, the system needs radical overhaul. As Rory touches on and we have long argued, employee national insurance and income tax should be merged. This step alone would be a big step forward in the economy’s recovery from the pandemic.