Contractors and other taxpayers earning over £50,000 with children who are caught in the withdrawal of the Child Benefit trap, or those earning over £100,000 and suffering from having their personal allowance taken away are simply not paying progressive tax rates.
In fact, when you analyse the marginal tax rates of contractors caught in these traps, the marginal rates soar to between 50.66% and, in a potentially extreme example, over 100%. Not only is this not progressive, but the processes underpinning these punitive marginal rates are the total opposite of any kind of tax simplification agenda.
We should have marginal tax rates that are progressive, increasing in line within increased earnings. Instead, and only because of cunning plans devised by the Treasury to make it appear that there has not been an increase in income tax, we have a tax landscape that resembles the Alps – all jagged peaks.
The first chart below shows us the marginal rate of a contractor, or any taxpayer, who has a single child. The marginal rate remains at zero through the personal allowance to £10,000, then rises to the standard rate of 20%. At the ridiculously low level of £41,865 it increases to the higher rate until the contractor’s earnings reach £50,000, when it shoots up to well above the highest rate of income tax, and stays there until earnings reach £60,000.
This is what happens when a contractor with one child earns over £50,000. And then, if you look further along the graph, you can see when earnings increase to £100,000, the personal allowance is withdrawn, the marginal rate leaps again to 60% for the next £20,000 of earnings. Finally, 45% kicks in when earnings top £150,000 per year.
If you look closer at Child Benefit, and how it is calculated, it quickly becomes clear that the more children you have, the higher your marginal rate on earnings between £50,000 and £60,000.
That’s because Child Benefit is progressively withdrawn from families when one earner in the household earns over £50,000. For every £100 earned over £50,000, child benefit is reduced by 1%, giving you a straight-line reduction between £50,000 and £60,000.
the first chart shows you that a family with one child pays a marginal rate of 50.66%. A 50% tax rate on someone earning only £50,000 is pretty appalling. But it gets worse, because the effective marginal rate depends on the number of children a contractor has. The greater the number of kids, the larger the amount of Child Benefit that needs to be clawed back.
The second chart below shows you what happens to a contractor’s marginal rate who has two children. Compare this with the first chart, and you’ll see the marginal rate has shot up from that pretty appalling 50.66% to a shocking 57.71%.
It gets worse. Contractors with three children pay a marginal rate of 64.75% on their earnings between £50,000 and £60,000, and for those with four children, it increases to 71.8%. In theory, in an extreme example, a contractor with eight children or more is paying an effective marginal rate of 100% or more.
To add insult to injury, contractors who then breach the £100,000 a year ceiling face a further leap in their marginal rate. From £100,000, the personal allowance is withdrawn at the rate of one pound for every two pounds that the contractor earns over £100,000.
This was another fudge dreamed up during the final years of the Labour administration to hit the highest earners, alongside the then 50% top rate of tax. Again, despite the marginal rate leaping to a shocking 60% between £100,000 and £120,000, it could be claimed that technically the income tax rate has not been increased.
The 45% top rate of tax that does actually lead to a marginal rate of 45% is almost a relief for any contractor in that earning band.
What these graphs show is that the UK income tax rates are far from being progressive. But, because it is perceived that somehow £50,000 is a lot of money to earn, no fuss is made when those contractors and other taxpayers with children who are earning it are punished with a highly complex, illogical and punitive tax rate.
Wouldn’t it be simpler to just not give child allowance to households that have someone earning over £50,000? Or are there too many political obstacles in the way of that tax simplification measure?
These examples further illustrate that simplification of the UK’s taxation of income is desperately in need of reform. But sadly, it is unlikely that we will see a political administration with the courage and determination to grasp this particular nettle.