Real income tax rates are not progressive, nor are they as published. When stealth taxes are applied, the highest marginal rates can reach over 70% or more, which is well above the supposed top rate of 45%. And these punitively high marginal tax rates take effect well before the £150,000 threshold for the top rate.
Limited company contractors are able to mitigate some of the impact of stealth taxes because they can be flexible in how and when they pay themselves, although they can’t mitigate it all. But employees can’t do anything about it, so it is a wonder that there are not many more employees who choose to go contracting.
The table below shows us the published rates of income tax, starting with the basic rate of 20%, through 40% as an employee earns progressively more, and ending with the top rate of 45%.
| Band | From | To | Rate |
|---|---|---|---|
| basic rate | 0 | 31865 | 20% |
| higher rate | 31866 | 150000 | 40% |
| additional rate | 150001 | 45% |
Note that these are the published rates, and the percentages we all hear used by politicians and civil servants in the media, and during occasions such as the Budget. They are rates that most of us are familiar with. And they seem straightforward enough.
But these rates aren’t real. There are times when an employee could be paying a marginal rate that is as high as 60%, when stealth taxes are applied. The table below shows real income tax rates incorporating stealth taxes.
| Band | From | To | Rate (2 children) |
|---|---|---|---|
| basic rate | 0 | 31865 | 20% |
| higher rate | 31866 | 50000 | 40% |
| Child tax | 50001 | 60000 | 57.71% |
| higher rate | 60001 | 100000 | 40% |
| Reduction rate | 100001 | 150000 | 60% |
| additional rate | 150001 | 45% |
The stealth taxes that result in such a high marginal rates include the child tax, removing child benefit from those earning over £50,000 a year, and the reduction rate, that takes away a taxpayer’s personal allowance by £100 for every £200 that they earn above £100,000.
The above example is for a family with two children, and shows that the child tax marginal rate between £50,000 and £60,000 is 57.71%. If a family is receiving child benefit for a single child, the marginal rate between annual earnings of £50,000 and £60,000 is 50.66% - less than 57.71% but still well over both the higher and top rates.
A family with three children fares even worse, with a marginal rate of 64.75% on earnings between £50,000 and £60,000. For a four children family, the marginal rate is a crippling 71.80%.
Think about an employee on £110,000 with four children – a marginal rate of 71.70% between £50,000 and £60,000 and a marginal rate of 60% between £100,000 and £110,000.
Fortunately, limited company contractors have the flexibility to mitigate or remove the impact of these stealth taxes. For example, they can choose to income split with a spouse, so that neither parent earns above the £50,000 a year threshold of the child tax.
Or they could choose not to pay themselves over £100,000 one year, and pay extra the following year so the reduction rate only kicks in every other year. Both of these measures can save a contractor thousands of pounds in income tax.
But employees have no such options. They are forced to pay these stealth taxes that give such high marginal rates. Contracting must seem like a much more attractive option for those employees who have the right blend of skills, and their marginal rate of tax can also be a great source of motivation.