Taxing Problem: The UK's Incoherent Tax System

Abstract

The UK tax system is incoherent. Even ignoring benefits styled as tax credits and the withdrawal of child benefit, taxpayers can face seven different marginal rates of personal tax. When allowing for the withdrawal of tax credits and child benefit, many families face very high effective marginal tax rates. For example, a single earner married couple would face an effective marginal rate of tax (including benefit withdrawal) of over 60 per cent across the income ranges: £10,000-£39,407; £50,000-£60,000; and £100,000-£120,000. This represents a severe disincentive to career progression, training and work effort and produces a complex and barely comprehensible system. Since 2010, the system of taxes on income has become more complex and the way in which the transferable tax allowance is being introduced will add another significant anomaly. Indeed, the withdrawal of the transferable tax allowance for higher rate tax payers will lead to an infinite marginal tax rate for some families. Fiscal drag has brought more people into paying higher rates of income tax over recent decades. The higher rate tax threshold has fallen by over 40 per cent relative to wages since 1979. The number of higher rate taxpayers has trebled since 1990. The Conservative Party’s pledge to increase the higher rate tax threshold in the next parliament will not stop the number of higher rate taxpayers increasing given reasonable expectations of inflation and real wage growth. The long-term objective of personal tax reform should be to move towards a simple, coherent marginal rate structure which is as flat as possible – with well-understood and automatic increases in thresholds. The four main political parties have suggested a range of changes to personal taxation for after the next general election, including: o Raising the income tax personal allowance further o The creation of a 10 pence income tax band o The creation of a 35 pence income tax band o An increase in the additional rate of income tax o Abolition of the transferable tax allowance o An increase in the higher rate income tax threshold Many of these proposals would further complicate the tax system and make it even less coherent. Increasing the top rate of tax may even lead to less revenue being generated. Instead, there are a range of steps governments could take to making the tax system more coherent: o Abolition of the savings income allowance o Significantly raising the employees’ national insurance allowance o Starting the process of integrating income tax and national insurance o Raising the higher rate income tax threshold o Abolishing the additional rate of income tax o Abolishing the withdrawal of the personal allowance at the £100,000 income level In the long term, aiming for significantly lower levels of government spending could facilitate substantial marginal tax rate cuts, and the government should aim to return to a tax system with two, or preferably one, overall marginal rates of tax on income. The benefits system should be reformed to replace most benefits by household tax allowances that depend on household size and composition with a ‘negative income tax’ being received by those households earning less than their combined allowances. This would substantially improve work incentives and end the discrimination against single-earner households and family formation in the UK tax system.