The value of key tax thresholds is being eroded, as elements of the income tax system lag behind inflation.
The erosion in the values of tax thresholds is known as ‘fiscal drag’ and is a highly-effective form of stealth tax used by Chancellors from successive governments.
Fiscal drag is the result of not adjusting tax thresholds (or allowances) in line with inflation. Because incomes and values usually rise with inflation, the consequence of freezing a threshold or allowance is a real (inflation adjusted) tax increase. From the politician’s viewpoint, however, the numbers do not change so they can claim that taxes are not being increased.
Three key thresholds relating to income tax have been subject to fiscal drag:
■ High income child benefit tax charge This tax charge, introduced in January 2013, effectively claws back child benefit at the rate of 1% for each £100 of income over £50,000 (based on the higher of the two parental incomes). The £50,000 threshold has not changed since its introduction.
■ Personal allowance tapering The personal allowance is reduced by £1 for each £2 you earn over £100,000. The net result is that for each £2 of excess income, you pay tax on £3 until your personal allowance is nil. In 2018/19 that generally means an effective marginal rate of 60% (61.5% in Scotland) on income between £100,000 and £123,700. The £100,000 threshold was announced by Alastair Darling in 2009 and neither of his successors have revised it.
■ Additional/Top rate tax starting point The additional tax rate started in 2010/11 with a threshold of £150,000. Whilst it has since been reduced from 50% to 45% (or the 46% top rate in Scotland), the threshold has not increased. It would now be about 20% higher had it been CPI-linked, as would the personal allowance tapering threshold.
One way to limit the effect of these income-based thresholds is to reduce the income being measured, through tax-efficient uses of income, savings & investment. Some options include:
■ Tax-efficient financial planning You may be able to reduce your income by transferring investments to your spouse or civil partner. Even if you both pay the same marginal rate of tax, a switch could reduce your joint tax bill.
■ Change the type of income If you are a business owner, drawing more income as dividends rather than salary can help reduce taxation. However, the dividend allowance was reduced to £2,000 in April 2018.
■ Make pension contributions Personal pension contributions reduce your income for tax purposes. Because of the way the tax relief operates, you could find a 60% marginal tax rate means 60% tax relief on pension contributions.
■ Tax-efficient investments There is no income tax payable on investment income held in ISAs, and they don’t have to be declared on your tax return.
As it is early in the tax year, there is more scope for reducing your personal fiscal drag in 2018/19, with professional advice. For specialist advice please refer to a member of our team
Levels and bases of taxation and tax reliefs are subject to change and their value depends on individual circumstances.
Current tax rates and thresholds are provided on GOV.uk here
Details of the high income child benefit tax charge are available here
The tapering away of the personal allowance for high earners is detailed here
Details of the introduction of the additional rate can be found here
The calculation for the impact of inflation on the additional/top rate threshold is based on CPI data taken from here