What is Income Tax?

Introduction

Welcome to the first in a series of posts looking in depth at tax and finances in the UK.

I am sure that if you have a job or run your own business you will know what income tax is at a basic level, but it is really quite an interesting topic when you start to delve more into the details. As nearly everyone will be paying income tax in some form, whether deducted automatically from your pay or not, this should be a topic close to everybody’s heart!

Income tax has a long history in the UK and because it is so ubiquitous it is also quite politically charged, with parties on both sides of the house having their own ideas about how it should be applied.

In this article we will look at the following:

• The history of income tax in the UK
• What are the tax rates today?
• How do you calculate the tax you should pay?
• How do governments increase tax without raising the tax rate?
• Why you might pay 60% tax on some of your income
• What can you do to legally pay less tax?

So without further ado, let’s get started!

The History of Income Tax in the UK

If you want to go deeply into the dates and history I can refer you to Wikipedia, they have a great in depth page explaining the History of Taxation in the UK. If we only consider more modern times then we can basically say that income tax has always been around at differing levels.

There are two main types of tax for a typical person, tax you pay when you earn money and tax you pay when you spend money. The tax burden in the UK is split between these two categories but the unique thing about income tax is that the more income you get the more tax you pay as a %. For example, if you buy a £100 TV or a £1000 TV you still pay the same 20% VAT, whereas if you earn very little you will pay no income tax, while someone else who earns more may pay 40% or more income tax. For that reason income tax is seen as a progressive tax, meaning that the highest tax burden is on those who can (in theory) afford to pay it. As the split between earning and spending taxes have changed over the years you can end up with an incomplete picture of how much tax people paid in total in the past if you just look at income tax rates.

Over the years the level of income tax has varied dramatically. The highest rate was during the second world war at 99.25%, but even up to the 1970’s the top rate of income tax was around 90%. In more recent times the rates since 1990 have remained reasonably constant with a starting rate around 20% and a higher rate around 40%. It was only in 2010 that the highest rate was raised to 50%, and even that has now dropped back to 45%. If you would like to see the details since 1990 there is a table published by HMRC here.

These headline high tax levels are of course for the highest earners, and so would not have affect the majority of the workers in the UK.

The problem with charging tax rates of up to 90% for the people with the highest income is that these people are also the ones with the most resources and motivation to avoid paying the tax. I am sure there are not many people who would willing hand over 90% of their pay to the government and continue to be motivated to generate income. This led to people looking for ways around the tax by becoming residents of countries with lower tax demands. As we will see later on there is a situation in the UK today where you can still pay around 60% tax on part of your income if you are a higher earner.

What are the Tax Rates Today?

We just started the new 2023 tax year, and today the income tax rates are:

Band	Taxable Income	Tax Rate
Personal Allowance	Up to £12,570	0%
Basic Rate	£12,571 to £50,270	20%
Higher Rate	£50,271 to £125,140	40%
Additional Rate	over £125,140	45%

What this means is that if you earn anything up to £12,570 you will pay no income tax, taking the lowest earners out of income tax altogether. If you earn more than this, up to £50,270 you will pay 20% income tax on the amount of money you earn above £12,570, not on the total amount you earn. The same applies for the higher tax bands, the tax rates only apply to that part of your income.

This demonstrates the progressive nature of income tax mentioned earlier, with the lowest earners paying little or no tax and the higher earners paying up to 45% tax on part of their income.

How Do You Calculate the Tax You Should Pay?

It is quite straightforward to make a spreadsheet to calculate the total tax but there is no need to reinvent the wheel as there are plenty of online calculators that will do it for you. The one I often use is The Salary Calculator.

As a simple example I will look at the calculation for someone earning £25,000:

• Up to £12,570 at 0% = £0
• From £12,571 to £25000 at 20% = £2,485.80
• Total income tax: £2,485.80

This is a simplified calculation and doesn’t include things like payments to a pension scheme; we will look at that in more detail later. If you are looking to calculate the tax you owe as a self employed person I would discuss it with your accountant or look at the HMRC website in more detail.

If we look at the total percentage of income tax you would pay when earning from £0 to £150,000 you get the graph shown below:

Taking into account all the tax bands, the highest percentage tax in this income range is 35.8%. As the level of income increases above £150,000 the percentage will creep closer to the additional rate at 45%.

How Does the Government Increase Taxes Without Raising the Tax Rate?

In the tax rates table, and in the graph above, you will notice that there is a part of your income that is tax free, currently this is £12,570. Historically the tax free allowance increased almost every year to take account of inflation, however this value has now been fixed by the government until at least 2028, which will lead to everyone paying more tax overall. The tax allowances since 1990 can be seen on here on the HMRC website.

Currently the official rate of inflation is around 10%, and you will probably be aware from the news of multiple strikes with demands for above inflation pay rises. Even without these high pay rises you might expect some pay increase every year, let’s say 5% so we have a figure to work with.

If you have a salary of £30,000 then today you would pay 11.6% income tax overall, or £3,486. In 5 years time, if we consider this hypothetical 5% annual pay rise, you will be earning £34,465 and all of this additional £4,465 will be taxable. This will mean that you will now be paying a total income tax around 12.7% instead of 11.6%, an increase of over 1p in every pound you earn. If you are a higher rate tax payer then the situation is worse, if you currently earn £80,000 you are paying 24.3% income tax today, compared to 27% in 5 years time. If the personal tax free allowance continued to increase every year then all or part of these pay rises would be tax free, meaning the overall level of tax would remain the same.

My comments here are not intended to be a criticism of any government or political party. Currently the UK is significantly in debt after all the support that was provided during the pandemic, and of course this does have to be paid back somehow. While raising the income tax rates could target those most able to pay, this freezing of the tax free allowance increases the tax burden even for the lowest paid in society.

Why You Might be Paying 60% Tax on Some of Your Income

There is one situation where the rate of tax for part of your income is 60%, this may come as a nasty surprise if you are not familiar with it.

The personal tax free allowance only applies fully until you earn £100,000 per year, at which point the allowance is steadily reduced at a rate of £1 for every £2 you earn over £100,000. By the time you reach an income of £125,140 the allowance is reduced to £0.

In practice what this means is that for every £1 you earn above £100,000 you pay the normal 40% income tax, but in addition to this you lose £0.50 of your tax free allowance. This loss of the tax free allowance means that for that extra £0.50 you will be taxed on you have to pay 40% income tax, or £0.20. So taken together, for every £1 you earn between £100,000 and £125,140 you will be paying £0.60 in tax, or a 60% tax rate!

If you earn over £100,000 then HMRC normally requires you to complete a tax return and you may end up paying this additional tax at the end of the year as this reduction in your tax allowance is often not taken into account as part of the tax deducted in a PAYE scheme. So, all I will say is to make sure you have some money in the bank at the end of the year!

What Can You Do To Legally Pay Less Tax?

There are a few of options available to reduce your overall tax bill, I’ll cover the ones available to most people here.

If you fall into the 60% tax problem mentioned above you might want to consider one or more of these options to reduce your income below £100,000 and avoid giving up so much of your salary!

Pay Money Into Your Pension

Any money paid into your pension benefits from tax relief, so in exchange for locking away your money until retirement you can save into your pension without paying tax on that part of your income. For example, if you earn £2,000 in one month and pay £200 into your pension then you will only be taxed on £1,800. This is done either by your company deducting it from the gross amount using something called Salary Sacrifice, or if you pay into a pension from your taxed income the government will refund the tax on that amount by topping up your pension account.

If you are saving long term for your retirement you really can’t beat a pension for growing your money, assuming you have the right low cost pension plan. For example, if you pay 40% tax on some of your income and then save it in a 5% interest account it will take 11 years before the interest on your savings gets you back to the pre-tax amount you could have paid into your pension, and that is ignoring the effects of inflation or growth of the money in your pension.

Donate Money To Charity

If you are a higher or additional rate tax payer and make gift-aid donations to a registered charity then you can reclaim the difference between the basic rate and your highest tax band. For example, if you are a higher rate tax payer and donate £1000 in a year to charity then the charity will reclaim £250 tax and you can reclaim an additional £250 of tax relief. There are certain rules about the amount you can donate, but most people won’t have to worry about it.

Overall this means that by donating to charity you are in fact helping to reduce your tax bill in addition to giving money to a worthy cause.

Job Related Expenses

If you have to purchase certain items or subscriptions to carry out your job then you may be able to claim tax relief on these purchases. Note that this is things that you NEED to buy to do your job, for example, a uniform when your employer does not provide it, or an annual fee you need to pay to be a member of a professional body so you can carry out your job (list of approved memberships here). Costs such as childcare do not count as they are not directly required for everyone to do the job, you just require them to free up your time to work.

If you do a lot of driving for work then you may be able to claim tax relief if your employer pays you less per mile than the HMRC approved rate. You can find the list of mileage rates here. For example, if you drive 3,000 miles per year for work and your employer reimburses you at 25p per mile then you can claim tax relief on the difference between the approved rate (45p/mile) and what you have received. If you are a 40% tax rate payer then this would work out as below:

3000 miles x £0.20 = £600 difference between what you received and the HMRC allowance

£600 x 0.40 (tax rate) = £240 to reclaim

Salary Sacrifice Options

Salary sacrifice is basically a reduction in your monthly pay in exchange for another benefit from your employer. Not all employers will offer the same options, but in general there are quite a few things you can purchase in this way, for example:

• Purchasing an electric car
• Cycle to work scheme
• Gym memberships
• Health insurance
• etc

The benefit of using salary sacrifice is that your gross salary is reduced, meaning you will pay less tax.

The best thing to do here is to check with your employer to see what options they can provide.

Summary

Income tax can be a complex topic, and hopefully this article has given you a good overview of what you are paying and what you can do to reduce your tax bill if you want to.

I am always interested to learn more, so feel free to leave any remarks or corrections in comments section.

In the next article in this series we will look at National Insurance, another tax on income. I will also be publishing articles on other topics such reviews of finance related books and courses, together with updates on my ongoing projects, hope to see you back here soon!