Taxlab Taxes Explained

Income tax explained

Income tax is the single most important source of revenue for the UK Treasury. It is forecast to raise around £200 billion in 2021–22 – about a quarter of all government tax receipts.

It is levied on most forms of personal income, but each person has a personal allowance of income that can be received tax-free, and only around 60% of adults have income high enough to pay income tax. Above the personal allowance, income is split into bands that are taxed at different rates. The chart below shows the rate of tax paid on an additional £1 of income at different income levels. Some powers to adjust income tax are devolved to Scotland and Wales, and income tax rates in Scotland now differ slightly from the rest of the UK.

Savings, dividends and pensions are taxed less heavily than ordinary income. And income from employment and self-employment is subject to National Insurance contributions as well as income tax.

What incomes attract tax?

Most income is subject to income tax, including income from employment, self-employment, private and state pensions, investments and property rental. Income from certain savings products, and many state benefits, are not subject to income tax.

Money contributed to a private pension or donated to charity can be deducted from an individual’s income for income tax purposes. For example, if an individual earns £30,000 but puts £5,000 of it into a pension, then she will only be taxed on £25,000 of income (though the income later received from the pension will be taxed at that stage). The tax treatment of private pensions is discussed in more detail below.

Income tax rates, bands and allowances

Each individual has a personal allowance – currently £12,570 – of income that they can receive tax-free. Only those with incomes in excess of the personal allowance pay income tax.

Above the personal allowance, different bands of income are taxed at different rates. The current bands and their associated tax rates in England, Wales and Northern Ireland are as follows (they are different in Scotland):

Income tax rates and thresholds in England, Wales and Northern Ireland, 2021–22

The table above also shows the number of taxpayers in each band (including Scottish taxpayers). 59% of the adult population have incomes high enough to pay tax: 51% at the basic rate, 8% at the higher rate and 1% at the additional rate. Despite their vastly different numbers, basic-, higher- and additional-rate taxpayers each contribute almost exactly a third of total income tax revenue – a reflection of the concentration of income in the hands of the better-off as well as the higher tax rates they face.

The personal allowance is gradually withdrawn from individuals with incomes over £100,000 a year, creating an effective 60% tax rate on incomes between £100,000 and £125,140. In a similar fashion, families receiving child benefit have it withdrawn when the highest-income parent’s income exceeds £50,000.

If a person’s income is below the personal allowance, they can choose to transfer 10% of the full allowance to a spouse or civil partner who is a basic-rate taxpayer.

Most income tax bands and allowances increase automatically at the start of each tax year (in April) in line with inflationInflation is the change in prices for goods and services over time.Read more (as measured by the Consumer Prices Index, CPI), unless parliament intervenes. This mitigates a phenomenon known as fiscal drag, whereby income growth pulls ever more taxpayers into higher tax bands. However, a number of new thresholds introduced since 2010 do not increase with inflationInflation is the change in prices for goods and services over time.Read more in this way: these include the £150,000 threshold at which the additional rate becomes payable, the £100,000 threshold at which the personal allowance starts to be withdrawn and the £50,000 threshold at which child benefit starts to be withdrawn. As a result, the number of people affected by these high effective rates of tax has grown rapidly since their introduction.

One of the biggest changes to income tax in recent years has been a large increase, over the 2010s, in the level of the personal allowance. Since the mid 2010s, there has also been a large rise in the higher-rate threshold, following a large reduction earlier in the decade. However, the government changed direction in the 2021 Spring Budget, announcing that all income tax thresholds, including the personal allowance and the higher-rate threshold, will be frozen in cash terms at their 2021–22 levels up to and including 2025–26.

Changes in the personal allowance and the higher-rate threshold naturally affect the number of taxpayers and the number of higher-rate taxpayers – although these numbers also reflect other factors such as trends in demographics, employment and income inequality.

As shown in the charts below, the proportion of the population paying any income tax rose steadily through most of the 1990s and 2000s but fell from the late 2000s onwards as a result of the big increases in the personal allowance. Today, around 60% of adults pay income tax. Around 9% of adults pay higher rates of income tax, a share that has risen sharply since the early 1990s and that is likely to rise further with the coming freeze in the higher-rate threshold.

Savings, investments and pensions

Income from savings and investments is taxed differently from other income. Income from savings and investments held in an Individual Savings Account (ISA) is completely exempt from tax. Each individual is also allowed to receive certain amounts of interest income and dividends outside ISAs free of tax. And dividends that are still subject to tax are taxed at reduced rates. When calculating which income falls into which tax band, dividends are treated as the top slice of income, followed by interest income.

Pension income is treated as (deferred) earnings for tax purposes. Broadly speaking, income that is paid into a pension is exempt from tax, income earned within the pension fund is also exempt, but money received from the pension is taxed instead (although 25% can be taken as a lump sum free of tax). There are annual and lifetime caps on the amount that can be saved in a pension, both of which have been reduced significantly in recent years.

Devolution

The Scottish and Welsh parliaments both have the power to make certain changes to the rates of income tax within their jurisdictions. These powers do not apply to savings and dividend income, which continue to be taxed on a consistent basis across the UK.

So far, only the Scottish government has chosen to use these powers, creating a separate system of rates and bands for Scottish taxpayers.

Administration

Most income tax is deducted from income ‘at source’ by employers and pension providers through the Pay-As-You-Earn (PAYE) system and passed on to the government by them. Only a minority of taxpayers must fill in a tax return at the end of the year.

Who pays income tax?

Only 59% (about three-fifths) of adults have income high enough to pay income tax. More people than this are affected by income tax, because a higher proportion live in a family in which someone pays income tax, and a higher proportion still will pay income tax at some point in their lives. But even so, income tax reductions are poorly targeted as a way to help the poorest in society.

The schedule of rates and allowances makes income tax progressiveA tax is progressive if tax liability increases more than in proportion to the tax base, or to income.Read more, meaning that people with higher incomes pay a larger share of their income in income tax. This can be seen in the following chart, which shows that the average tax rateThe amount of tax paid as a percentage of the tax base (typically income).Read more is rising at all levels of income.

Basic-, higher- and additional-rate taxpayers each contribute about a third of revenue (as shown in the first table in this article), reflecting the concentration of income in the hands of the better-off as well as the higher tax rates they face.

The chart below is another way to see the concentration of income tax payments among those who pay income tax. It shows that, in 2020–21:

  • the higher-income half of taxpayers (the top 30% of all adults – those with incomes above £26,700) received three-quarters of the pre-tax income of income tax payers and provided over 90% of the revenue;
  • the top 10% of taxpayers (the 6% of adults with incomes above £60,100) received 34% of the pre-tax income of taxpayers and provided 61% of the revenue;
  • the top 1% of taxpayers (0.6% of adults, with incomes above £192,000) received 13% of taxpayers’ pre-tax income and provided 29% of all income tax revenue.

The chart below shows that income tax payments have become increasingly reliant on a small group of taxpayers. The top 10% of taxpayers paid 61% of all income tax in 2020–21, up from 35% in 1978–79. The share of income tax revenue contributed by the top 1% of taxpayers rose from 11% in 1978–79 to 29% in 2020–21, despite big cuts in top rates of tax in the first 10 years of that period.

The reasons for the increase have changed over time: before 2007 it was driven mainly by rising income inequality, whereas since then it has been driven more by policy choices.

Some care is needed in interpreting these figures since, as discussed above, income tax payers have been a changing proportion of the population over time. For example, during the 2010s the proportion of adults paying income tax fell as the personal allowance rose – so the top 1% of taxpayers constituted a shrinking share of the population even as they provided a rising share of the revenue.

Income tax is not the whole story, of course. While it is by far the UK’s biggest tax, it still only accounts for a quarter of revenue. The next two biggest taxes, National Insurance contributions and VAT, are much less progressiveA tax is progressive if tax liability increases more than in proportion to the tax base, or to income.Read more, while some smaller taxes such as capital gains tax and inheritance tax fall even more heavily on a small group of the very well-off.