Why The Treasury Cannot Count! - ANDREW DUGGAN corrects the official line with marginal rates of tax.

Why The Treasury Cannot Count!
ANDREW DUGGAN corrects the official line with marginal rates of tax.
I SAW A little gem in Hansard recently, and it seemed that the record should be put straight on the point. What better place is there to do so than in the columns of Taxation!?
A simple answer
The beleaguered Dawn Primarolo recently gave the following written answer, according to Hansard for 15 November 2000 (Vol 356, No 160, Col 712W).
'Mr Willetts: To ask the Secretary of State for Social Security how many families will be subject to a marginal rate of income tax of more than 40 per cent during the period that the Children's Tax Credit is withdrawn from them.
Dawn Primarolo: I have been asked to reply.
The highest rate of income tax is 40 per cent.'
The Treasury gets its sums wrong
On the face of it, what Ms Primarolo is saying is perfectly true, which raises the question of why this query was made. The answer is that although the highest rate of tax may be 40 per cent, this does not mean the highest marginal rate is 40 per cent.
We may have finally escaped from the lunatic position where an employee paid £63 per week received £63 per week, while an increase in salary of just £1 would leave him with just £62.72 after National Insurance contributions – a marginal tax rate of 128 per cent! There are still potential pitfalls however, and as will be demonstrated here various marginal rates of tax are indeed higher than 40 per cent.
Children's tax credits
Looking first at the Children's Tax Credit, this is given in full on incomes up to the higher rate threshold. Thereafter it reduces on a sliding scale of £1 in benefit for every £15 income. Since the maximum benefit is £442, it is thus reduced to 'nil' on incomes exceeding the limit by £6,630. Example 1 shows the impact of this as the taxpayer goes into the higher rate of tax.
Example 1
(1) Salary (after personal allowance)
£28,000
Tax for 1999-2000:
£1,500 at 10 per cent £150
£26,500 at 23 per cent £6,095
Tax due £6,245
Less children's tax credit 442
Tax due £5,803
(2) Salary (after personal allowance)
£34,000
Tax for 1999-2000:
£1,500 at 10 per cent £150
£26,500 at 23 per sent £6,095
£6,000 at 40 per cent £2,400
Tax due £8,645
Less children's tax credit £42
Tax due £8,603
With the taxable income of £34,000, children's tax credit is restricted to £442 – (6000/15) = £42.
As Example1 shows, further tax of £2,800 is due on income of £6,000 – a marginal rate of 46.67 per cent.
Investment income
Another area where marginal rates cause problems is that of dividends slipping into and out of higher rates as Example 2 shows.
Example 2
Salary (after personal allowance)
£25,000
Dividend £4,000
Tax due for 1999-2000
On salary £1,500 at 10 per cent £150
£23,500 at 23 per cent £5,405
On dividend £3,000 at 10 per cent £300
£1,000 at 32.5 per cent £325
Net tax due £6,180
Salary (after personal allowance)
£26,000
Dividend £4,000
Tax due for 1999-2000
On salary £1,500 at 10 per cent £150
£24,500 at 23 per cent £5,635
On dividend £2,000 at 10 per cent £200
£2,000 at 32.5 per cent £650
Net tax due £6,635
In Example 2 the only difference in income is a £1,000 increase in salary. The tax effect is £455 – a marginal rate of 45.5 per cent.
An unpleasant combination
So what happens if both of these effects are combined? Example 3 picks up the tax figures from Example 2 and completes the picture with figures for children's tax credits.
Example 3
Tax due as in Example 2 £6,180 £6,635
Less children's tax credit
442-(1000/15) 375 442-(2000/15) 309
Net tax due £5,805 £6,326
As Example 3 shows, the further tax due is now £521 – a marginal rate of 52.1 per cent. If this were a real case, involving the owner of a small company, he would benefit from receiving a pension contribution from the company instead of a salary hike. When employer and employee National Insurance contributions savings are taken into account, there would be effective tax relief at the rate of around 75 per cent.
So the real answer to the question by Mr Willetts is that the highest rate of income tax is 40 per cent, plus the special children's tax debit of 6.67 per cent for taxpayers with children, plus the special investment income surcharge of 5.5 per cent for taxpayers with dividends. National Insurance, of course, is not a tax. This is indeed fortunate, because in the above example there would have been a marginal tax rate of 62 per cent, and this would never do under our current régime of low direct taxation.
Andrew Duggan is a tax consultant for Wright Vigar and Co, and can be contacted on 01522 531341 or by e-mail at andrew@wrightvigar.co.uk.
 

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