Philip Booth: The UK's tax system punishes work, training, family formation and saving

Professor Philip Booth is Editorial and Programme Director of the Institute of Economic Affairs.

If one were to set out to design a malfunctional tax and benefits system from scratch you would probably end up with what we have in the UK. As such, the Taxpayers’ Alliance new publication “The Single Income Tax” is extremely useful.

It is worthwhile examining just how bad the tax and benefits system is today by taking the simplest possible case – note, the simplest possible case – of a couple with three children not claiming Housing Benefit, Council Tax Benefit or assistance with child-care costs (or a host of other ad hoc benefits that are available).

The couple will receive total benefits of £13,275 assuming that they undertake 30 hours work a week between them. These benefits are then withdrawn at a rate of 41 pence of benefit for every pound earned over £6,420 until the household income level reaches £38,798. It is assumed that this is a single-earner household (the tax and benefit position in reality depends on the way in which earnings are split between the two persons in the couple). The first point to note is that this couple receive the basic means-tested benefit until their income is almost £39,000.

National Insurance contributions – once a tax that could be understood by any self-respecting A-level school leaver, but which now cannot be understood without a PhD - begin at £7,592 a year at the rate of 12% and continue at that level until earnings reach £42,484 (£42,475). At that point they decrease to 2%. This only includes the employees’ element.

Income tax is paid at 20% on earnings from £8,105 to £42,475 at which point income tax increases to 40% (the difference between the earnings level at which National Insurance is reduced and that at which income tax increases arises due to rounding error because of the different way the two taxes are calculated – as such the figure in brackets is used for National Insurance in the calculations below: it is a bit simpler than it looks, for a change).

This means that, from an earnings level of about £8,000 a year to a level of about £39,000, the couple suffer tax, National Insurance and the problems caused by the withdrawal of means-tested benefits. Remarkably, the couple then only have a slice of earnings of around £10,000 during which they can breathe a sigh of relief before they are back in the spaghetti bowl of benefit withdrawal once again.

The reason for this is that child benefit is withdrawn when the income of the highest earner reaches £50,000. Note that this is not based on the earnings of the couple like all other aspects of the benefit system, or earnings of the individual like most aspects of the tax system, but on the earnings of the highest earner within the couple! There is no rationale to this at all. The net result will be that our couple with one person earning over £50,000 will suffer a loss of 25% of every additional pound that they earn in addition to higher rate tax and National Insurance contributions – a total tax and benefit withdrawal rate of 67%.

Having reached an income of £60,000, the family can then relax, having escaped the complexities of the benefit system and will be paying tax and National Insurance at a combined rate of 42% until earnings reach £100,000. At this point, the personal tax allowance is withdrawn and the couple suffer a 62% tax rate until earnings reach £116,210 at which point life becomes simple again.

Earnings above £116,200 are taxed at 40% (with the addition of 2% National Insurance) making a marginal rate of 42% until earnings reach £150,000 at which point income taxes rises to 45% and the total to 47%.

In summary, the position looks like this with the second column showing the disincentive the couple face when they wish to try to earn an extra pound of income.

Earnings band	Total marginal tax and benefit withdrawal rate	Income tax	National insurance	Benefit withdrawal
£6,420-£7,592	41%	0%	0%	41%
£7,592-£8,105	53%	0%	12%	41%
£8,105-£38,798	73%	20%	12%	41%
£38,798-£42,475	32%	20%	12%	0%
£42,475-£50,000	42%	40%	2%	0%
£50,000-£60,000	67%	40%	2%	25%
£60,000-£100,000	42%	40%	2%	0%
£100,000-£116,200	62%	60%	2%	0%
£116,200-£150,000	42%	40%	2%	0%
£150,000+	47%	45%	2%	0%

What is shocking about this picture is both the size of the marginal rates faced by couples with children and their complete incoherence. Certain differences can be justified, for example where benefits are withdrawn or where National Insurance has a different function from income tax. However, several of these marginal rates exist because of simple political expediency.

Unfortunately, this is really the beginning of the story and not the end. To simplify, I have omitted Housing Benefit, Council Tax Benefit student loan repayments, employers’ National Insurance contributions and indirect taxes. Together these might feasibly reduce the retained income for an individual to not much more than 20% of any increase in pay over much of the income spectrum and to 3% over part of the income spectrum (for about 750,000 households).

There are certain consequences that arise from this situation, all of which are highly undesirable:

• In order to earn a decent living that is significantly above the amount one can receive on benefits from doing no work at all, it is necessary to go very far up the income scale – to £30,000+.
• A couple can reduce their tax bill or increase their benefit receipts dramatically by splitting up (or, more likely not committing to each other in the first place) or by both of them going out to work.
• Education, upskilling, promotion and so on are basically a waste of time for those in the bottom half of the earnings distribution unless it will take you into the top half of the earnings distribution.
• The new student loan system penalises success and rewards failure and will exacerbate these problems right up the income scale – as do the reforms to child benefit.

Unfortunately, nothing that the government has proposed so far has begun to address these problems – though there are rumours about better things to follow. The message is simple, though: if you want to create a society that punishes work, training, family formation and saving then just follow the UK model. If you want to see the results, look around you.