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Economy explainers: what is income tax?

Author: ICAEW Tax Faculty

Published: 12 Jun 2024

Political debates often discuss income tax, but what is it? ICAEW experts describe what income tax covers, how it is calculated and what the marginal rate is.

What is income tax?

Income tax is a tax payable by all individuals on their income, regardless of their age. This includes earnings from employment, profits from self-employment, property income, pension income and interest.

The government raises more in income tax than it does in any other tax. For 2023/24, HMRC estimated the total income tax liability to be £273bn - approximately one-third of the total amount of tax payable for that year.

Most income tax is paid on earnings and is collected through PAYE. Income tax is also paid through self assessment. 

Total tax payable for 2023/24 by tax
 

How is income tax calculated?

Income tax is payable if the person’s total income for the tax year exceeds their tax-free personal allowance - currently £12,570.

The personal allowance is reduced where income exceeds £100,000, and is lost entirely where income exceeds £125,140.

Income above the personal allowance is taxed by reference to which tax band it falls into. Different rate bands apply where the person lives in Scotland. For a person living in England, the rates of tax on earnings above the personal allowance are 20%, 40% and 45%.

Rates of income tax for 2024/25*
Basic rate  Taxable income up to £37,700 20%
Higher rate £37,701 to £125,140 40%
Additional rate Above £125,140 45%
*Rates apply to non-savings, non-dividend income in England, Wales and Northern Ireland.

What is a marginal rate of income tax?

The marginal rate of income tax is the percentage of tax paid on a particular slice of income. This may be higher than the headline rates of 20%, 40% and 45%. For example, the marginal rate of income tax on earnings between £100,000 and £125,140 is 60%, due to the withdrawal of the personal allowance.

Other taxes may be payable on or by reference to the same income. If national insurance contributions are included, the marginal rate of tax on income from employment and self-employment in this band is 62%.

 

Marginal tax rates
 

What is fiscal drag?

If the personal allowance and tax thresholds are not increased in line with inflation and earnings growth, more people must pay income tax, and more will pay at the higher rates. This is referred to as fiscal drag.

The personal allowance is frozen at the amount for 2021 (£12,570) – and is not expected to increase before April 2028. The Office for Budget Responsibility estimates that it would now be £15,220 had it increased in line with inflation, and that there will be around 3.7 million more taxpayers by 2028/29 due to fiscal drag.

Actual and estimated personal allowances
 

UK needs tax strategy

In its Manifesto, ICAEW sets out its vision for a renewed and resilient UK, including the need for an overarching tax strategy.

Manifesto 2024: ICAEW's vision for a renewed and resilient UK

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