Patricia Mock and Sally Campbell, co-authors with Bill Dodwell of a recent Tax Law Review Committee discussion paper, consider a range of principles to help inform future tax policy.
Thresholds are an integral part of the tax system. They apply to exempt some taxpayers from a charge; define when tax is levied, or a higher rate applies; or define when an allowance or other benefit is withdrawn. Thresholds can define administrative savings (those with income, gains or sales below a threshold may not need to register and comply with a tax or may be able to file in a simpler way). Yet thresholds also present challenges for taxpayers. Going over a threshold may result in very high tax costs, as well as administrative costs and burdens.
The Tax Law Review Committee, a committee within the Institute for Fiscal Studies (IFS), has recently published a paper, Thresholds in the Tax System, to discuss the difficulties in the main tax threshold rules as they affect individuals and small businesses, and to consider a range of principles that might assist in the design of tax policy in the future. The paper focuses on the additional thresholds layered onto the basic system, such as the tapering of the personal allowance for incomes of more than £100,000.
The paper puts forward seven general recommendations and four specific recommendations (covering VAT, pensions, savings and childcare) for policymakers to consider. Some of the recommendations made are discussed in this article.
There should be a periodic review of thresholds, say every five years
The paper makes the distinction between thresholds that cause higher marginal rates (such as the tapered personal allowance and high income child benefit charge) and those where exceeding the threshold means that the taxpayers are worse off overall, such as exceeding the VAT threshold (typically) and exceeding the income limit for tax-free childcare. It recommends that this second type of threshold should be avoided due to the potential for economic barriers and unfairness. The paper makes the same recommendation regarding very high marginal rates, as they too present barriers to economic growth.
The paper also recommends that there should be a periodic review of thresholds, say every five years. This should not prevent governments freezing thresholds if that is their policy choice, but it is important that this be considered, and a note of the increasing numbers affected published where the limit is not increased.
Administrative thresholds are also important and, while it is good to minimise burdens, sometimes it may be easier to supply information as part of a tax return rather than as part of a compliance enquiry.
Income tax and childcare
The main thresholds for income tax are the £100,000 income threshold, which affects both the level of personal allowance and aspects of child support, and the £50,000 (increased to £60,000 for 2024/25 – see below) income threshold over which child benefit is clawed back by means of the high income child benefit charge.
Personal allowance withdrawal
The personal allowance is gradually withdrawn when adjusted net income exceeds £100,000. This gives an effective rate of income tax of 60% on income between £100,000 and £125,140 (2023/24 rates, excluding Scotland). It may be possible to reduce adjusted net income by making pension or gift aid contributions or possibly by incorporating a self-employed business. While there is anecdotal evidence of pension contributions being made in these circumstances, HMRC figures do not show this in practice. The £100,000 limit has been in force since 2010 and raised £4bn in 2020/21.
Possible changes to reduce this spike in marginal rates will need to consider both the cost to the government and how taxpayers would be affected. A basic rate reducer is one possibility, so that at current levels all taxpayers would receive a tax reduction of £12,570 at 20%, ie, £2,514. While this would reduce tax for those with income between £100,000 and £125,140, it would increase it for other higher rate taxpayers, so there is no easy solution.
Childcare support
The threshold income for ceasing eligibility for tax-free childcare is also £100,000. This gives a government contribution of 25% of sums deposited by the taxpayer into a childcare account, up to a maximum annual contribution of £2,000. Both parents need to be working, earning more than £2,167 per quarter, and neither must earn more than £100,000. If they do, they cease to be eligible for the support. There is no tapering; this is an immediate reduction of £2,000.
At the same time, eligibility for free nursery hours for three- and four-year-olds is reduced from 30 to 15 hours per week, and parents will not be eligible for the free nursery places for younger children gradually being rolled out – again this is a cliff edge where exceeding the limit makes parents immediately poorer.
The combined effect of these three withdrawals creates an almost insurmountable barrier, where any parent increasing their income over £100,000 finds their household to be much more worse off. This is a massive disincentive to increase earnings over this level.
The IFS has noted that a parent with two children under three whose childcare provider charges England’s average hourly rate for 40 hours per week would, after these reforms, find that their disposable income (ie, earnings net of tax and childcare outgoings) falls by £14,500 if their pre-tax pay crosses £100,000. Disposable income would not recover its previous level until pre-tax pay reached £134,500, meaning a parent earning £130,000 would be worse off than one earning £99,000.
High income child benefit charge
As is fairly well known, this charge (introduced in 2013) claws back child benefit payments in households where the higher earner has income of more than £50,000. The clawback is on a sliding scale over a £10,000 income band up to £60,000. As child benefit payments depend on the number of children in the family, the clawback rate also depends on the number of children. At 2023/24 rates, this means that an employed individual has an effective tax rate (including national insurance contributions (NIC)) in the band of 54% (one child) increasing to 71% for three children (different rates apply to the self-employed as NIC rates are lower; also the higher rate threshold is £50,270 so lower rates would also apply in the band £50,000 to £50,270). Even higher effective rates can apply if there are student loan repayments or withdrawal of universal credit. It could be argued that this rate is too high and is a disincentive to work. The paper recommends that a single taper rate should be applied, irrespective of the number of children.
The recent Budget contains proposals to increase the threshold to £60,000 and the taper range to a £20,000 band meaning that, from 2024/25, families where both earners have incomes of less than £80,000 will still receive some child benefit. The effective tax rates (including NIC) for 2024/25 will be 49% (one child) increasing to 57% for three children.
This change is welcome and is estimated to take 170,000 families out of the charge. However, in order to tackle perceived unfairness in the way the charge operates, there are plans to administer it on a household basis rather than an individual basis, from April 2026. Details will follow in a consultation, but there will be significant additional complexities in such an approach.
VAT
The threshold at which businesses need to register for VAT has been much debated, as many argue that the threshold of £85,000 – in place until 31 March 2024 and which had been frozen at that level since 1 April 2017 – is distortionary and stops businesses growing. Some businesses deliberately stall their growth to avoid having to register for VAT and the result is a bunching effect of businesses whose turnover remains just below the VAT threshold.
The announcement in the March 2024 Budget of an increase in the threshold to £90,000 from 1 April 2024, simply moves the bunching effect to a slightly different point and does not improve the position.
The Office of Tax Simplification (OTS) explored the bunching effect in its 2017 report and more recently the issues have been highlighted by other bodies, including the Office for Budget Responsibility, whose chart below compares the anticipated effect in 2025/26 with earlier years.
This also illustrates that bunching occurs at just below whatever happens to be the VAT threshold for that particular year.
The threshold is particularly problematic as it is effectively a cliff-edge: once past the threshold VAT has to be applied to all sales, creating a very high marginal tax rate.
The current threshold level is likely to represent, particularly for service-based businesses with low costs, a good standard of living for many people, certainly well above the UK median household income of £35,000 for 2022. Moving above that threshold and developing the business would entail increased administrative costs, as well as increased commitments such as perhaps moving to bigger premises and taking on staff.
The relatively modest VAT threshold increase from 1 April 2024 is unlikely to resolve the underlying issues
An additional barrier to becoming VAT registered is the increased compliance needed. VAT-registered businesses must keep digital records and file VAT returns digitally. Some will face the complexity of choosing the right method of accounting and others the challenge of identifying the right rate of VAT to charge on each sale.
The relatively modest threshold increase from 1 April 2024 is unlikely to resolve those underlying issues.
There is no easy solution but some sort of smoothing mechanism, such as a lower initial rate, would seem most likely to encourage businesses to cross the threshold. There could, for example, be an ‘introductory’ flat rate for the first year of being VAT registered; the 2017 OTS report on VAT suggested a reduction of 5% in the first year, 3% in the second year and 1% in the third.
Pensions
The paper also explores the pension allowance limits and the complications and uncertainties these create. Unlimited tax relief on all contributions would be very expensive, so there are currently limitations on the amount that can be contributed annually and, until it was effectively abolished in the March 2023 Budget, a lifetime allowance that limited the overall amount that could be built up within all pension pots.
Exceeding the limits creates a tax charge. The paper makes the point that the annual pension contribution limits are particularly problematic for those in defined benefit schemes – typically public sector workers – as the charge is based on growth in value of the scheme, over which the employee will have little or no control. It is therefore almost impossible for them to plan for their likely pension charge.
The suggestion is that, if pension saving is to be supported and encouraged, it would be helpful for the government to commission a broader review of pension taxation to remove some of the current barriers to pension saving. This could be particularly relevant if further changes are planned, eg, the potential reintroduction of a lifetime allowance put forward by the Labour opposition.
Sally Campbell and Patricia Mock
