In my last blog post I looked at the complexities of the UK tax system. Unfortunately, in order to make it remotely comprehensible, it was greatly simplified. The example taken was a relatively simple one of a single-earner couple with three children. The following table summarised their tax position:

Earnings band Total marginal tax and benefit withdrawal rate Income tax National insurance Benefit withdrawal
£0-£6,420 0% 0% 0% 0%
£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%

There are four further potential elements to add to this picture: employers’ National Insurance contributions, indirect taxes, student loan repayments and Council Tax Benefit and Housing Benefit. We will ignore childcare benefits and a host of other benefits given to schoolchildren whose parents are in the benefits system.

These four elements should be dealt with as follows:

Employers’ National Insurance: in the long run, employers’ National Insurance is likely to be largely borne by the employee because it raises the cost of employment and will therefore lower wages in a competitive labour market. There are circumstances when this might not happen, but to assume that it is borne by the employee is a reasonable working assumption. When calculating the effect of employers’ National Insurance we need to gross up the wage by the amount of National Insurance paid. This means that we now assume that somebody who has earnings of 100 shown on their payslip actually earns 113.8 (their earnings plus employers’ National Insurance contributions) and all taxes will be expressed as a proportion of 113.8. 113.8 can be thought of as the ‘value added’ by the employee from which all taxes are deducted. It just happens to be the case that the employee only sees 100 of this 113.8 on their payslip.

Indirect taxes: these are levied at about (on average) 25% on all spending. To be conservative, and because some of these taxes are lump sum taxes and also are not levied on that part of income that is saved, we will assume that indirect taxes are levied at 20% on take-home pay after direct taxes and benefits.

Student loan repayments: in the new system for providing students loans, the system is at least partly like a tax. Both the interest rate and the amount of the loan that will be written off will depend on your income. Therefore, although the student loan repayment can be regarded as a reduction in the loan liability rather than as a tax, the effect is like a tax. However, there is an element of loan repayment so it has been assumed here that, of the 9% of income above an income level of £21,000 that an individual earns, five percentage points takes the form of a tax – a calculation that seems reasonable given the detailed work done on this subject by other organisations.

Housing and Council Tax Benefit: this is complicated and depends on family circumstances, rent levels and so on. However, families renting who are earning low-to-middle incomes will receive Housing Benefit and Council Tax Benefit. This is withdrawn at the rate of £85 for every extra £100 of net income until the entire benefit is lost. The net income is effectively income after Child Tax Credits, employees’ National Insurance and Income Tax. When an individual earns an extra £100, their net income increases by £27 after the loss of Tax Credits, National Insurance and Income Tax (see previous post) over most of the income scale. They will then lose 85% of this £27 (i.e. £23). This leads to a marginal tax and benefit withdrawal rate of nearly 100%. However, this applies to a relatively small number of people who have families with children and who are working (around 750,000 people).

To illustrate how all this fits together, let us assume that a particular individual worked for a company for an additional ten hours a year and that those extra ten hours had a value added to the company of £113.80 at a point on the earnings scale when National Insurance and the basic rate of Income Tax were being paid and Child Tax Credit was being received. Assume that the individual is paying back a student loan and pays indirect taxes but is not in receipt of Housing and Council Tax benefit. This is what would happen to the £113.80:

·         £13.80 would be paid in national insurance contributions by the employer

·         £12 would be paid in national insurance contributions by the employee

·         £20 would be paid in income tax

·         £5 would be the assumed student loan repayment

·         £41 would be lost in child tax credits

·         This leaves disposable income of £22 on which it is assumed that indirect taxes of 20% (£4.40) would be paid

The worker receives £17.60 or 15% of his value added. It should be stressed that this is not a quirk of the system: it is the main feature of the system for the income range between £21,000 and nearly £39,000. Only slightly smaller marginal rates are in force at some other points on the income scale.

These withdrawal rates are a strong disincentive to train – unless it is believed that one can earn around £40,000 a year or more – and a strong disincentive to diligently improve one’s position within the company one is working for. Couples also have an incentive to arrange their affairs in order to reduce these tax and benefit withdrawal rates (for example by ensuring that income is split between them). It is also notable that a single-earner couple will be considerably worse off on the same household income than a two-earner couple (by around £3,000 if they move from being a single-earner couple on £40,000 a year to being a dual-earner couple on £20,000 a year each).

It is also interesting to note how much a couple have to earn to ‘bust through’ the morass of the benefit system and actually start to benefit from earning a reasonable amount of money. This is demonstrated by comparing the position of a couple where one member earns well above median earnings with that of a couple where nobody works. A couple with three children would typically receive about £20,000 in benefits after taking into account Housing Benefit and Council Tax Benefit but excluding Child Benefit (which does not affect anything at the margin until earnings reach £50,000). A couple with one spouse working 40 hours a week and being paid 100% above the minimum wage would gross about £28,000. After benefits and taxes, this would leave – coincidentally – just over £28,000. In other words, a 40 hour working week would gross the couple just £3.80 an hour above the position from not working. This figure might be understated a little depending on how Housing Benefit is treated. However, it is definitely overstated because the effect of student loans, employer’s National Insurance contributions and indirect taxes is ignored – not to mention travel-to-work costs.

If a couple with three children earning £25,000 a year were to separate (or never either live together or marry) they would gain hugely too. A much higher level of benefits would be received and no less tax would be paid.

These two blogs explain much about the UK employment market. If you want to create a society that punishes work, training, family formation and saving then just follow this model. Until recently people could escape this trap as long as they earned around £35,000, but even this changes with the new student loan system and the recent changes to child benefit which cause large marginal deductions from benefits to take place at ever-higher levels of income. The situation is better for single people, for those with no children, for those who do not work and have children, and for those couples who can work round some of the worst aspects of the system through splitting their work and income. But, it penalises very heavily those who wish to improve their lot in life – especially if you are part of a family with children. George Osborne was dealt a poor hand by Gordon Brown, but the effect of his reforms is to make the problems worse and not to alleviate them.

Philip Booth 154x154
Philip Booth is Academic and Research Director at the Institute of Economic Affairs and Professor of Finance, Public Policy and Ethics at St. Mary's University, Twickenham. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. Previously, Philip Booth worked for the Bank of England as an advisor on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs and on the editorial boards of various other academic journals. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.