The Institute for Fiscal Studies (IFS) recently published a very interesting report on thresholds in the tax system, which highlighted a range of problems the ‘kinks and notches’ created.
What are kinks & notches?
Economists consider a kink to be a threshold above which tax is applied at a higher marginal rate, whilst a notch, is a threshold that, once crossed, costs the taxpayer a disproportionate amount of additional tax thus causing their post-tax income to reduce (aka: a cliff edge).
The 40% higher rate of income tax, which currently kicks in for earnings over £50,270 is a classic kink. On the other hand, the current £100,000 threshold for tax-free childcare is a notch; this is because the benefit is immediately withdrawn in full, once the earnings of the parent or guardian exceed the £100k limit, leaving the household worse off overall.
The report’s recommendations
The general recommendations for changes, outlined in the report appear to be universally very reasonable. They include the suggestion that policymakers should avoid those occasions when if a threshold is breeched, it results in a taxpayer becoming noticeably worse off, thus avoiding the ‘notch’.
The report clearly considers kinks to be more-or-less okay, but recommends that thresholds are periodically reviewed and reappraised, with the sensible suggestion that for most allowances this should be done at least once every five years.
Inheritance Tax
The IFS highlighted the oldest unchanged reliefs, namely those relating to inheritance tax (IHT), pointing out that many of the allowances within this tax have remained unchanged for nearly 50 years. For example, the small gifts exemption of £250 (set in 1980) would now be £1,200 if uplifted with inflation, whilst the annual exemption of £3,000 (set in 1981) would be closer to £14,000.
In gets even worse the further back you go; the marriage exemption set at a reasonable £5,000, when it was introduced in 1975, in today’s money, would be a gnat’s whisker under £60,000.
Whilst any government would struggle to put the marriage exemption up quite so much, it is hard to see any justification for failing to update any IHT reliefs for nearly 50 years. The report suggests that a periodic re-evaluation would provide the opportunity to see just how many people are currently affected, and as a consequence, review the level of the exemption, with the view of raising it.
Childcare
The report especially highlighted the thresholds in income tax and national insurance. Everyone is aware that the thresholds for universal credit (UC), are causing significant problems for the middle earners in society. Childcare thresholds are increasingly costly as thresholds of £60,000 and £100,000 are passed, especially as the £100k threshold, sees the beginning of ones’ personal allowance reduction.
In addition to the cliff edge for higher-earning parents at the £100,000 mark, where the loss of free childcare can result in an effective tax rise of £4,000 pa, assuming you have two children. there is effectively a second reduction in the form of HICBC (high-income child benefit charge) This kicks in once earnings reach £60,000 (a notch!). This is an n area described by the IFS as creating distortions that are “among the most severe you will ever see within a tax and benefit system”.
Jeremy Hunt did bring some changes to HICBC in his Spring Budget, by increasing the tapering to reduce some of the worst effects of the marginal rates of tax. Families now lose 1% of their child benefit for every £200 over £60,000 instead of 1% for every £100 over £50,000. While this is an improvement, the rates of the marginal rates of tax are still high, especially as the number of children increases.
The IFS suggested that recipients of child benefit should lose a fixed amount of benefit for every pound over a given threshold, which would avoid the more extreme marginal rates.
Savings
Last but not least, the IFS looked at savings interest, as frozen thresholds and higher rates have brought in around an additional 1M people into scope of tax on savings income. The IFS report highlights some of the complexities of the apparently straightforward personal savings allowance, bearing in mind that it is an allowance for tax, but does not reduce income for HICBC or the withdrawal of the personal allowance.
The report highlights the fact that the 0% savings rate for the first £5,000 of savings income for those earning under £17,570 is a poorly targeted relief, which was originally brought in to benefit pensioners living off capital. HMRC’s figures show that around 13,000 taxpayers benefited from it in 2020/21 but only a fraction of that number had pension income. The IFS concluded that the relief be scrapped, with the savings used to increase other allowances.
Accountant’s view
I enjoyed reading the IFS report, especially as it highlighted a handful of anomalies that I was not aware of in the interaction of thresholds. But overall, two issues clearly stood out, the first being that tax policy measures should not be considered in isolation, if they are to be effective and secondly, future chancellors really do need to review thresholds on a regular basis and ‘in a perfect world’, raise them.
