Guest blog: How to improve thresholds in the tax system

Almost every tax system has thresholds – a point where a tax rate increases, or when a benefit starts to be withdrawn. They are a fundamental part of delivering a progressive tax system – one where those earning more pay higher tax rates.

The Tax Law Review Committee, part of the Institute for Fiscal Studies, commissioned a discussion paper on thresholds, to help set out best principles in designing tax policy and administration. The report’s authors - Bill Dodwell, Patricia Mock and Sally Campbell (all formerly with the Office of Tax Simplification) - discuss challenges with thresholds relating to childcare and child benefit; savings; pensions; corporation tax; VAT; capital taxes and administration. The paper puts forward seven general recommendations to help improve tax policy making and four specific recommendations.

The first point to make is that we can’t avoid higher than expected tax rates if the political decision is made to offer a benefit only to those below a certain income level. If the personal allowance is only for those with income below £100,000 then there has to be an effective rate above 40% to withdraw it. HMRC estimates that in 2023-24 there are 35.9 million income tax payers, with 1.515 million having income over £100,000. There are estimated to be 862,000 additional rate taxpayers – so 653,000 face an effective 60% rate in the £100,000-125,140 band. The yield from withdrawing the personal allowance is substantial – about £8 billion.

Interestingly, HMRC data suggests that few taxpayers actually take the general advice to increase pension contributions where an individual faces an effective 60% rate.

The paper recommends that tapers should be as low as possible to limit the incentive to reduce work. It acknowledges that this has an exchequer cost, and it means that more individuals face the complexity of having the benefit withdrawn, but overall is less damaging.

The paper also recommends that all thresholds should be reviewed periodically, say every five years, to assess whether the measure continues to meet the original policy objective. Where the decision is made not to increase the threshold, the government should indicate the additional numbers affected and the tax raised, just as when the measure was originally introduced.

The worst type of threshold is where exceeding it means that the taxpayer is actually worse off – not just facing a high tax charge. The immediate withdrawal of tax-free child case and publicly funded nursery places for those with income of £100,000 or more is an example. The Institute for Fiscal Studies has estimated that those with two children of nursery age in London would need to earn at least £134,500 before they saw any additional money, compared to earning £99,900.

The VAT threshold is another example of this – going £1 over the threshold brings VAT on the whole turnover. The Budget choice to increase the threshold from £85,000 to £90,000 does not affect the overall picture – and is actually an expensive giveaway by government, which doesn’t offer a great deal to individual taxpayers. The paper recommends studying whether an allowance could reduce the impact of going slightly over the registration threshold and thus support businesses growing. This was tried in Finland with some success, but for some the administrative complexity of complying with VAT administration puts them off growing their businesses.

On tax administration, whilst there is a desire to set high thresholds for full reporting – such as those require to complete a Self Assessment return – the paper warns that this is only effective where there are in place simple ways to report income and gains. Often it is easier to report as part of an annual compliance process.

Read the full report or a longer article in Tax Adviser.

The views expressed in guest blogs are those of the writer and are not necessarily shared by CIOT.