What are the highest marginal rates of income tax in the world? In 2016 Japan and Denmark both levied a charge of around 56% on their highest earners; Sweden came in just above that level at 57.1%, with Aruba topping the global table at 58.85%.
At 45%, the UK apparently enjoys mid-table mediocrity, when compared with the global and EU averages currently at 33.17% and 39.9% respectively (source: KPMG).
These are all headline rates, however, and there are sometimes idiosyncrasies in tax legislation that can make effective rates of tax even higher. A good example in the UK is the removal of £1 the personal allowance for every £2 of income above £100,000.
An individual earning £110,000, for example, will therefore be subject to income tax on an additional £15,000 of income compared with someone earning £100,000. At the present higher rate of 40% this means an extra £6,000 in tax; in other words, an effective marginal rate of 60% on this extra £10,000 of income. National Insurance – in reality a second income tax masquerading under a different name – would add a further 2% charge, making an overall marginal rate of 62%.
So, in fact, the UK may have arguably already had the highest marginal rate of tax in the world at the point when the last Chancellor amended the special income tax charge on ‘excess’ pension contributions for higher earners and introduced the tapered annual allowance. This change really ensures that the UK can compete at the elite level of income taxation!
A higher earner in this context is someone with ‘threshold income’ (similar to taxable income) of over £110,000 and an adjusted income (another new income definition that incorporates employer pension contributions) of over £150,000. When both the threshold and adjusted income limits are exceeded then £1 of the standard annual £40,000 pension contribution allowance is lost for every £2 that adjusted income exceeds £150,000, until a minimum £10,000 annual allowance is reached
The tapered annual allowance was introduced in 2016-17 and the implications are particularly complex for members of defined benefit pension schemes such as the NHS, Local Government and Teachers’ Pensions schemes.
In these schemes, employer pension contributions are defined as the increase in the value of an individual’s pension benefits – less any personal contributions – and not the actual payments made by the employer to the pension scheme. A pay increase can therefore result in an increase in the pension fund value (as the pension benefits are linked to the salary) and so create a deemed pension contribution – and therefore an adjusted income – that bears little resemblance to the actual remuneration received in that year.
To illustrate my point, here’s a real-life example relating to a newly appointed Head Teacher whom we have recently been advising. In 2016-17 his net salary was £99,500 – ie. below the threshold income limit of £110,000. However, due to his recent promotion his deemed employer pension contribution was over £123,000 and his resulting adjusted income was in excess of £238,000.
Based on these figures we ascertained that his annual allowance would remain at the standard level for the year and, after allowing for unused annual allowances from the previous three years, his excess pension contribution would be approximately £40,000. Income tax at his marginal rate would be due on this figure.
But the taxman’s demands may not end there. The Head Teacher in question also has some taxable benefits in kind, a small amount of bank interest and other investment income and some property rental income. The precise amounts are still to be calculated by his accountant, but are likely to be in the region of £10,000 – £11,000.
And here’s the problem: if this additional taxable income results in a threshold income of £110,000 or less (including his £99,500 salary) then our existing calculations will still be valid. Just an extra £1 of income, however, resulting in a threshold income of £110,001 would mean that his annual pension allowance falls from £40,000 to £10,000. In turn this would result in an additional income tax liability of £13,500 (£30,000 x 45% additional rate income tax).
This bears repeating: £1 of income could result in an additional tax liability of £13,500, an effective marginal rate of income tax of 1,350,000 %!
The Head Teacher concerned had no inkling that he would incur such large, and arguably disproportionate, income tax liabilities due to his appointment, particularly when they relate to future pension benefits that he might never receive.
I wonder how many other senior members of the various public service pension schemes are about to receive a similar nasty surprise. It’s too late to do anything about the last financial year, of course, but advanced planning for the 2017/18 financial year is certainly advisable.