3 Understanding Income Tax

Figure 2

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This image shoes a payslip – PAYE and the amount is circled.

Figure 2

When you earn money by working you don’t receive the whole of your wage (your ‘gross’ pay). Instead, you get your gross pay minus certain payments to the government. What’s left is your ‘net’ pay.

In the UK the top two payments that come out of your gross income are Income Tax and National Insurance. Government’s tax and National Insurance receipts fund all benefits as well as other public services and state provision (for example, state education, the NHS, police, social security, some aspects of transport, the armed services). Depending on your circumstances, your wage might also be topped up with benefits.

Some people have further deductions in the form of contributions to a pension scheme. These schemes are discussed later, in Session 8.

Income Tax is imposed – levied – on almost all types of income (it’s not payable on gifts, lottery winnings, Premium Bond winnings and ISA earnings). When it’s collected through an employer (when the worker is employed rather than self-employed) it’s often referred to as a ‘pay as you earn’ (PAYE) tax.

Income Tax is paid on income that is received by you within a given tax year, from 6 April in one year to 5 April of the following year. It is the single largest source of government revenue, accounting for around a third of all tax receipts.

Watch the following video to find out more about Income Tax.

Download this video clip.Video player: mmmft_1_video_week2_section3_incometax.mp4

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NARRATOR

In the UK income tax system, most people are allowed to earn up to a certain amount of money before income tax has to be paid. This is called receiving an allowance of income. And the type of allowance is called a personal allowance. The personal allowance for the tax year 2017/18 was 11,500 pounds. The allowance is higher for certain groups of people, such as those who are registered blind.

Now, this personal allowance has an income limit which, in 2017/18, was 100,000 pounds. If you earn above this limit, the allowance tapers away. Income above the personal allowance is taxed at different standard rates. Let's have a look at the rates which applied in 2017/18. For the first 33,500 pounds of income after the basic personal allowance has been taken into account, the rate of taxation is 20 per cent.

Above this figure and up to 150,000 pounds of taxable income, the rate is 40 per cent. And then there's an additional rate of 45 per cent on taxable incomes over 150,000 pounds. So let's do some examples to see how much tax is paid for people on different incomes.

How much income tax would someone pay in 2017/18 if they earn 25,000 pounds? Well first, deduct the allowance of 11,500 pounds, no taxes paid on this. That leaves 13,500 pounds that is taxed, and all of this is taxed at 20 per cent. 20 per cent of 13,500 is 2700 pounds, simply found by multiplying 13,500 by 20 and then dividing by 100. So income tax of 2700 pounds is paid by someone earning 25,000 pounds per year.

But what about someone on 50,000 pounds a year? Well, a calculation is a bit more complex. First, deduct the allowance of 11,500 pounds, no taxes paid on this. That leaves 38,500 pounds. The first 33,500 pounds of this taxable income is taxed at 20 per cent. 20 per cent of 33,500 pounds is 6700 pounds. This is 33,500 times 20 divided by 100.

But that leaves the remaining 5000 pounds of taxable income. That's 38,500 minus 33,500, and this is taxed at 40 per cent. 40 per cent of 5000 pounds is 2000 pounds. That's 5000 times 40 divided by 100. So the total amount of income tax paid is 6700 pounds plus 2000 pounds, which is 8700 pounds. And that means that someone on 25,000 pounds a year pays 2700 in income tax, but someone on 50,000 pounds a year pays 8700 pounds of tax.

Now this demonstrates how income tax in the UK is a progressive tax. The more you earn, the higher the proportion of your income that is paid in tax. By doubling your income from 25,000 to 50,000 pounds, the amount paid in income tax more than triples from 2700 to 8700 pounds.

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In the UK Income Tax system most people are allowed to earn up to a certain amount of money before Income Tax has to be paid. This is called receiving an ‘allowance of income’, and the type of allowance is called a ‘personal allowance’. In 2023/24 this personal allowance was £12,570. The allowance is higher for certain groups of people, such as those who are registered blind.

The personal allowance has an income limit of £100,000, so if you earn above this limit the allowance tapers away.

Income above the personal allowance is subject to tax at three different standard rates:

• in 2023/24 in England, Wales and Northern Ireland the first £37,700 (after the basic allowance had been taken into account) was taxed at 20%. This is the basic rate tax ‘band’
• above the basic rate ‘band’ and up to £125,140 of taxable income, the rate was 40%
• there was a rate of 45% on taxable incomes over £125,140.

The animation at the top of this step shows how income tax works. It uses the allowances that applied in 2017/18 but the principles relating to how tax is deducted remain the same today.

Note that slightly different tax income ‘bands’ and income tax rates are applied in Scotland as a result of the devolution of powers to the Scottish Parliament. More details can be accessed here: income tax in Scotland [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] .

Discretion over Income Tax has now been extended to Wales.

By taxing additional income slices at higher rates, the proportion of tax increases with income. UK Income Tax is an example of ‘progressive’ taxation because the proportion of income paid as tax increases as a person’s income increases. This tax structure helps to reduce income inequalities in the country.