Imagine if a Chancellor stood up and announced that those earning up to £100,000 would pay a 40p tax rate, those earning £100,000 to £112,950 will pay a 60p rate, and those earning above £112,950 will pay the 40p rate, and then the top earners will pay a 50p rate. That'd be crazy, right?
But that's exactly what Alistair Darling announced in his 2009 Budget. So how did he get away with it? By delivering his announcement in code. Instead of talking about marginal tax rates, he described the move as withdrawing the personal allowance for those with incomes over £100,000. The language may be different — and may sound much more reasonable — but the effect is exactly the same. And because of the Liberal Democrats' policy of raising the personal allowance, the range of incomes facing that 60p rate has grown. The result is an income tax schedule that will look like this from 6 April:
'It seems likely that anyone expecting their total income to fall within these ranges will seek to reduce their taxable income slightly — for example, by making additional private pension contributions — to the point where the phase-out begins. In this case, the main distortion created by this tax increase for these individuals would seem to be the additional effort expended by these individuals when managing their affairs in a tax-efficient way. The change may also distort the decisions of slightly lower-income people deciding whether it is worthwhile seeking increases in pay that would take them into, or above, these bands.'
But beyond these distortive effects, the main problem with the current system is that it contravenes a fundamental principle to which our tax system should adhere: transparency. As the Mirrlees Review says:
'If setting these effective tax rates is the objective, then it should be explicit in the marginal rate schedule, not described opaquely as a phased withdrawal of the personal allowance: this peculiar mechanism serves no purpose except to obscure what the tax system is actually doing.'
Of course, simply reversing Darling's change so that all taxpayers benefit from the personal allowance would represent a tax cut for those on high incomes (£3,776 for those earning more than £118,880), and would cost somewhere in the region of £2.8 billion. It should therefore be accompanied by lowering the starting point for the 45p rate, both to limit the benefit to top earners and reduce the cost.
To prevent any benefit to those earning over £150,000 and make the change roughly revenue-neutral, the 45p threshold would need to come down to around £74,480. That'd bring on extra 750,000 or so people into the 45p band, but around 300,000 of them could hardly complain, as they'd be paying less tax as a result. The below graph shows the effect it would have on people's tax bills. As you can see, those earning between £74,480 and £108,507 would be slightly worse off, while those earning over £108,507 would be slightly better off.
That may seem like an odd change to call for — one that cuts tax for the richest at the expense of those earning less (albeit only slightly). But the prize is a more sensible, more straightforward, less distortive income tax schedule.
(If you think £74,480 is too low a starting point for the 45p rate, how about setting it higher and paying for the shortfall through something other than income tax — perhaps by abolishing the inheritance tax exemption of business and agricultural property, or through changes to capital gains tax?)
In his Budget speech last year, George Osborne said 'A tax system that is simple and transparent: that is our first goal.' If he really wants to achieve that goal, he should use his Budget next week to remove this pointless complexity and opacity.