The progressivity of the income tax system in the UK

What are the principles of a good tax system?

If you were creating a new tax system from scratch, what would be the main principles on which your system might be based? One set of principles known as the canons of taxation was developed by classical economist Adam Smith in his famous work on the ‘Wealth of Nations’ published in the late 18th century. When you are asked to discuss the justification for different forms of taxation, it is often worth coming back to these principles when evaluating the relative merits and de-merits of alternative forms of taxation

• Efficiency - an efficient tax system raises sufficient revenue to pay for government spending, without creating negative distortions such as reducing work-incentives for individuals and investment incentives for companies
• Equity – the principle of equity is that taxes should be fair and based on people's ‘ability to pay’. Income tax satisfies this condition because it is a progressive tax system, the marginal and average rate of tax rises with income – but some indirect taxes may not – for example the duty on cigarettes is said to have a regressive effect on the overall distribution of income
• The ‘benefit principle of taxation’ – this principle is that taxes paid by people have a link with the benefit that the person paying the tax actually receives from government spending. However, there are some problems with too much emphasis on the benefit principle. Firstly if ignores the redistributive aims of taxation. For example, the government might introduce a new tax or raise an existing one with purely redistributive aims in mind i.e. a desire to reduce relative poverty. The benefit principle is mainly concerned with allocative efficiency rather than equity. A second problem is that the benefit principle assumes correct revelation of preferences by consumers – whereas in reality many consumers do not have to pay for the public goods and services provided for them (consider the ‘free rider problem’). It is also difficult for the government to assess individual benefits from public goods.
• Transparency and certainty - taxpayers should understand how the system works and should be able to plan their tax affairs with a reasonably degree of certainty. Taxes should also be difficult to evade – we know that in many countries there is a fast-growing industry that provides information to people on how to reduce their tax liabilities. Collection costs should be kept to an acceptable level so that the costs of collection are very low relative to the total tax revenues collected.

The progressivity of the income tax system in the UK

To what extent does the income tax system work to reduce the gap between the highest and lowest paid households in the UK? In a progressive tax system the average rate of tax rises with income. And we see from the table below that income tax is indeed progressive in its effects on disposable income. The average rate of tax rises from around 5% on incomes between £7,500 - £9,999 to three times for people in the £20-£30k income bracket. For people earning over £50,000 per year, over a quarter of their income is paid directly in income tax.

But the system is not as progressive as it might be and as it was over twenty years ago. The extent of the "progressivity" of the income tax system has been reduced over the years. Before 1979, the top rate of income tax was 83 per cent, with a 15 per cent supplement for investment income. Now most taxpayers face a similar marginal tax rate of 22% compared with a top rate of 40 per cent but on top of the basic rate there is national insurance contributions (NICs) at 11 per cent and 1 per cent extra on NICs for higher earners, making the overall rates 33 per cent, and 41 per cent. This is not such a great progression. If a government wanted to use the income tax system to achieve a more even final distribution of income, it could

• Raise the top rate of income tax above 40%
• Increase the tax free allowance for people
• Introduce lower marginal rates of tax for lower-income households

Income tax payable: by annual income, in 2005/06
	Number of taxpayers (millions)	Total tax liability (£ million)	Average rate of tax (percentages)	Average amount of tax (£)
£4,895–£4,999	0.1		0.1
£5,000–£7,499	2.9		2.0
£7,500–£9,999	3.5	1,580	5.1
£10,000–£14,999	6.1	7,560	9.8	1,220
£15,000–£19,999	5.1	11,500	13.0	2,260
£20,000–£29,999	6.4	24,000	15.4	3,760
£30,000–£49,999	4.3	28,900	17.9	6,690
£50,000–£99,999	1.5	25,900	25.7	17,000
£100,000 and over	0.5	34,200	33.4	71,100
All incomes	30.5	134,000	18.2	4,390
Source: Social Trends 36, ONS

The easiest thing to do would be to increase the higher rate of income tax but this might create incentive problems in the labour market.

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