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Jeremy Hunt has been urged to address “cliff edges” in the tax system that can result in higher-earning families losing out £10,500 from a £1 pay rise.
Thousands more workers are at risk of falling into these traps because of fiscal drag, where tax thresholds stay the same and rising wages push workers into higher tax brackets.
Under current government plans, the tax thresholds are frozen until 2028. With average wage growth running at 7.7pc, according to the Office for National Statistics, more are tipping over the thresholds where marginal tax rates can be at their highest.
Many workers pay a tax rate far higher than 45pc (the top income tax rate) because of the withdrawal of allowances and benefits at these cut-off points. In some cases, the rate can be as high as 99pc.
The Centre for Policy Studies, a think tank, is among those calling for the government to address high marginal rates in next week’s Autumn Statement.
Laura Suter, of stockbroker AJ Bell, said: “There are easy fixes the government could implement to change the system to either remove the threshold, raise the threshold so that fewer people are affected, or at least taper it to ensure that support is gradually withdrawn.”
The £100,000 cliff edge
Cost of £1 pay rise: £10,500
One of the most severe cliff edges in the tax system kicks in once a parent earns more than £100,000.
This is because once you start earning more than £100,000 you begin to lose both your tax-free personal allowance and your ability to claim 30 hours free childcare.
The personal allowance also drops by £1 for every £2 earned above this amount, until it disappears at £125,140.
On top of this, parents lose two lucrative parts of childcare support. Once one of them earns over £100,000, the number of free childcare hours they can claim from the government drops from 30 to 15. They will also lose their tax-free childcare, which lets parents claim up to £2,000 a year per child to help with the cost of care.
Crossing over the £100,000 threshold would therefore cost a two-child family £4,000.
Working parents can claim 30 hours of free childcare if their children are three- to four-years-old. Assuming the two-child family pays £3,187 a year per child for 15 hours of childcare, then a pay rise would cost them £6,500 in childcare costs.
Someone earning £101,000 a year would need a pay rise of more than £26,000 to replace that combined lost childcare help from both tax-free childcare and the free hours, according to AJ Bell.
Ms Suter said the cliff edge will get even worse under the Government’s plans to extend the 30 hours free childcare scheme.
From September 2025, parents of children under the age of five will be entitled to the 30 free hours.
The graduate tax sting
Marginal tax rate: 99pc
The introduction of student loans has only worsened the impact of high marginal tax rates.
A Plan 2 Student loan effectively works out a 9pc tax for those earning more than £27,295. Post-graduates pay an extra 6pc above the £21,000 threshold.
A post-graduate earning £124,150 who receives a £1,000 pay rise would keep only £6.50 – an effective tax rate of 99pc – due to the loss of the personal allowance as well and the 45pc tax rate. This also assumes they have £500 in savings which is then taxed at the 45pc rate.
Marriage allowance
Cost of £1 pay rise: £252
The marriage allowance allows couples to transfer up to £1,260 of their Personal Allowance to the other.
It was introduced in 2015 near the end of the coalition government after former prime minister David Cameron said he wanted to recognise marriage in the tax system.
By letting non-taxpayers share some of their personal allowance with their higher-income partner, the tax break was meant to help single-income families.
However the allowance “is both limited and poorly designed”, according to the CPS.
You can only claim the marriage allowance if your partner is a basic-rate taxpayer earning between £12,571 and £50,270. For someone earning £50,270, an extra £1,260 allowance would save them £252 each year. As soon as they earn more than this, the marriage allowance is lost – costing them £252 in tax.
More than two million couples claim the marriage allowance, according to government figures, about a third of whom are pensioners. This complex benefit is also creating a problem for hundreds of thousands of women now earning more than the personal allowance because of rises in the state pension.
The non-taxpayer can only share £1,260 of their allowance if they earn less than 90pc of the personal allowance. If the state pension rises by 8.5pc next year, in line with inflation, then many could see a modest increase in their income that would trigger unexpected tax bills.
Former pensions minister Steve Webb, of pension consultancy LCP, said: “We could see marriage allowance ‘mayhem’ as hundreds of thousands of couples have to decide whether to carry on with this arrangement or cancel it, to avoid low income pensioners being dragged into the tax net. The sooner the freeze on tax allowances comes to an end, the better.”
The child benefit tax charge
Marginal tax rate: up to 79pc
Sean McCann, of advice firm NFU Mutual, said one of the biggest traps is the “potential triple whammy” that can hit families once the income of the highest earner exceeds £50,270.
“Not only do they start paying 40pc income tax on earnings above that level, if their partner is a non-taxpayer, they also lose the marriage allowance worth up to £252 each tax year. In addition, couples with children are caught by the child benefit tax charge once the income of the highest earner exceeds £50,000.”
The High Income Child Benefit Charge claws back child benefit from a household where one parent earns more than £50,000.
It was introduced by former Chancellor George Osborne in 2013 and has been heavily criticised ever since. This is in part because a dual-income couple earning £49,000 each would be unaffected by the tax charge – whereas a single-earner family earning over £50,000 would lose some or all of their child benefit.
Child benefit for your first child is £1,248 per year and £827 for each subsequent child.
As soon as one parent passes the £50,000 threshold, child benefit is clawed back at a rate of 1pc per every £100 that they earn until it is lost completely when their income exceeds £60,000. This creates very high marginal tax rates, which vary depending on how many children you have.
This means someone earning £55,000 with two children would lose £1,038 per year. Their effective marginal tax rate would be 63pc. For someone with four children, the rate would go up to 79pc.