There have been increasing calls from some in the Conservative Party to ‘ease the squeeze’ on the middle classes by rolling back the 40% income tax threshold. The case made in the Spectator by Nick de Bois MP is that the Government’s centrepiece tax reform of increasing the personal allowance is helping the low paid and should be applauded. However, the aspirational middle classes are seeing little benefit from this and are in fact being hit by the reduced threshold for the 40% rate. It is certainly easy to have sympathy with this view because the 40% rate is paid by those earning more than £41,450 a year, compared to £43,875 in 2010-11. The result is that approximately 1.35 million more people are being captured by this higher rate and more people paying the 40% rate means more people facing diminished work incentives. So whilst the personal allowance increase has been good for the low paid, the argument is that we should now look for ways to help the middle classes.
Some, such as on Left Foot Forward argue against any increase in the personal allowance from the opposite perspective because they believe it benefits the richest the most. They argue that in cash terms a higher personal allowance will benefit higher earners more because the very lowest earners do not pay income tax anyway. This of course is not a particularly useful critique because what is actually relevant for measuring the static impact of the policy is the size of the tax cut as a proportion of income. A £500 tax cut means much more to someone earning £10,000 a year than someone earning £95,000 a year.
The reality however, is that the Government’s increases in the personal allowance have helped lower earners as well as the middle classes. Future increases can be expected to carry on that trend.
Yesterday, the IFS published its Green Budget in which it modelled the impact of an increase in the tax free personal allowance to £12,500 in April 2014. This chart taken from their publication shows that raising the threshold in such a way would lead to at least a 1.5% increase in net income for every decile apart from the lowest two and the top decile. The lower deciles of course benefit disproportionately from other policies such as the council tax freeze. The middle classes therefore clearly benefit from a higher personal allowance. Looking at the impact of the policy through the prism of families, the middle classes benefit even more because they are more likely to have two earners both gaining from the tax cut.
Another interesting chart in the publication highlights the positive, dynamic impact of raising the personal allowance through improved work incentives. The chart shows that the policy leads to a lower effective marginal tax rate especially for everybody apart from the highest two deciles, i.e. they get to keep more of each extra pound that they earn. It also shows a lower participation tax rate for everyone, i.e. a lower percentage of earnings lost in taxes and withdrawn benefits when an individual moves into work. This means that the incentive to work at all and the incentive to earn more once you’re in work are both improved.
So as well as being a powerful supply side policy to increase work incentives, raising the personal allowance has been a tax cut across the board, including for the middle classes. The Government should aim to build on this good progress through continued increases in the personal allowance.