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Kinks, notches and uncomfortable tax thresholds

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The Institute for Fiscal Studies has published a useful discussion paper on thresholds in the tax system, highlighting a range of problems they create.

16th May 2024
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Written by names familiar from the now-defunct Office of Tax Simplification, a new discussion paper on thresholds in the tax system has been published by the Tax Law Review Committee of the Institute for Fiscal Studies (IFS). The paper is a pleasingly accessible read, highlighting a range of problems created by thresholds that are likely to be familiar to many tax practitioners. 

For economists, a kink is a threshold above which tax is applied at a higher marginal rate, while a notch is a threshold that, once crossed, costs the taxpayer so much their post-tax income actually falls.

The 40% higher rate of income tax – which kicks in for earnings over £50,270 (or 42% above £43,663 for Scottish residents) – is a kink, while the UK-wide £100,000 threshold for tax-free child care is a notch, as it is immediately withdrawn once the earnings of a parent or guardian exceed the limit, leaving the household worse off overall. 

Reasonable recommendations 

The general recommendations in the paper for changes are all very reasonable – starting with the suggestion that policymakers try to avoid those occasions where the result of a threshold is a taxpayer becomes noticeably worse off. Avoid notches, but kinks are okay. 

The report also recommends reviewing thresholds periodically – with the sensible caveat that for many allowances every five years would be sufficient. 

One of the areas that has the oldest reliefs is inheritance tax (IHT), with some of the allowances here unchanged since the 1970s and 80s. The small gifts exemption of £250 (set in 1980) would now be £1,173 if uplifted with inflation, while the annual exemption of £3,000 (set in 1981) would be closer to £13,820. The marriage exemption would be a massive £59,120 compared to the £5,000 set in 1975. While I’d struggle to put that last allowance up quite so much, it is hard to see any justification for failing to update any IHT reliefs for over 40 years. 

The authors further suggest that a periodic review would provide the opportunity to see how many people are affected, and if the policy intent is being met. In my experience, policy reviews are rarely done, but really should be otherwise we never get to learn what is or is not effective.

Childcare challenges 

The largest section of the paper is devoted to the thresholds in income tax and national insurance. This is not surprising as we all know how thresholds for universal credit (UC) can cause issues for those at one end of the income spectrum, while childcare thresholds can prove costly as thresholds of £60,000 and £100,000 are passed. The latter also marks the start of personal allowance withdrawal. 

In addition to the notch or cliff edge for higher-earning parents at the £100,000 mark – where the loss of free child care can result in a pay rise reducing their net income – there is another childcare kink in the form of the high-income child benefit charge (HICBC). This applies once earnings reach £60,000, and it is even possible for those on UC to encounter the HICBC, where marginal rates can reach 80–87% depending on the number of children. 

The marginal rates issues around the £100,000 mark are widely known in the tax community, with campaigners like Dan Neidle looking to raise public awareness. What struck me from the paper was the line that “the Exchequer savings from the £100,000 cliff edge are not known, and nor is the size of the population affected”. It is surprising how little detail we have on an area described by the IFS as creating distortions that are “among the most severe you will ever see within a tax and benefit system”. 

The Spring Budget did bring some changes to HICBC, where the tapering has been increased to reduce some of the marginal rates of tax here. Families now lose 1% of their child benefit for every £200 over £60,000 instead of 1% for every £100 over £50,000. While an improvement on the previous position, there are still high marginal rates of tax for those affected, especially as the number of children increases. 

One solution put forward by the paper was for recipients of child benefit to lose a fixed amount of benefit for every pound over a given threshold. This would increase complexity by giving households their own personal taper period while avoiding more extreme marginal rates. 

But while withdrawing benefits more slowly can help to reduce marginal rates, it also increases the Exchequer costs and brings more people into the complexity of partial clawbacks. 

Savings interest 

The other area that caught my eye related to savings interest. With higher rates bringing an estimated 1m people into scope of tax on savings income, the Association of Taxation Technicians has been trying to raise awareness of the potential issues. 

The report highlights some of the complexities of the apparently straightforward personal savings allowance. For example, it is an allowance for tax, but doesn’t reduce income for HICBC or personal allowance withdrawal. 

It also highlights that the 0% savings rate for the first £5,000 of savings income for those earning under £17,570 is a poorly targeted relief. I have little practical experience of this relief and had always assumed it was intended to benefit pensioners living off capital. HMRC’s figures suggest 2% of the taxpayer population (635,000 taxpayers) benefited from it in 2020/21 but only 16,000 of those had pension income. In the absence of a clear rationale for the relief, the report proposes scrapping it and using the monies saved to improve the design of the PSA.  

Highlighting anomalies 

This was an interesting paper and highlighted a few anomalies that I was not aware of in the interaction of thresholds. I took away two key points. Firstly, to be effective, tax policy measures cannot be considered in isolation. Secondly, we really do need to review thresholds from time to time. A good use of a sunny afternoon perhaps.

Replies (9)

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By RFL H
16th May 2024 12:11

Any notch is a failure by the Treasury as it will reduce GNP.

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By FactChecker
16th May 2024 15:44

Whilst 'discussion papers' are always welcome ... unfortunately, as with much of the output from the OTS, that welcome only extends as far as those who find the content interesting (whether purely intellectually or as confirmation of what they've been saying to anyone who will listen)!

I echo Helen's cri de coeur:
"In my experience, policy reviews are rarely done, but really should be otherwise we never get to learn what is or is not effective."

But it's worse - not only is the opportunity to learn/improve spurned.
It feels like an act of deliberate omission (as in 'if you don't ask then it's not your fault').
Where is the will to improve policies in the light of measurable (and measured) outputs?

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By mhkay
20th May 2024 08:12

If we had a higher level of numeracy there would be no thresholds, kinks, or notches, everything would be calculated using continuous functions.

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By whopkinscom
20th May 2024 08:22

Was there any mention of the complete withdrawl of carers allowance for a penny over the earnings limit? Or has this been overlooked yet again?

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By Mr J Andrews
20th May 2024 09:51

Is is no surprise that annual tinkering, with no real thought - in the hope of more votes - that problems, complexities and anomolies occur ?
Stick any of the last shower of eight we've seen this century { particularly he of M.T.D. infamy }, in front of a double entry book-keeping exam and no doubt their unbalanced kinks and notches would be revealed.

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By Tufdevil
20th May 2024 11:08

Of course, the £50,270/£125,140 thresholds can also be a notch for people with at least £1,000/£500 in bank interest. The marginal rate for £1 extra income over the £125,140 is eyewatering!

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paddle steamer
By DJKL
20th May 2024 14:23

Killer for me is my combined IT and NI marginal rate in Scotland

Up to £43,662 I have IT 21%, NI 8%, marginal 29%
£43,662 to £50,268 I have IT 42%, NI 8%, marginal rate 50%
£50,268 to what I do earn I have IT 42%, NI 2%, marginal 44% (these days never over the new 75k band and in to new 45% IT rate as only part time)

The above is as barking as the £100k threshold and personal allowance removal, but at least there the salary is a bit more substantial than £43,662

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By Nick Graves
22nd May 2024 12:06

The taxman's taken all my dough,
And left me in my stately home,
Lazing on a sunny afternoon...

-The Kinks.

Actually, the marginal rates were far more dreadful way back then.

Perhaps after the system entirely collapses, they will reform it - a nice 13% flat-rate tax sounds divine, yet still there are Russians who want to overcomplificate that and invoke the Law of Unintended Consequences. We humans never learn...

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By adjadj
23rd May 2024 15:05

Is there a link to the paper? It would be good to see the original document

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