The growing problem of the personal allowance phase down.
It is sometimes a wise political strategy to ignore a problem and hope it resolves itself. Occasionally that works, and sometimes an overly hasty intervention can make matters worse. However, this is not the case when it comes to the phase down of the personal allowance. What was a minor irritation in 2010 has become a major economic distortion by 2026.
How the 60% band was created: The phase down of the personal allowance was introduced by Alistair Darling in his final Budget. It reduced the personal allowance by one pound for every two pounds of adjusted gross income above £100,000. For a 40% taxpayer, this effectively added an extra 20% to the marginal tax rate, creating a 60% marginal rate.
When introduced, £100,000 was a substantial income and the measure affected only a small proportion of taxpayers. Over the 16 years since, inflation has pushed many more people into this band, and other policy changes have increased its impact.
When you add 2% employee national insurance and a 9% student loan repayment rate, the marginal rate for many individuals now reaches 71%.
Inflation and policy changes have deepened the distortion: Between 2010 and 2020, the personal allowance nearly doubled. As a result, the income band over which the allowance is withdrawn expanded from around £12,000 to £25,140.
I recall sitting next to a Treasury minister during the coalition years and asking whether the 60% band caused any concern. He replied that ‘people of ambition’ would simply rise above that income level. A decade later, this complacency looks badly misplaced. Increasing numbers of people are refusing promotions or even reducing their hours to avoid falling into the 60% plus marginal rate trap.
The childcare cliff edge makes the problem worse: The situation has been made worse by the replacement of childcare vouchers with direct childcare support in the early 2020s. This support, £2,000 per child rising to £4,000 for a child with a disability, has a hard cut off at £100,000 of income. Unlike the personal allowance, this is not tapered.
It is a cliff edge.
A family with three children loses £6,000 of support if either parent earns even one pound above £100,000. The result is that someone offered a promotion could be better off earning £99,999 than earning more than £120,000.
This ‘doom loop’ is now seriously distorting behaviour at the upper skilled end of the UK labour market, reducing the available pool of the workforce at an age when they are skilled, experienced and productive.
What employers and employees can do: Since the government does not appear to view this as a priority, employers and employees must consider interim strategies.
For owner managers, controlling salary and dividend flows provides flexibility.
For employees and employers, options include:
Increasing pension contributions to reduce adjusted gross income. This is less attractive if the individual needs the cash now, but still preferable to paying marginal rates above 70%.
Making charitable contributions, which can reduce AGI (Adjusted Gross Income) even after the tax year.
Negotiating a different compensation package, including benefits that are lightly taxed or untaxed, such as electric vehicles or additional training.
Deferring income, although advisers must be cautious because earmarked funds can create tax complications.
Using tax advantaged share schemes, which can reduce current tax liabilities while providing long term incentives.
Employers offering access to independent financial advice to help employees navigate these complexities.
A problem the government cannot ignore forever: Eventually, a government will have to address this issue. The current system risks undermining the UK’s attractiveness to highly skilled workers and is already distorting labour market decisions.
In the meantime, individuals caught in these bands must understand their position clearly, and employers need to be more flexible and creative in how they structure compensation.
The growing problem of the personal allowance phase down.
It is sometimes a wise political strategy to ignore a problem and hope it resolves itself. Occasionally that works, and sometimes an overly hasty intervention can make matters worse. However, this is not the case when it comes to the phase down of the personal allowance. What was a minor irritation in 2010 has become a major economic distortion by 2026.
How the 60% band was created: The phase down of the personal allowance was introduced by Alistair Darling in his final Budget. It reduced the personal allowance by one pound for every two pounds of adjusted gross income above £100,000. For a 40% taxpayer, this effectively added an extra 20% to the marginal tax rate, creating a 60% marginal rate.
When introduced, £100,000 was a substantial income and the measure affected only a small proportion of taxpayers. Over the 16 years since, inflation has pushed many more people into this band, and other policy changes have increased its impact.
When you add 2% employee national insurance and a 9% student loan repayment rate, the marginal rate for many individuals now reaches 71%.
Inflation and policy changes have deepened the distortion: Between 2010 and 2020, the personal allowance nearly doubled. As a result, the income band over which the allowance is withdrawn expanded from around £12,000 to £25,140.
I recall sitting next to a Treasury minister during the coalition years and asking whether the 60% band caused any concern. He replied that ‘people of ambition’ would simply rise above that income level. A decade later, this complacency looks badly misplaced. Increasing numbers of people are refusing promotions or even reducing their hours to avoid falling into the 60% plus marginal rate trap.
The childcare cliff edge makes the problem worse: The situation has been made worse by the replacement of childcare vouchers with direct childcare support in the early 2020s. This support, £2,000 per child rising to £4,000 for a child with a disability, has a hard cut off at £100,000 of income. Unlike the personal allowance, this is not tapered.
It is a cliff edge.
A family with three children loses £6,000 of support if either parent earns even one pound above £100,000. The result is that someone offered a promotion could be better off earning £99,999 than earning more than £120,000.
This ‘doom loop’ is now seriously distorting behaviour at the upper skilled end of the UK labour market, reducing the available pool of the workforce at an age when they are skilled, experienced and productive.
What employers and employees can do: Since the government does not appear to view this as a priority, employers and employees must consider interim strategies.
For owner managers, controlling salary and dividend flows provides flexibility.
For employees and employers, options include:
Increasing pension contributions to reduce adjusted gross income. This is less attractive if the individual needs the cash now, but still preferable to paying marginal rates above 70%.
Making charitable contributions, which can reduce AGI (Adjusted Gross Income) even after the tax year.
Negotiating a different compensation package, including benefits that are lightly taxed or untaxed, such as electric vehicles or additional training.
Deferring income, although advisers must be cautious because earmarked funds can create tax complications.
Using tax advantaged share schemes, which can reduce current tax liabilities while providing long term incentives.
Employers offering access to independent financial advice to help employees navigate these complexities.
A problem the government cannot ignore forever: Eventually, a government will have to address this issue. The current system risks undermining the UK’s attractiveness to highly skilled workers and is already distorting labour market decisions.
In the meantime, individuals caught in these bands must understand their position clearly, and employers need to be more flexible and creative in how they structure compensation.
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