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Thursday, 1 March 2012

EFFECTIVE TAX OF 58%?


The claim by 537 company directors in today’s Telegraph that there is an effective tax rate of 58% on extra earnings over £150,000 is wrong.

Let me explain why.

The letter calls on the Chancellor to end the 50p in the pound additional rate of income tax. The rate “puts wealth creators in a very awkward position” and scrapping it would show that the Chancellor wanted “to celebrate British entrepreneurialism, stimulate industry and contribute to…growth.”

But I was struck by this phrase.

“The tax, which is in effect a 58p tax after national insurance is taken into account”

How did they get to 58p?

A number of tweeps and one firm of accountants came to my aid.

One identified this paragraph in Wikipedia.

“After consideration of employer and employee National Insurance contributions, the effective marginal top rate for 2011-12 is 58%: that is, to pay an employee £1,000 gross costs the employer £1,138 and the employee receives £480 after deductions.http://en.wikipedia.org/wiki/Taxation_in_the_United_Kingdom

But, like much Wiki-info, it needs care when it is used.

Here is how the Wiki-sum goes.

If an employee earns more than £150,000 then to get another £480 into their pocket you do indeed need to pay him or her £1000. That is subject to 50% tax and 2% NI leaving £480. But the employer also has to pay the employer’s National Insurance which is 13.8% or £138.

So out of a total cost to the employer of £1138 the employee gets just £480. Subtract one from the other and tax of £1138 - £480 = £658 has been paid. So the ‘rate’ of tax is £658 / £1138 = 57.8% which Wiki rounds up to 58%.

But hang on a minute. These are large companies paying full-rate corporation tax on their profits. The whole cost of paying employees – their gross pay and the employer’s National Insurance charge – is deductible from profits.

So in fact the gross cost of paying someone £1000 is reduced by the corporation tax saved. Corporation tax is currently 26% and falls to 25% from 2012/13. The total extra pay bill of £1138 reduces corporation tax by £1138 x 25% = £284.50. So the net cost to the employer is £1138 - £284.50 = £853.50.

The employee gets £480 in their pocket. And the amount that has disappeared in tax is £853.50 - £480 = £373.50. So the tax ‘rate’ is £373.50 / £853.50 = 43.8%, which rounds up to 44% of the total costs.

Assuming the employer makes a profit and pays corporation tax.

And if it doesn’t perhaps it shouldn’t be paying its directors more than £150,000 a year.

FIDDLY BITS
If these guys (and 89% of them ARE guys) are partners then there is no employer’s National Insurance to pay so the effective tax on the extra £1000 is just 52% which they pay. So 58% is simply wrong for partners. And that is the effective marginal tax rate for employees too as far as the employee is concerned.

If they are directors and earning dividends then the extra tax on paying another £1000 in dividends is £361.10 or 36%. There is no national insurance paid by them or the firm. So again 58% is simply wrong.

If the employees are in a final salary scheme then employer’s National Insurance is 10.4% not 13.8% and effective tax is 42%, not 58%.

If the firm is small then corporation tax is 20% not 25%. Effective tax is 46% (contracted out) or 47% (not contracted out) so 58% wrong for them too.

The only occasion when the net tax take from the grossed up pay would be almost 58% is if the person earning over £150,000 is an employee who is not contracted out of state second pension, and the company makes no profit. 

All figures are given at announced 2012/13 rates and may change in the Budget.