Rachel Reeves is said to be considering raising income tax in the Autumn Budget.
Despite repeated assurances that Labour would not break its election manifesto by hiking the tax, the size of the fiscal black hole may be too big for Chancellor Rachel Reeves to ignore.
The Chancellor will need to meet a £22billion shortfall, which has been driven by the Office for Budget Responsibility’s decision to downgrade productivity forecasts.
There have been months of speculation that Reeves will raise taxes on the wealthy, but this is unlikely to create enough fiscal headroom, which means more tax rises in this parliament.
A bigger revenue raiser would be to increase income tax, which accounts for approximately a quarter of the total tax take.
Find out more about what this means below – and use our calculator to work out how much more income tax YOU could pay.
Another U-turn? Reeves has previously ruled out raising income tax but she may be left with little choice given the need to raise revenue and fill the fiscal black hole
What is income tax and what do we pay now?
For most people, income tax makes up the largest portion of the tax they pay.
Those who earn less than £12,570 per year don’t pay any income tax. Those who earn between £12,571 and £50,270 pay the basic rate of 20 per cent on all their income.
Those who earn between £50,271 and £125,140 pay the higher rate of 40 per cent on any income above £50,271. Above £125,141, the additional rate of 45 per cent is paid.
It is charged on earnings from employment and self-employment, but also on pension income, landlords’ rental income and savings interest.
Income tax rates haven’t been increased since 2010 when the additional rate band was introduced.
How much would it raise for the Treasury?
The current economic reality means Reeves may be left with little choice but to raise income tax again.
Government borrowing reached its highest level in five years last month, and while interest rates on government debt have fallen, Reeves has very little headroom to meet her own borrowing and spending rules.
The Institute for Fiscal Studies estimates that raising the rates of all income tax by 1 percentage point would yield approximately £10.9billion a year by 2029-30.
The bulk of the tax take would come from increasing the basic rate of tax, which is the portion of income earned between £12,570 and £50,270 a year, as more people pay this rate.
However, there is a risk that increasing income tax rates would encourage more people to put their savings into tax-efficient vehicles like private pensions and Isas, rather than in taxed forms.
Would the Chancellor raise all income tax rates?
The Treasury is reportedly unsure whether to raise income tax rates across the board, which would see basic rate taxpayers pay 21 per cent, higher rate 41 per cent and additional rate 46 per cent.
Raising the basic rate by 1p would raise over £8billion a year by 2028-29, according to HMRC figures, but this wouldn’t be politically palatable.
Adding 1p to higher rate tax to make it 41p would raise £1.2billion, while making the 45p rate a 46p one would only raise £230million.
Raising the basic rate would mean that more people would pay a higher rate on a portion of their income, but would fuel concerns over the cost of living. It would be the first time the basic rate of tax has been increased since the 1970s.
Reeves has promised to make those with the broadest shoulders face the highest burden, so if only the basic rate was increased, some will question why higher and additional rate taxpayers won’t pay more tax on that portion of their income.
For example, someone earning £60,000 would pay no income tax up to £12,570, and then pay £7,971 basic rate (21 per cent) on the next £37,700.
They would then pay £3,892 on the final portion (40 per cent higher rate), meaning their tax bill will be £431 more than it is currently.
If both the basic and higher rates were raised by 1 percentage point, someone earning £60,000 would pay £3,989.30 on the final portion of their salary. This means they would pay £528.30 more than they currently pay in tax.
These calculations do not include student loan repayments or pension contributions.
It becomes more complicated for individuals earning over £100,000, when the personal allowance starts to be removed at a rate of £1 for every £2.
The tax burden on higher earners has, in fact, increased more than for low and middle-income earners. That’s because the Tories increased the personal allowance from £6,475 to £12,570, meaning less of their income fell into the tax bracket, instead shifting the burden to higher earners.
Last year the IFS said that the share of income tax paid by the top 10 per cent of earners had increased from 53.5 per cent in 2010 to 60.3 per cent.
And new figures show that if the top 100 taxpayers decided to leave the UK, there would be a loss of £4.1billion in tax revenues, according to the figures.
Alex Race, chartered financial planner at Rathbones, says: ‘Increasing the basic rate is a tough sell for the government but targeting higher-rate and additional-rate taxpayers could raise significantly more revenue in the short term, particularly given that the top 50 per cent of earners contribute around 90 per cent of income tax.’
A 1 percentage point increase in the higher rate of tax would increase revenue by £2.1billion, while a boost to the additional rate would bring in £230million.
Reeves may say that raising the basic rate of tax, paired with widely rumoured wealth taxes, will still see high earners bear the biggest burden.
Among the Chancellor’s plans are increasing national insurance for individuals employed through partnerships, including doctors, lawyers and accountants, which could raise £2billion.
How much would an income tax rise cost you?
An increase in income tax rates across the board would affect almost everyone, because it is not only charged on income from employment but also from pensions, rentals and savings.
Individuals may also have to pay income tax on some state benefits, including Bereavement Allowance, Carer’s Allowance and Jobseekers’ Allowance.
Someone earning £20,000 currently pays £1,486 in income tax every year, but this would increase by £74.30 – or £6.19 a month – if Reeves raises rates.
An individual earning £35,000, which is approximately the average salary, will be £224.30 worse off a year, or £18.69 a month.
Higher-rate taxpayers earning £55,000 and £75,000 a year, would pay £424.30 and £624.30 more in income tax each year, respectively.
An individual earning £110,000 a year will pay £1,024.30 more in tax a year if the basic and higher rate taxes increase and the personal allowance falls to £7,570.
Tax bands to remain frozen
Reeves is also widely expected to extend the freeze on tax thresholds, which would raise nearly £10billion a year.
This would compound the impact of higher income taxes, because keeping thresholds frozen as wages and inflation grow means they fall behind the cost of living.
This phenomenon, known as fiscal drag, creates a colossal tax raid as lower earners are dragged into paying tax, while the number of taxpayers in higher bands increases.
If Reeves continues the freeze until 2030, the personal allowance will be nearly £5,000 less than it would have been had it risen in line with inflation to £17,047, according to AJ Bell analysis.
The impact of frozen thresholds paired with higher rates of income tax would disproportionately affect middle earners.
Workers who earned £50,000 before the thresholds were frozen in 2021 are expected to be earning £64,295 in the current tax year, in line with forecasts.
However, they are paying nearly £3,000 more in tax because of the frozen thresholds. If the higher-rate threshold had increased to £62,819, their tax bill would be £10,422, but with frozen tax bands they are paying £11,978.
By 2030, the same worker will be earning £73,912 in line with OBR forecasts, with a tax bill of £16,997 if income tax thresholds stay at the same level.
If the higher rate threshold increased to £68,174, in line with 2 per cent inflation forecasts, their tax bill would be £12,520 – £4,476 lower.
Race says: ‘A 1p hike in income tax might seem modest at face value, but its impact is amplified by the scourge of fiscal drag – where rising wages, driven by inflation, push more people into higher tax brackets or into paying tax for the first time.
‘This combination hits middle earners hardest, eroding disposable income at a time when many are still grappling with elevated living costs. It’s a double whammy that could also dampen consumer spending, adding further strain to household finances.
‘For retirees, it’s a double hit – higher tax on pension income could erode living standards.’
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