You may not have heard of Tax Freedom Day, but one thing is sure: after reading about it, you will recognise the importance of tax planning. In summary, Tax Freedom Day is an annual calculation carried out by the Adam Smith Institute demonstrating how many days a year we need to work to pay our annual taxes. While seen by some as a potential gimmick, this is the harsh reality of life in the UK today!
Tax Freedom Day is getting later and later
It will be no surprise to learn that Tax Freedom Day in 2023, 18 June, is the latest since records began in 1995. To put this into perspective, if the “average” taxpayer were to allocate their pay to cover their tax bill on 1 January, it would take 169 days before the debt was cleared. To put the current situation into context, Tax Freedom Day was on 8 June last year. Going back to the initial calculation in 1995, it was 4 May!
While the long-term trend certainly remains upward, there have been blips at the turn-of-the-century, as a consequence of the financial crisis in 2008 and the challenges of COVID-19. Unfortunately, the rate is projected to rise sharply in the coming years, expected to hit 23 June by 2025. So what does this mean, and how can you protect yourself in the future?
How is Tax Freedom Day calculated?
Firstly, there is no “average” taxpayer due to the enormous complexity of the UK tax system. At first glance, many people will look towards income tax as the main driver. In reality, those on relatively low incomes are hit hardest proportionately by VAT and other similar taxes. The basic calculation is as follows:-
UK taxpayer contributions in 2023: £901.8 billion
Net national income: £1.95 trillion
Taxpayer contributions/Net national income: 46.25% (169 days of the year)
Tax Freedom Day: 18 June
Those who calculate Tax Freedom Day readily admit that there is no “average” taxpayer, but it gives you an idea of the growing tax take across the spectrum.
What does the future hold for Tax Freedom Day?
The UK government is in a very tricky situation at the moment. The national debt continues to rise; interest rates followed suit (but should start falling soon), and budgets for public services are under severe pressure. Unfortunately for taxpayers, several announcements in the recent budget will lead to an extended Tax Freedom Day and a more significant percentage of our income going to HMRC.
Income threshold
All politicians and governments are reluctant to increase income tax rates as they do not resonate well with the electorate. Unfortunately, they can undertake an activity known as “fiscal drag”, which sees rates remain unchanged but increases the tax take. How does this work?
Traditionally, income tax bands have increased in line with inflation, which, in theory, maintains relative spending power for individuals and families. However, the Chancellor of the Exchequer, Jeremy Hunt, recently announced a five-year freeze on income tax thresholds.
To put this into context for an individual:-
Tax year: 2023/24
Gross salary: £12,570
Personal allowance: £12,570
Taxable element: £0
If we assume 10% inflation and a likewise increase in gross salary for the tax year 2024/25 to maintain relative spending power, the situation would be as follows:-
Tax year: 2024/25
Gross salary: £13,827
Personal allowance: £12,570
Taxable element: £1257
Income tax liability (20%): £251
Even though the 10% increase in gross salary was simply a means to maintain spending power, accounting for inflation in the 2024/25 tax year, the tax liability of £251 equates to a real-term cut in income.
According to some experts, due to “fiscal drag”, 1.7 million people will pay income tax for the first time in 2023, with 1.2 million pushed into the higher income tax band. Figures from the Office for Budget Responsibility are even more alarming, suggesting the number paying the 40% tax rate will increase from 5.3 million to 6.7 million.
Dividend tax allowance
The dividend tax allowance currently stands at £1000, which means that the first £1000 of any dividend income will not be subject to dividend tax. First introduced back in 2016, the original allowance stood at £5000 before being reduced to £2000 in 2018. The Chancellor halved the rate to £1000 for the 2023/24 tax year with a further 50% reduction to £500 for the 2024/25 tax year.
While the dividend tax rate is less than income tax, it is still an additional charge:-
- Basic rate taxpayers 8.75%
- High rate taxpayers 33.75%
- Additional rate taxpayer 39.35%
At the stroke of a virtual pen, those receiving more than £1000 a year in dividend income will be hit with a further tax charge.
Capital gains tax allowance
The capital gains tax allowance, which stood at £12,300 for the 2022/3 tax year, was slashed to £6000 for the 2023/4 tax year. It will also fall by a further 50% in the 2024/25 tax year, taking the figure down to £3000.
Due to the ongoing reduction in the capital gains tax allowance, more taxable gains will be added to your income and charged at the relevant rate. This will be particularly damaging for those with gains outside tax-efficient investment vehicles such as pensions and ISAs.
Inheritance tax allowance
The inheritance tax allowance was frozen at £325,000 from April 2009 until 2026. However, just recently, the Chancellor extended this freeze up to 2028. This is the level at which chargeable assets in a deceased estate will incur a 40% tax charge. Considering that the average UK home is now valued in excess of £281,000, and many people have additional assets, investments and savings, it puts the freeze into perspective.
If the inheritance tax allowance had been increased in line with inflation between 2009 and 2023, it would now stand at £483,812 – an allowance shortfall of £158,812.
Tax planning
While there is a jovial element to “Tax Freedom Day”, there are potentially severe consequences for those who fail to undertake even basic tax planning. At the moment, it looks as though the situation will get worse before it gets better, which increases the benefits of tax investment vehicles such as:-
- ISAs
- Pensions
- Trusts
There are also numerous gift allowances which can be used in your lifetime. For those facing significant capital gains, Enterprise Investment Scheme (EIS) relief may also be relevant and worth discussing with your financial adviser.
Conclusion
In isolation, the UK government’s various tax “tricks” seem relatively benign. Only when you consider them together does the cumulative impact become evident. Consequently, it is essential you consult with your financial adviser, as there may be ways to reduce your tax liability and increase your savings for the future.
The initial Tax Freedom Day was calculated on 4 May 1995 and stands at 18 June today. We are working more than one month extra to cover the average taxpayer’s annual liability, and the situation seems set to worsen before it improves.
Call us today and see if you can take a few days off working for HMRC!