Income tax: the percentage game

Simple, it's not: Clifford German guides you through the complex web of allowances and bands

Nigel Lawson achieved a major milestone in 1987 when he simplified the income tax system down to just two basic rates. Since then his successors have in practice reversed the process as a result of their attempts to bring in minor "improvements" to impress the voters.

The income of employees is calculated by adding bonuses and overtime and casual earnings to income from employment and then subtracting any earnings that employees pay into an approved pension scheme, occupational or personal.

In the tax year that starts on Saturday everyone has a pounds 3,765 a year tax-free allowance. The single earner then starts to pay the reduced rate of 20 per cent on the next pounds 3,900 of income which means anything up to pounds 7,665 a year, rising to 24 per cent on the next pounds 21,900, up to and including pounds 29,265 a year, and then 40 per cent on anything above that.

But married couples (and some others) have a further allowance of pounds 1,790 a year, which they can share between them or allocate to whichever earns the most. These allowances push up the starting points of the three tax bands, but this extra band is only given tax relief at 15 per cent, which means in practice you still pay 5 per cent if you are a reduced rate taxpayer, 9 per cent as a standard rate payer and 25 per cent as a top rate taxpayer.

No income tax is payable on interest on Tessas and dividends on PEPs and Corporate Bond PEPs, or on tax-free National Savings certificates. Anyone who earns less than the tax-free allowance can register as a non- taxpayer and received interest gross and tax-free, and can apply to reclaim tax on dividend interest.

Other interest and dividend income is added to earned income for tax purposes. But lower rate and standard taxpayers alike only pay 20 per cent on their interest and dividend income, although top rate taxpayers are liable to pay a further 20 per cent on interest and dividend income.

Our flowchart shows how complex the tax system has become again; and it makes no mention of the fact that mortgage interest tax relief is only worth 15p in the pound, and unlike the married allowance it does not raise the starting point of the main tax bands.

It also leaves no room for the higher tax-free allowances which raise the starting point for tax for people aged over 65 and over 75, or their married couples allowances which also qualify for tax relief of only 15 per cent. Worse still, these higher tax-free allowances are reduced by pounds 1 for every pounds 2 of extra income.