Workers May Cut Hours to Avoid Higher Taxes, Budget Watchdog Warns

Workers may reduce their working hours to avoid being pushed into higher tax brackets, according to an analysis by the UK's Budget watchdog. This warning comes as the government has extended the freeze on income tax thresholds until the end of the decade.

The Office for Budget Responsibility (OBR) forecasts that these frozen thresholds could lead to a decrease in the labor supply by approximately 215,000 hours annually. This 'stealth tax raid' is projected to generate significant revenue for the Treasury, potentially reaching £55 billion per year by 2030. The income tax thresholds have remained unchanged since their freeze was implemented in 2021.

A significant factor contributing to this potential reduction in working hours is the "childcare cliff edge" at the £100,000 income mark. Families with one parent earning over this amount lose their entitlement to 30 hours of free childcare and tax-free childcare, which is worth up to £2,000 annually. They also lose eligibility for child benefit. As incomes rise due to inflation and wage growth, more parents are crossing this £100,000 threshold, exacerbating the issue.

The OBR noted that it is "possible that individuals earning above the £100,000 cut-off threshold have reduced their hours worked to receive the childcare benefit." If the childcare threshold had been adjusted for inflation since its introduction, it would now be around £137,000.

Furthermore, individuals earning £100,000 or more face a marginal tax rate of 60% because their tax-free personal allowance begins to taper off before being fully eliminated at £125,140. The threshold for the additional rate of income tax (45p) was also reduced by the Chancellor from £150,000 to £125,140 starting in April 2023. If this threshold had kept pace with inflation, it would be £132,160 currently and £135,920 by 2030-31.

The freeze on the tax-free personal allowance, which has remained at £12,570 for five years, means that as wages rise with inflation, more people are brought into the tax system or moved into higher tax brackets. The analysis suggests that if this allowance had risen with inflation, it would now be £16,080. This phenomenon, known as fiscal drag, is estimated to cause millions more taxpayers to fall into higher and additional rate bands, leading to thousands of pounds in additional tax payments annually.

By 2031-32, it is forecast that 6.7 million more people will pay income tax and 5.4 million more will be subjected to the higher rate compared to a scenario where thresholds had increased with inflation. The UK's overall tax burden, already projected to reach record levels, is now expected to peak even higher, with the OBR forecasting it to increase sharply from 36% of GDP in 2025/26 to a record 38.6% by 2031/32.

In a separate development, plans are in place to raise the income tax threshold for the poorest pensioners to £13,036, aligning it with the full new state pension rate from April. This measure is intended to prevent those solely reliant on the state pension from paying income tax for the first time, as the annual amount would have exceeded the current £12,570 threshold. However, concerns have been raised that this change might only apply to pensioners under 75 receiving the new state pension, potentially excluding older pensioners on older systems and creating a 'two-tier' system.