Frustrating UK tax quirks can easily mean missed mortgage payments

WHEN HMRC wrongly changed my tax code last October, I was paying 40 per cent of my total income as tax for six months. It had a huge impact on my finances – my take home pay went below my mortgage costs. And HMRC couldn’t correct it, despite admitting its error. In the end I had to hire an accountant to reclaim the money I was owed. It’s no wonder that tax accountants like complex tax codes.

Although this was highly frustrating, it only cost me a few hundred pounds and I appreciate that mistakes can happen. But I recently had another nasty surprise and was once again unable to pay my mortgage. And it wasn’t an error. It was the result of an integral part of the tax system.

In the UK, we have a progressive income tax – the marginal rate rises with your income. Most of us get to keep £8,105 tax free, with a 20 per cent rate on the next £34,370. Once your earnings go above this, you pay 40 per cent on the additional amount. And currently, 50 per cent is levied on earnings above £150,000. At least this is what I thought. But it isn’t actually the case.

Pay As You Earn (PAYE) taxes are calculated on a cumulative, monthly basis. Therefore, these thresholds are not applied to your annual income. They are adjusted to an estimate of your annual salary, based on your monthly earnings. This is an important difference.

In June, I made the fatal error of doing some additional work and received a bonus. HMRC treated the additional payment section of my payslip as the same as basic pay, and thus inferred that my annual salary had tripled. So it began taxing part of my earnings at a higher rate.

When I received my July pay slip, I was shocked to see that my tax rate continued to reflect this inference, even though my basic salary was back to normal. From June to July my basic salary did not change, and I will not be earning more than £150,000 in this tax year. And yet the proportion of my income taken as tax doubled. Once again, I find myself paying 40 per cent of my monthly salary as tax, rising to around 48 per cent if you include national insurance contributions.

As the year passes, and it becomes obvious to HMRC that my bonus was indeed a bonus, it will start paying back some of this money. But, just like last year, I am in the frustrating situation of the state taking more of my earnings than it should, while refusing to pay it back. This time it isn’t an error, but how PAYE is supposed to function.

If you look at my situation over the course of a year, the correct amount of tax will have been levied. But the marginal rate has fluctuated wildly from month to month. The fact that it will be corrected over time is scant consolation when I have bills to pay right now. What is more frustrating is that these quirks of the tax system are hidden when you look on an annual basis. But they place significant burdens on taxpayers, and are a major reason why simpler, flatter taxes would be fairer.

Anthony J. Evans is associate professor of economics at ESCP Europe Business School.

Twitter: @anthonyjevans