The OBR commissions forecasts of income tax receipts from HM Revenue and Customs for each fiscal event. The forecasts start by generating an in-year estimate for receipts in the current year, then use different models to forecast growth in receipts from that starting point. We provide HMRC with economic forecasts that are then used to generate the tax forecasts. These are scrutinised in a challenge process that typically involved three rounds of meetings where HMRC analysts present forecasts to the Budget Responsibility Committee and OBR staff. This process allows the BRC to refine the assumptions and judgements that underpin the forecasts before they are published in our Economic and fiscal outlooks.
PAYE income tax
The PAYE income tax model takes our forecasts of employment and earnings and applies an average (‘effective’) tax rate and a marginal tax rate respectively to them to generate a forecast of PAYE tax receipts.
HMRC estimates the effective tax rate on wages and salaries using their Personal Tax Model (PTM) – a micro-simulation model based on a survey of taxpayers’ liabilities. This model calculates the average marginal tax rate on additional income by taking account of reliefs, allowances and our assumptions on inflation and any differences in earnings growth at different points in the earnings distribution. The model then applies these tax rate forecasts to income growth to generate a receipts forecast.
The effects of past policy measures that have not yet been fully implemented, off-model factors such as the effect from incorporations and any new policy measures announced by the Government are then added onto generate our final forecast.
SA income tax
The SA IT forecast starts by splitting up historical tax return data into key income streams (e.g. sole traders’ profits, dividend receipts, savings income, land and property income). These income streams are then projected forward using determinants from our forecasts. An average effective tax rate is then calculated and projected forward using an econometric model. This average effective tax rate is applied to the forecast income streams to create an SA liability forecast.
SA income tax is generally paid in the financial year after the SA liability arises. To account for this, the SA liability forecast is converted to receipts using timing information from previous years. Future changes to the tax system (announced as Budget measures) and other ‘off-model’ factors (such as the tax implications of rising incorporations) are also included in the forecast.
Other income tax
Other minor streams of income tax are forecast in line with historic trends.
Main forecast determinants
The main determinants of our income tax forecast are those related to the tax base and those that used by the Government in setting parameters of the tax system. See the ready reckoners section below for more information on the effects of these determinants on income tax receipts.
- Average earnings
- Other SA income tax streams (i.e. income from self-employment, dividends and other forms of income)
Main forecast judgements
The most important judgements in our income tax forecast are related to the economy forecast that underpins it – most important of all being the outlook for productivity growth and hence earnings growth. Alongside those, we need to make a number of other forecast judgements. These include:
- In-year estimate – Our estimate for income tax receipts in the current year is determined by performance of receipts year-to-date, our economy forecast and any other indications from the HMRC model. The in-year estimate determines the base year from which we use our models to forecast receipts growth. For PAYE income tax, it implicitly reflects the average effective tax rate on wages and salaries.
- Differential earnings growth – Given the importance of the shape of the income distribution for PAYE receipts, we allow for differential earnings growth across it when calculating the average and marginal tax rates for the forecast. The top-end of the income distribution is more ‘tax-rich’ as the average tax rate broadly rises in line with income, so this is an important judgement in the forecast.
- Assumption on bonuses – PAYE income tax receipts are received disproportionately towards the end of the financial year, reflecting the tax paid on end-of-year bonuses. Our assumptions on financial and non-financial sector bonus growth drive our expectations of these end-of-year receipts.
- Incorporations – Our PAYE, SA, NICs and corporation tax (CT) forecasts are affected by our assumption that incorporations will continue their rising trend. Employment income is taxed more heavily that profits and dividends, so when formerly employed or self-employed individuals incorporate, their tax bills generally fall and the government loses income tax revenue. (See Box 4.1 of our November 2016 EFO for more detail.)