Taxes on different forms of personal income provide the biggest source of revenue for government. In our latest forecast, we expect income tax to raise £174.7 billion in 2016-17. That would represent 24.2 per cent of all receipts and is equivalent to £6,300 per household and 8.9 per cent of national income.

The main reason that income tax is the biggest source of revenue is that personal income makes up the majority of total national income. There are many sources of personal income on which income tax is levied. These include: labour income (the wages and salaries of employees and earnings of the self-employed), income from investments (including interest on savings and the rental income from buy-to-let properties) and pensions income (from both the state pension and any occupational or private pensions).

Income tax is collected in a variety of different ways:

  • for the majority of employees, it is paid via the pay-as-you-earn (PAYE) system. The amount of tax to be paid is calculated by the employer and transferred directly to the tax authorities (HMRC). This is also known as being deducted at source. It means the individual does not need to deal directly with HMRC and that the tax is paid promptly. We expect 85.0 per cent of income tax in 2016-17 to be raised through the PAYE system.
  • for the self-employed and for those with more than one source of income, it is paid via the self-assessment (SA) system. The amount of tax to be paid is calculated by the individual and declared on a tax return sent to HMRC. Tax returns and associated payments are completed after the tax-year has ended – in most cases in the following January (so January 2018 for the 2016-17 tax year). We expect 16.4 per cent of income tax in 2016-17 to be raised via the SA system.
  • other smaller sources of income tax include company income tax, non-SA repayments (for example, when employees have paid too much tax through the PAYE system), investigation settlements and some receipts that cannot be allocated to a particular source. Taken together, we expect minus 1.5 per cent of income tax in 2016-17 to be raised from these sources – i.e. we expect repayments to exceed other payments.

For most employees National Insurance Contributions (NICs) are also deducted at source while the self-employed pay NICs via SA.

  • Recent trends

  • Latest forecast

    Our latest fiscal forecast was published in March 2017. Income tax receipts are set to rise by 0.1 per cent of GDP by 2021-22. This is more than explained by a rise in the effective tax rate. Most of this is due to our assumption that productivity and real earnings growth will pick up (although to still historically subdued rates), which will mean that more income is subject to tax at the higher and additional tax rates. The process by which the effective tax rate rises as earnings grow faster than the pace at which tax thresholds are increased is called ‘fiscal drag’. It is particularly important in the income tax system because of its progressive structure and large tax base.

    More detail on our latest forecast and how it was revised relative to our previous forecast in March was provided in paragraphs 4.43 to 4.49 of our March 2017 EFO. We describe income tax and NICs together in our EFOs, given the similar underlying drivers of each.

    Expand to read the extract from our March 2017 EFO

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  • Latest monthly data

    Income tax receipts are not evenly spread across the year. PAYE receipts tend to be slightly higher towards the end of the year when many sectors of the economy – particularly the financial and business services sectors – pay bonuses. SA receipts largely arrive in July and January. Both factors mean the monthly data may not provide a good guide to full-year receipts. That is particularly true if there are policy measures that are expected to affect SA receipts in the January.

    Our March 2017 forecast is for total receipts by the end of 2016-17 to be £5.8 billion (3.4 per cent) higher than in the previous year. Around £4.0 billion of that reflects forestalling ahead of a dividend tax change that boosted SA receipts in January. Income tax receipts in 2016-17 are so far up 4.1 per cent on the same period in 2015-16.

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  • Forecast methodology

    Forecast process

    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.

    Forecasting models

    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
    • Employment
    • Inflation
    • 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.)

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  • Previous forecasts

    PAYE income tax receipts were significantly weaker than our initial forecasts, in part reflecting weak average earnings growth. But these errors also reflect movements in tax thresholds that were not factored into our early forecasts (due to differences in inflation and to successive policy measures to raise the personal allowance) as well as the composition of employment gains, which have been concentrated in lower paid industries and age groups, where a larger proportion of each individual’s earnings will be subject to the tax-free personal allowance.

    Employment growth has been stronger than expected, but has not been sufficiently strong to offset the effect of slower growth in earnings. Since the large downward revisions to our economy forecasts in December 2012 and March 2013, PAYE IT receipts have been much closer to forecast up to 2015-16. Receipts in the first half of 2016-17 were particularly weak, prompting a downward revision to our November 2016 forecast that was reversed slightly in our March 2017 forecast.

    SA income tax receipts also fell short of our earlier forecasts. As with PAYE IT, this partly reflects a less favourable mix of labour income growth than expected, with more growth through employment and less through earnings. The distribution of incomes, notably for new workers and among the self-employed, has also been skewed towards the lower end. Tax thresholds were also higher relative to earnings, initially due to higher inflation but also due to policy-driven increases in the personal allowance.

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  • Policy measures

    Since our first forecast in June 2010, the Coalition and Conservative Governments have announced 210 policy measures affecting our forecast for income tax. The original costings for these measures are contained in our policy measures database and were described briefly in the Treasury’s relevant Policy costings document. For measures announced since December 2014, the uncertainty ranking that we assigned to each is set out in a separate database. For those deemed ‘high’ or ‘very high’ uncertainty, the rationale for that ranking was set out in Annex A of the relevant Economic and fiscal outlook.

    Key income tax policy changes since 2010 have included:

    • Above inflation rises in the personal allowance and higher rate threshold. Chart 4.4 (page 97) of our July 2015 Economic and Fiscal Outlook sets out how the personal allowance has been raised faster than was assumed in previous forecasts on the basis of announced policy at the time;
    • Reforms to pensions and savings policy. These include restrictions to the pensions annual and lifetime allowance, additional pensions flexibility, changes to ISA limits and the introduction of a ‘Lifetime ISA’.  Our 2016 working paper ‘Private pensions and savings: the long-term effect of recent policy measures’ sets those changes out in more detail.
    • Changes to the higher rate threshold. Under the previous government, the higher rate threshold was lower at the end of the Parliament than in 2010. Subsequently there have been above-inflation increases for both 2016-17 and 2017-18;
    • Anti-avoidance measures. Since 2010, the Government has announced a large number of policy measures aimed at reducing the level of tax avoidance and evasion and to enhance the compliance performance of HMRC. These measures have been one of the Government’s preferred sources of revenue-raising in recent Budgets and Autumn Statements and costing these types of measures is typically subject to considerable uncertainty. Our 2016 working paper Anti-avoidance costings: an evaluation sets out those policies in more detail.

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  • Ready reckoners

    ‘Ready reckoners’ show how our fiscal forecasts could be affected by changes in selected economic determinants. They are stylised quantifications that reflect the typical impact of changes in economic variables on receipts and spending. These estimates are specific to our March 2016 forecast and we would expect them to become outdated over time, as the economy and public finances, and the policy setting, continue to evolve. They are subject to uncertainty because they are based on models that draw on historical relationships or simulations of policy settings. The table below shows that:

    • changes in labour income have a large impact on income tax receipts. Staggered income tax thresholds mean that receipts rise (and fall) proportionately more than changes in labour income. Income tax receipts are more geared towards earnings than employment, given staggered income tax thresholds;
    • increases in self-employment and other streams of income also feed through into receipts, but with a longer time lag given the self-assessment system which requires taxpayers to file returns by the January after the financial year; and
    • the impact of changes in inflation on cash receipts depends on the extent to which inflation feeds through into higher nominal tax bases, in particular wages. Assuming that average earnings growth is unchanged (which might be the case if inflation was pushed higher by import prices or oil prices), higher inflation would reduce income tax receipts. Higher thresholds – which are uprated in line with inflation – mean that less income is taxed at higher rates. The ready-reckoner picks up just the direct effect of inflation on allowances and thresholds.

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