Pensions expert Steve Webb has warned that an extra 2.5m taxpayers could face being dragged into the higher rate tax over the course of the current Parliament.

Sir Steve, a partner at pensions consultancy LCP and a former Pensions Minister, says faster than expected wage growth and the freezing of tax thresholds is likely to push millions more into the higher rate bracket. 

He warns that by the time of the next election in 2024/25 1 in 5 of all taxpayers could be paying higher rate tax.

On the positive side, he says this will also mean that they could potentially get 40% tax relief on their pension contributions.

According to his analysis of HMRC figures published in June 2021, at the time of the last election in 2019/20 there were 4.3m people paying income tax at the higher rate of 40% or the additional rate of 45%. 

When HMRC published the analysis last year, it estimated that the number of higher rate taxpayers would have grown to 4.6m people by 2021/22, an increase of around 300,000.

However, when HMRC published its estimates in 2021, it only had access to OBR estimates for wage growth published in the March 2021 Economic and Fiscal Outlook. Since then, the OBR has “dramatically” increased its estimate of wage growth to date and into the future, he said.

The table shows the changes in the OBR’s assumptions between the two reports.

Table: Percentage growth in wages and salaries compared with previous year 

Source: LCP / HMRC 

Source: Economic and Fiscal Outlook, OBR, March 2021 and March 2022

HMRC’s estimate of the number of higher rate taxpayers in 2021/22 was based on assuming growth in total wages and salaries of 0.9% in 2020/21 followed by an increase of 2% the following year, giving a combined increase of 2.9%, Sir Steve said. However, OBR now thinks that wages and salaries grew by 2.6% in 2020/21 and 7.5% in 2021/22 giving a combined increase of over 10%, more than three times as fast.  

Using published HMRC data on the distribution of taxable incomes and tax deductions, Sir Steve estimates that a much greater than expected increase in taxable incomes between 2019/20 and 2021/22 means the number of higher rate taxpayers in 2021/22 is likely to be closer to 5.2m, an increase of just under 1 million higher rate taxpayers since the election. 

He said: “In total, it seems likely that up to 2.5m extra people could be brought into higher rate tax between the general election in 2019 and an election in 2024/25.  This means more than 1 in 5 taxpayers will be paying at the higher rate in 2024/25 compared with fewer than 1 in 10 in 2010/11.

“HMRC admitted last year that it thought over a third of a million extra people would be brought into higher rate tax in the first two years of this Parliament.  But that was before the surge in wage levels as the economy has bounced back from the pandemic.  As a result it is likely to be closer to a million people who have been brought into higher rate tax so far. In addition, three more years of relatively rapid wage growth coupled with a freeze on tax thresholds could bring a further 1.5 million people into higher rate tax by the time of the next election, making a total of 2.5 million more over the whole Parliament.

“There is no doubt that freezing tax allowances and thresholds is the ultimate stealth tax. No minister has to announce a rise in tax rates, but tens of millions of people pay more tax, and millions of those will even be dragged into higher tax bands purely because of wage inflation. This is certainly not a transparent way of raising extra tax revenue.  However, it does mean that millions of people now have a much bigger incentive to put more money into their pensions, potentially enjoying double the rate of tax relief on any contributions.”