Budget 2015: The personal tax allowance will be increased to £10,800 from April 2016, and to £11,000 from April 2017, Chancellor George Osborne has announced during the 2015 Budget.
The allowance, which is the amount employees can earn before they have to start paying tax, will enable the average taxpayer to save £905 a year by 2017-2018.
Mike Kelly, head of living wage at professional services firm KPMG, said: “With personal allowances growing to £11,000 before being subject to tax, it will mean that people on less than a living wage will only be £6.40 per week better off in 2017-18. Surely this isn’t good enough?
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“The fact remains that more than five million people are earning less than they need to live on and this change will not eradicate working poverty.”
Julie Hutchison, savings and tax expert at Standard Life, said: “The combination of a higher starting point for income tax, a new band of tax-free savings income, and the ability to transfer some unused personal allowance to a spouse or civil partner are all positive aspects which re-balance the tax system in favour of the saver.
”So if an employee is on a lower income, they will be able to keep more of their money and pay less tax.”
Savers should treat the Budget’s stepped increase in tax free allowances as an opportunity to increase their pension contributions. The best time to increase contributions to savings is when you received a pay rise and this increase in tax free allowances should be treated in the same way. According to the Chancellor, by 2017 an individual could be £900 a year better off when the tax free allowance moves to £11,000. If invested and assuming a 5% per annum investment return over 20 years1 that could amount to over £32,000 in additional savings for retirement.
This is a consideration savers should take particularly seriously. The average defined contribution pot size is £35,6002, meaning a median earner has less than a 50:50 chance of achieving an adequate income at retirement from state and private pensions if they don’t contribute more than the minimum required by automatic enrolment, even taking into consideration current plans for auto escalation.
The higher personal allowance of £10,800 is another shot in the arm for pension freedoms, boosting the tax-free amount people can draw from their pensions. With careful planning, a couple could have £306,000 saved in pension and draw this tax-free over their lifetimes on top of their state pensions
One justification of increasing the personal allowance often cited is that taking the lowest paid out of tax improves work incentives. It is important, therefore, to be clear about just how increasing the personal allowance does affect those on low incomes.
Any increase in the personal allowance will not benefit the lowest paid at all. If the personal allowance is already £10,000, and it goes up to £11,000 by 2017/18, those earning under £10,000 a year will gain nothing. That includes all those who have earned the national minimum wage for 30 hours a week over the last year.
As for those on the next rung of income, the picture is mixed depending on whether they receive tax credits or means tested benefits. Because entitlement to tax credits is assessed on pre-tax income, tax credit claimants on incomes above £10,000 a year should receive the full benefit of any future increases in the personal allowance. But because universal credit, like other means-tested benefits, is assessed on after-tax income, claimants will see a reduction in their universal credit equivalent to the cut in their tax bill. The net result is that they will receive only 35% of the benefit of any increase in the personal allowance.
If the Government want to improve work incentives for those on the lowest incomes too they should increase the work allowance in universal credit and the first income threshold in working tax credit. The work allowance in universal credit is the amount a claimant can earn before their benefit starts to be progressively withdrawn. The first income threshold fulfils a similar function in tax credits. At present both are frozen year-on-year, but increasing them would help those on the lowest incomes who see no benefit from any increase in the personal allowance.