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 £188.5 billion in 2018-19. That would represent 24.3 per cent of all receipts and is equivalent to £6,600 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 84.4 per cent of income tax in 2018-19 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 16.1 per cent of income tax in 2018-19 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 0.5 per cent of income tax in 2018-19 to be raised from these sources – i.e. we expect repayments to exceed other payments.

Some income tax has already been devolved to the Scottish Parliament and in future more will be devolved to the National Assembly for Wales. For more information see our webpages on fiscal devolution.

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

  • Latest forecast

    Our latest fiscal forecast was published in March 2018. Income tax receipts are set to rise by 0.3 per cent of GDP between 2017-18 and 2022-23. Around a third of this rise reflects base effects in 2017-18, including the unwinding of dividend forestalling. The bulk of the remaining increase is 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 November 2017 was provided in paragraphs 4.37 to 4.45 of our March 2018 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 2018 EFO

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  • Latest monthly data

    Income tax receipts are not evenly spread across the year:

    • PAYE receipts are usually fairly stable, but 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 when taxpayers make advance payments on account and any outstanding balancing payments.

    Both of these 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 – towards the end of the fiscal year.

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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 involves two 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 on to 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.

    Devolved income tax

    Income tax devolved to the Scottish Parliament and National Assembly for Wales is forecast by aggregating the relevant whole UK income tax streams and applying a share estimate. For more information see our devolved taxes and spending forecasts publication.

    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.

    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 several 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 than 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.)
    • Assumptions about forestalling – The path of SA income tax receipts has been significantly affected by income shifting (largely of dividends) in response to policy measures such as the April 2016 dividend tax rise and the April 2013 cut in the additional rate of income tax to 45p. Both the size of any income shifting and the speed of unwinding can affect SA forecasts.

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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 218 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.
    • Dividend taxation. Reforms to the taxation of dividend income were made in Summer Budget 2015. The basic, higher and additional rates were raised by 7.5 percentage points and a tax-free allowance introduced on the first £5,000 of dividend income (later reduced to £2,000). We allowed for substantial income shifting ahead of the dividend tax rise.
    • 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 2017 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. More information can be found in the ‘Tax and spending ready reckoners’ spreadsheet we published alongside our 2017 Fiscal risks report.

    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.
    • 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.

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  • Other information

    A further breakdown of our income tax and NICs forecast can be found in our EFO supplementary tables.

    Model review

    In our 2017 Forecast evaluation report we set out the initial conclusions of our review of fiscal forecasting models. This section sets out the conclusions of our review of some of our income tax forecasting models.

    Self-assessment income tax

    Self-assessment income tax is a relatively complex receipts stream because the underlying liabilities relate to a range of different income sources about which there is generally a lack of timely data. This generates uncertainty about the tax base assumptions fed into the forecasting model. The effective tax rate modelling is relatively simple, based largely on historical averages, forecast judgement and off-model adjustments for the effects of policy measures, of which there have been many in recent years.

    The average absolute two-year ahead fiscal forecasting difference since our March 2012 forecast has been 9.3 per cent, which on a volatility-adjusted basis is higher than average across our fiscal forecasts. The average difference has been negative at 9.3 per cent, again larger than average, with all the past four March forecasts over-predicting receipts at the two-year horizon.

    While much of the relatively poor forecast performance will relate to tax-base assumptions and policy costings, we consider modelling issues to have contributed too and have agreed the following priorities with HMRC for development work over the coming year:

    • Develop alternative approaches to modelling the effective tax rate.
    • Deeper analysis of trends in the tax base and (with the ONS) consider how these are reflected in the National Accounts so that the model can appropriately transform elements of our National Accounts-based economy forecast into tax base assumptions.

    PAYE and NIC1 integrated payment model

    Income tax and ‘Class 1’ NICs paid through PAYE are the largest item in our receipts forecast, so while they are not particularly volatile relative to some taxes, even small percentage forecast differences can be material for our overall fiscal forecast. Our PAYE forecast model uses our earnings and employment growth forecasts to project the tax base from the latest base year and applies average effective tax rates (AETRs) derived from the ‘Personal Tax Model’ (the PTM, which we have reviewed separately). The model was extended to incorporate NIC1 payments in 2015, which had a number of advantages relative to the previous modelling approach (see our November 2015 EFO for more detail). Abstracting from uncertainty around the key determinants, the main fiscal forecasting challenge relates to the judgements that are fed into the model, in particular the current year receipts estimate and assumptions about differential earnings growth, which drive the shape of the income distribution that underpins the effective tax rate assumption.

    For PAYE income tax, the average absolute two-year ahead fiscal forecasting difference since our March 2012 forecast has been 1.7 per cent, which on a volatility-adjusted basis is lower than the average across our fiscal forecasts. The average difference has been negative at 0.2 per cent, smaller than average, with an equal number of March forecasts since 2012 under- or over-predicting receipts at the two-year horizon. NICs fiscal forecasting differences have tended to be larger and positive, although these mostly reflect differences from forecasts produced using the old model.

    We have agreed the following priorities with HMRC for development work over the coming year:

    • Improve the transparency of smaller receipts streams in the model (such as the tax on occupational pensions).
    • Exploit real-time information (RTI) data more to help inform key assumptions (such as the in-year estimate and differential earnings growth).

    Personal tax model (PTM)

    The Personal Tax Model (PTM) is 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 about 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 main forecasting challenge relates to the shape of the income distribution and the differential earnings growth assumptions that are fed into this model to project the distribution.

    The PTM model is a component of our overall PAYE income tax and NIC1 forecasts. The fiscal forecasting differences associated with these overall forecasts are discussed in relation to the PAYE and NIC1 integrated payment model.

    We have agreed the following priorities with HMRC for development work over the coming year:

    • Exploit real-time information (RTI) data to help inform the projection of the base-year micro data.
    • Develop a top-down representation of the underlying income distribution to provide a cross-check on the model outputs in order to facilitate forecast scrutiny.

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  • Boxset