The impact of a 4 per cent cut in income tax

The promise to cut the basic rate of income tax by 4 per cent by the end of the decade, if inflation is brought under control, is certainly eye-catching, but how might it work in practice and who is likely to benefit from it?

Income tax is the Treasury’s most valuable player for generating government revenues so it’s an incredibly expensive tax to cut. In the year to 5 April 2022, income tax accounted for £228bn of the £916bn raised in public sector receipts, nearly 25 per cent.

Latest government statistics suggest that a 1 per cent cut in the basic rate of income tax could cost around £6.4bn per year from April 2024. Assuming the figures remain around that level for the rest of the decade, a 4 per cent cut to the basic rate of tax could cost the public purse around £25.6bn per year in tax revenues.

Given it is simply a leadership election pledge at this stage, there is limited detail on how this tax cut would apply. However, Mr Sunak did announce a similar policy in the Spring Statement earlier this year when he committed to cutting the basic rate of income tax from 20 per cent to 19 per cent from April 2024.

If Mr Sunak’s recent proposal follows the same approach, the basic rate tax cut he proposes would not apply to dividend income. It would however apply to income such as salaries, rental income and interest.

So, an individual, such as a business owner or pensioner, who receives their income from dividends would remain worse off than they were last year and would not feel the benefit of Mr Sunak’s proposed tax cuts, due to the 1.25 per cent increase in the tax rate that applies to dividends from April 2022.

For example, a business owner who withdraws £50,000 profits each year by way of dividends would be around £440 worse off in April 2024 and in later years than they were in the 2021/22 tax year, irrespective of the proposed future income tax cuts.

In contrast, a buy-to-let landlord receiving rental income of £50,000 would be nearly £1,500 better off if the basic rate of income tax was reduced to 16 per cent.

It seems peculiar that dividend income would be penalised by the proposed income tax cuts whereas other forms of investment income or profit extraction would not be. It may simply be an unintended consequence of a policy introduced at pace ahead of the Spring Statement and could be ripe for review. If it is a deliberate move however, perhaps the motivation is to limit the tax advantage available to small business owners of extracting profits by way of dividends. At a time of international football success, the former Chancellor runs the risk of an own goal with some party members on a key tax policy.