Tax U-turn comes at a price

CHANCELLOR Alistair Darling delighted taxpayers last week when he handed a tax bonanza of an extra £120 annually to around 22 million people. But in doing so he blew a major hole in the Government's finances which will have to be repaid in years to come through higher taxes.

Furthermore, the long-term goal of aligning tax and national insurance has also gone out the window.

HM Revenue & Customs is to begin contacting employers immediately to notify them that their staff's tax codes have changed. It is expected that a rebate will hit September wage packets to compensate for the backdated cut from April. Then tax bills will be slightly lower for the rest of the tax year.

Similarly HMRC will contact insurance companies and pension funds to notify them of a change to the tax they should be deducting from annuity payments.

Darling was effectively forced to rewrite his Budget only weeks after it was delivered because of a storm over the scrapping of the 10p tax band, which had been decided upon and announced by Prime Minister Gordon Brown while he still occupied 11 Downing Street.

Backbench MPs revolted and threatened to defeat the Government's finance bill when it emerged that more than five million people on earnings below £19,355 were left up to £232 worse off. Together they had lost up to £1bn.

Targeting compensation directly at the different groups affected was problematic. So the Chancellor decided to raise the personal allowance for everyone by £600 from £5,435 to £6,035.

Mike Warburton, head of tax at Grant Thornton, said: "I wouldn't have wanted to start where the Chancellor was forced to start. But given that was where we were, this is the least bad option for fixing the problem."

And the good news is the higher personal allowance is here to stay. Opposition MPs have decried the move as a one-off. But once allowances have been increased it is virtually impossible for them to be clawed back.

Governments are obliged to increase personal allowances by at least the rate of inflation, so despite suggestions to the contrary, it will be very difficult for Labour to unpick the windfall next year.

Those earning £6,035 to £40,835 gain most, enjoying the full £120 windfall. However, not everyone wins, and according to the Institute for Fiscal Studies, of the 17.5 million families who gain, 13 million weren't losing to start with.

Higher-rate taxpayers will not benefit, because the Government has reduced the band of income at which tax is levied at 20% by £1,200 from £36,000 to £34,800. This means higher-rate tax will now normally bite at £40,835 rather than £41,435, dragging 150,000 more individuals into top tax, although even these will not technically be worse off because of the package of reforms.

Those earning between £5,435 and £6,035 should gain something, but less than £120, because they were not paying that much in tax anyway. Similarly, anyone earning between £6,635 and £13,355 may still be losing out as a result of the abolition of the 10p band. As before, the worst hit are those earning around £7,755, but rather than £232 their shortfall will have dropped to £112.

The big question is what happens at next year's Budget? The Government's finances are heading for the rocks, so while they may not be able to cut the personal allowance again, workers should brace for tax hikes in other areas.

Warburton also pointed out: "The Government has been working to bring the tax and national insurance thresholds into line, but they are now wide apart, so we will have to see what happens on that front."