12th January 2021

What is taxation?

Taxation – tax for short – is the way the Government raises much of the money the country needs to pay for the things that we all benefit from, such as schools, the NHS and roads.

Who pays tax?

There are many forms of tax, but the one we’re going to look at in detail is income tax.

As soon as we start to earn over a certain amount of money each year, a proportion of that money is paid to the Government via their tax collection agency Her Majesty’s Revenue and Customs (HMRC). The amount paid to the Government is known as income tax.

If we work for an employer, the employer deducts income tax from our earnings and sends it to HMRC. If we’re self-employed (i.e. we work for ourselves), we are responsible for paying the income tax we owe directly to HMRC.

The personal allowance

Each year, nearly everyone is allowed to earn up to a certain amount of money free from income tax. This is known as the personal allowance. In tax year 2020/2021 – which runs from 6 April 2020 to 5 April 2021 – the personal allowance is £12,500. The personal allowance generally (but not always) goes up each tax year and its existence means that those on relatively low incomes, including most of those who work part time while in full time education, do not typically pay any income tax.

For example, if Edie works part time and earns £10,000 a year, she will not pay any income tax because her income is below the personal allowance of £12,500. The personal allowance will reduce, partially or completely, for those earning over £100,000.

The tax bands

UK income tax is a progressive tax. This means that the Government takes more money from those who earn more, than from those who earn less. Most people feel this is fair.

Income in excess of the personal allowance is known as taxable income. It is taxed as follows

Taxable income
(income in excess of £12,500)
Tax band Tax rate
Up to £37,500 Basic rate 20%
£37,500 to £150,000 Higher rate 40%
Over £150,000 Additional rate 45%

Again, these figures are for the 2020/21 tax year.
(Different bands and rates apply if you live in Scotland.)

The tax bands in practice

Let’s say Edie gets a full time job and now earns £20,000 a year. She’ll pay income tax as follows:

  • First £12,500, no tax as this falls within her personal allowance
  • Next £7,500, taxed at 20% as this falls within the basic rate tax band

Edie’s tax bill is therefore:
£7,500 x 20% = £1,500

Why do you think Edie still benefits from a personal allowance?

Even when you start to earn more than the personal allowance you generally get to keep it, so you’ll not usually pay tax on the first £12,500 of your earned income.

The one exception to this rule is if you earn over £100,000. Once your earnings reach this level, the Government starts to gradually withdraw the personal allowance. Once you get to £125,000, you receive no personal allowance at all.

Let’s take a look at another example:

Kazia joined the graduate scheme of a top London investment bank. Her starting salary was £35,000, but she’s also managed to earn herself a bonus of £20,000.

Here’s how much income tax Kazia will have to pay:

  • First £12,500, no tax as this falls within her personal allowance
  • Next £37,500, taxed at 20% as this falls within the basic rate tax band
  • Remaining £5,000, taxed at 40% as this falls within higher rate tax band

Kazia’s tax bill is therefore:
(£37,500 x 20%) + (£5,000 x 40%) = £9,500

Kazia’s boss Tariq has total earnings of £170,000.
He will have to pay:

  • £37,500 taxed at 20%, as this falls within the basic rate tax band
  • £112,500 taxed at 40%, as this falls within higher rate tax band
  • £20,000 taxed at 45%, as this falls within the additional rate tax band

Tariq’s total tax bill is therefore:
£7,500 + £45,000 + 9,000 = £61,500

Remember, that due to his high earnings, Tariq does not get a personal allowance.

Progressive tax can be a little tricky to get your head around so see if you can complete the table below to check your understanding. Place a tick or a cross in the appropriate cell:

Benefits from
personal allowance
Pays some tax at
Pays some tax at
Pays some tax at
Jo earns £8,500
Lou earns £23,000
Karl earns £90,000
Gemma earns £165,000

With thanks to our partners over at the NMBA for content.