Britons to be clobbered with highest tax burden since the 1940s

Jason Hollands, Managing Director of Bestinvest, the online investment platform, comments:

Today’s Autumn statement confirms what many had already feared – Britons are set to be clobbered by the highest tax burden since the late 1940s as the costs of the COVID pandemic come home to roost. This will add to the financial pain they are already feeling from declining real incomes and rising borrowing costs.

The irony is that this heavy tax burden has happened under a Conservative government – the traditional champions of a low-tax environment. The drawn-out nature of the freeze on tax allowances and thresholds confirmed today will last well beyond the next election, putting whichever party forms the next Government in a very constrained position.

Millions more to be drawn into higher rate tax bands

The new set of measures unveiled by Chancellor Jeremy Hunt could not be more different to those delivered in Kwasi Kwarteng’s disastrous mini budget. That pro-growth stance, which included fast-tracking the 1p basic rate cut and the seismic move to abolish the additional 45 per cent tax rate, have now been consigned to the history books.

Instead, higher tax rate payers now face a very different outlook with the 45% additional rate of tax kicking in at £125,140, down from £150,000, while extending the freeze on most personal tax allowances by two years until April 2028 which will drag millions more into the income tax net and the higher tax bands.

Since 2019/20 the number of people being drawn into paying higher rate tax has already soared by an incredible 43.9% to 5.5 million because of the £50,271 threshold being frozen. Last year the number of people paying it expanded by just over 15%. That rate of growth is now likely to accelerate from here given nominal wages have risen to around 6% on average, so it is quite possible we will end up with over 8.5 million people paying higher rate tax in the next few years.

Business owners hit

Savage cuts to the dividend allowance from £2,000 to £1,000 next year and then to £500 from April 2024 are a real blow to business owners, many of whom pay themselves dividends in lieu of salaries. It will also impact people with investments outside of ISAs and pensions who rely on dividend income to supplement their pensions. Anyone in this position should seek to migrate investments held in a taxable environment into tax-free ISAs, a process known as Bed and ISA, acting while the current capital gains allowance is in place.

In another blow to entrepreneurs, investors, and owners of second properties, the annual exemption for capital gains tax will be slashed from £12,300 to £6,000 next year and then to a paltry £3,000 from April 2024. This will mean great care needs to be taken when managing an investment portfolio outside of tax-free wrappers to avoid incurring tax liabilities when shifting holdings around. This increases the case for using fund structures for investment portfolios outside of ISAs and pensions, as trades made within these do not trigger CGT liabilities.

Not just high earners being hit…

Like any Budget, to truly understand its impact the devil is in the detail, as today’s tax blow will not only cause headaches for those on higher incomes but also many low-income earners who will start paying income tax for the first time. This is because the standard personal allowance threshold remains stuck at £12,570 and has not been adjusted for inflation, while the living wage for the over 23s has been increased meaning more people will end up paying 20% tax.

These moves alongside higher energy bills from April when the Energy Price Guarantee rises from the current level of £2,500 to £3,000 until April 2024, means the painful squeeze households are already grappling with – such as higher prices and borrowing costs and falling real incomes - will endure as the UK sinks into recession.

For pensioners, the state pension triple lock - a mechanism that guarantees the state pension will rise by the highest of average wages, consumer inflation or 2.5% - is back with the state pension now set to rise by 10.1% from next April.

With the lock retained, it means the full state pension for those retiring after April 2016 will rise to £203.85 per week or £10,600 per year - taking it above the £10,000 benchmark for the first time. At the same time, however, the continued freeze on the lifetime allowance at the current level of £1,073,100 – the limit on the value of pension benefits an individual can build up during their lifetime without paying tax - is a stealth tax on savers with more people set to breach it.

More estates to be impacted by Inheritance Tax

In a similar vein, extending the freeze on the nil rate band for Inheritance Tax, which had already been fossilised at £325k per person since 2009, will see even more people being hit with death duties as their parents’ or grandparents' estates become subject to IHT for the first time. This is a situation amplified by the strong rise in property and share prices over recent decades. By extending the freeze on the IHT threshold until 2028, this will capture a period when the post-war baby boomer generation is set to near average life expectancy.

While there are multiple ways to mitigate a potential IHT liability, including making lifetime gifts which become potentially exempt after seven years or investing in assets that potentially qualify for Business Relief such as Enterprise Investment Schemes and many AIM companies, this does require careful planning well ahead.

Reassuring the bond and currency markets?

The worry is that Hunt’s restrictive measures – in large part aimed at restoring the confidence of the bond markets - will only deepen a recession already expected to last two years – the longest economic contraction since records began. There is however a risk that if the economy underperforms forecasts, this could have a boomerang impact which undermines expected tax receipts.

But for now, these measures should help reassure the bond markets which have calmed in recent weeks and may give further support to the sharp rebound in Sterling over the last month which will help reduce the cost of imports.

Use every allowance you can…

Today’s Autumn Statement underlines the importance of maximising tax-free allowances to protect your wealth.

Using up your tax-free ISA and pension allowances will be key going forward with higher pension contributions the best way to mitigate exposure to higher rate income tax, as they provide tax relief at your marginal rate. An overhaul of pension tax reliefs had been mooted but once again they have survived another Budget, reinforcing their reputation as a “cat with nine lives”. Those who have the option of contributing to a pension via salary sacrifice should certainly consider this as this system offers relief from National Insurance in addition to income tax.

Married couples could consider switching savings and investments between each other – known as interspousal transfers - to benefit from whichever one of them may pay tax at a lower rate, as well as to make optimal use of capital gains and dividend tax allowances which are facing savage reductions.

VCTs and EIS likely to see further demand

On the investment front, Venture Capital Trusts and Enterprise Investment Schemes which offer generous tax reliefs for investors could well see increased demand given the ballooning numbers of people exposed to the higher and additional rates of tax and constraints on pension allowances. Both VCTs and EIS provide 30% income tax relief on new issues, subject to certain caveats, and reinvesting realised capital gains made on other assets into EIS shares can be used to defer a CGT liability as well to mitigate inheritance tax. However, these types of schemes are no panacea as VCTs, and EIS invest in small, early-stage companies – the types which may struggle in a recession - and so carry a high degree of risk and are not suitable for most people.

What does this mean for UK equities?

For investors puzzled by how today’s news will affect their portfolios, like any major fiscal policy change there will be relative winners and losers. More restrictive fiscal measures could add to the recessionary woes, placing domestically focused businesses under pressure, particularly those more reliant on consumer spending, such as retailers, the hospitality sector and travel companies. The residential property sector is expected to see sharp falls in house prices and strain from higher borrowing costs, while the commercial property sector faces the prospect of rising numbers of empty units as firms go bust or close outlets. Even the banking sector, which has gained from this new era or rising rates, will be impacted by bad loans amid rising consumer and business indebtedness.

While the outlook for the UK domestic economy is tough, a recession has already been substantially baked into valuations ahead of today. There is more promise for the large companies of the FTSE 100 which collectively earn around three quarters of their revenues outside of the UK. The FTSE 100 also has healthy representation of sectors that typically stay resilient in tougher economic times, such as companies focused on consumer staples – everyday items people will buy no matter what state the economy is in, as well as healthcare and utilities. The good news here is that this part of the market is also incredibly cheap both compared to longer term trends and other developed markets globally, which alongside a high level of dividend yield which remains at a premium to bond yields represents a decent entry point for long-term investors.