Blog by Professor Graeme Roy

Most of us expect some taxes to be deducted from our pay. Those on low pay often have their incomes topped up with social security payments. But what happens to these taxes and social security payments when our income changes? And what does this mean for devolution? 

Increased earnings might come from a well-earned pay rise or from working more hours. But some of that income might be "taxed away" through personal taxes or the withdrawal of means-tested social security payments. How much you are taxed (or how much your social security payment is reduced) for each extra £ you earn is known as a 'marginal tax rate'. 

All tax systems apply some form of marginal rate, particularly progressive systems where tax rates typically increase with income. These marginal rates can directly influence financial incentives, so an ideal system strives to make them as smooth as possible to avoid inefficient outcomes. 

However, oddities in marginal rates can arise for a variety of reasons. In some cases, they emerge due to technical interactions between different policy frameworks. With fiscal devolution, a growing number are emerging because of overlapping decisions by the UK and Scottish Governments. 

Diverging Tax Systems

Perhaps the most widely recognised example so far is the interaction between income tax and national insurance. For individuals, and just like income tax, national insurance acts as a tax on earnings deducted at source. However, while income tax on earnings in Scotland is devolved and set by the Scottish Government, national insurance remains reserved and is set by the UK Government.

In recent years, Scotland’s income tax rates and bands have diverged from those in England. For the 2024/25 tax year, taxpayers in England start paying the ‘higher rate’ of 40% income tax on earnings above £50,270. At the same threshold, national insurance contributions (NICs) for employees reduce from 8% to 2%. In Scotland, however, the ‘higher rate’ of income tax is 42%, applying to earnings above £43,662. But NICs continue at the UK-wide rate of 8% until the same £50,270 threshold is reached.

This results in a combined marginal tax rate of 50% for Scottish taxpayers earning between £43,662 and £50,270 (42% + 8%): for every additional £1 earned, they take home 50p. In contrast, someone earning the same amount in England faces a combined marginal tax rate of 28% (20% + 8%). A Scottish taxpayer earning slightly above £50,270, then sees their marginal rate fall from 50% to 44% (42% + 2%) once the lower NIC kicks-in.

What types of workers are impacted by this marginal rate? Interestingly, it includes many in the public sector who might not have traditionally viewed themselves as ‘high earners’. The main grade scale for teachers for example, is currently £40,305 to £50,589 and others such as Police Constables and Nurses and NHS workers in Band 6 and above also fall in similar pay ranges impacted by these high marginal tax rates.

Quirks in marginal rates can exist higher up the income tax distribution too, most notably at points where UK Government decisions to taper (i.e. reduce) child benefit – or (for really high earners) to taper the personal allowance – interacts with higher tax rates in Scotland.

Low Earners and the ‘Cliff Edge’ Effect

But marginal tax rate challenges can also affect lower earners too, particularly in the context of social security.  

Tackling child poverty is a central focus of the Scottish Government, exemplified by the Scottish Child Payment – a flat payment of £26.70 per week per child. 

Eligibility for the Scottish Child Payment extends to families receiving Universal Credit (UC), regardless of the amount of Universal Credit they receive. However, Universal Credit is subject to a taper: for every £1 of net income earned above a certain threshold, the Universal Credit payment decreases by 55p. This taper continues until Universal Credit entitlement is eliminated entirely. 

This creates a ‘cliff-edge’ for families whose modest Universal Credit payments qualify them for the full Scottish Child Payment. If their earnings increase slightly – either through higher wages or working more hours – they could lose eligibility for both their (small) remaining Universal Credit payment and the full (£1,388.40 p.a.) Scottish Child Payment. For families with two or three children, this could mean a small increase in take-home pay results in an annual income loss of several thousands of pounds.  

Plans recently announced to mitigate the UK Government’s two-child limit from 2026/27, with the offset payment expected to also operate at a flat rate like the Scottish Child Payment, increase these cliff-edge effects. Indeed, the Scottish Fiscal Commission highlight a striking example: a three-child family with income just below the Universal Credit threshold could see their annual income fall by around £8,000 due to a small increase in any take-home earnings. In short, a welcome boost to monthly take-home pay could have a significant negative effect on a household’s broader finances.

Complexity and its Consequences

It’s to be expected that individuals and households respond to marginal tax rates. This could include changing hours worked, seeking/not seeking promotion or adjusting pension contributions. Policymakers need to consider the implications of these likely changes for the public finances and broader objectives on the economy, the labour market and inequalities.  

But the examples underscore a broader point: while decisions over devolved and reserved taxation and social security are informed by diverse objectives, complex systems can throw up quirks and unintended consequences that need to be carefully considered – and if necessary – carefully managed.

Author

Graeme Roy is Professor in Economics (Economics), Dean of External Engagement and Deputy Head of College and Assistant VP (Social Sciences College Senior Management). He is a Senior Fellow of the Centre for Public Policy. 

Header image for blog by 89Stocker on Canva.

First published: 18 February 2025

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