Direct and indirect taxes; progressive, proportional and regressive; marginal against average rates and fiscal drag; the Laffer curve and whether cutting rates can raise revenue; what tax changes do to incentives, prices, output, distribution and investment.
In March 2021 the Chancellor froze the income tax thresholds: the personal allowance at £12,570, the higher-rate threshold at £50,270. The freeze has since been extended twice and now runs to April 2031, with the additional-rate threshold at £125,140 since 2023. Had the thresholds risen with inflation, the OBR calculates the higher-rate threshold would have been £62,080 in 2025/26.
The result is fiscal drag. As pay rises with prices, more of each salary is taxed and more of it at 40%. The share of taxpayers paying the higher or additional rate rises from 15% in 2021–22 to 24% by 2030–31. Income tax accounts for nearly half of the increase in receipts as a share of GDP, which the OBR expects to reach 38.5% by 2030–31, above the 1948–49 record of 37.2%.
What kinds of tax are there, who pays them, and is there a point at which a higher rate raises less?
Source: Office for Budget Responsibility, Economic and Fiscal Outlook, November 2025 and March 2026; HMRC income tax rates and thresholds.
A direct tax is levied on income or wealth and paid by the person it falls on: income tax, National Insurance, corporation tax, capital gains tax, inheritance tax. An indirect tax is levied on spending and collected by the seller, who may pass it on: VAT, fuel and alcohol duties.
A progressive tax takes a rising share of income as income rises; proportional takes the same share; regressive takes a falling share. The marginal rate is the tax on the next pound earned; the average rate is total tax ÷ total income. A tax is progressive when the marginal rate exceeds the average rate. Income tax is progressive; VAT is regressive, because poorer households spend a larger share of their income.
The Laffer curve plots tax revenue against the tax rate. At 0% revenue is zero; at 100% nobody works, declares income or stays, so revenue is zero again. In between, revenue rises and then falls. Below the revenue-maximising rate a cut loses revenue; above it, in the prohibitive range, a cut raises revenue because the base grows by more than the rate falls. The argument is about where a country sits on the curve.
The income tax personal allowance has been £12,570 since 2021, and will stay there until 2031.
No rate of income tax has gone up. Yet income tax is forecast to raise far more as a share of GDP, and the share of taxpayers paying the 40% or 45% rate is set to rise from 15% to 24%.
How can that be?
That is fiscal drag. Freezing thresholds while prices and wages rise is a tax increase without a vote on a tax rate. The OBR expects the freezes to help push the tax burden to 38.5% of GDP by 2030–31, the highest since records began in 1948.
Three shapes. The progressive line rises: UK income tax takes nothing below £12,570, so the average rate climbs as income does. The proportional line is flat: a flat 20% takes the same share from everyone. The regressive line falls: VAT and duties take a larger share from low earners, who spend all they get. The test is the share of income, not the pounds paid.
Check: A household earning £20,000 spends it all and pays £2,500 of VAT; one earning £100,000 spends £60,000 and pays £7,000 of VAT. VAT here is:
Progressive, proportional and regressive are about the share of income, not the number of pounds. 2,500 ÷ 20,000 = 12.5%; 7,000 ÷ 100,000 = 7%.
Marginal against average. At £60,000 the marginal rate is 40%: the next pound earned is in the higher band. But the average rate is 19.1%, because the first £12,570 is untaxed and the next £37,700 pays 20%. Marginal above average is what makes a tax progressive. Fiscal drag works here: a pay rise at frozen thresholds pushes more income into the 40% slice, so the average creeps up each year.
Teacher tip: Students often think crossing the higher-rate threshold means all income is taxed at 40%. Walk through the slices on the board: it kills the myth and makes the average-versus-marginal distinction concrete.
Check: Someone earns £60,000. The personal allowance is £12,570, the basic rate 20% up to £50,270 and the higher rate 40% above that. Their marginal and average rates are:
Tax = 0.2 × 37,700 + 0.4 × 9,730 = £7,540 + £3,892 = £11,432, which is 19.1% of £60,000. Only the slice above £50,270 is taxed at 40%.
The Laffer curve. Revenue is rate × base. Raise the rate from zero and revenue grows; but each rise also shrinks the base, as people work less, shift income into other forms, avoid, evade or emigrate. At T* the two effects balance and revenue peaks at Rmax. Beyond it the shrinking base outweighs the higher rate. The curve is a logical shape, not a measured one.
Check: On the Laffer curve, revenue is zero at a 0% rate and also at a 100% rate because:
Revenue = rate × base. At 100% the rate is maximal but the base is zero: people stop working, hide income or leave.
Two sides. At A (20%) and D (80%) revenue is the same, £64bn: the same money at very different rates. Left of T*, raising the rate raises revenue. Right of T*, in the prohibitive range, cutting the rate from 80% to 72% raises revenue, because more people work, declare and stay. Supply-side economists argue top rates sit on the right; most evidence puts them on the left.
Check: A country’s top rate is at point D, 80%. It cuts the rate to 72%. According to the curve, revenue:
Right of T* a cut raises revenue. Left of T*, at A, the same cut would lower it. The policy question is which side you are on.
What tax changes do. Incentives: higher marginal income tax rates can reduce hours, effort and enterprise, though the income effect can push the other way. Distribution: shifting from direct to indirect tax makes the system less progressive. Prices: indirect taxes raise the price level. Output and jobs: taxes cut disposable income and AD. Investment: corporation tax rates affect where multinationals locate, which is why they compete downwards.
Teacher tip: Edexcel lists these effects explicitly: incentives, revenue, distribution, output and employment, the price level, the trade balance and FDI. A paragraph on each, with the Laffer curve for revenue, covers the specification.
Check: Which effect of a rise in VAT is correctly described?
Indirect taxes feed straight into prices (the CPI jumped when VAT rose to 20% in 2011) and poorer households spend a higher share of income.
Where is the UK? Most estimates put the revenue-maximising top rate of income tax in the 40s or 50s, near where the rate already is: B, not D. Cutting it would probably lose revenue; raising it far would gain little. Fiscal drag raises revenue without touching the rate, which is why Chancellors prefer it. But it works by stealth, and the OBR expects workers to respond by bargaining for higher pay.
Check: The best evidence on whether cutting the UK top rate would raise revenue is:
When the top rate rose to 50% in 2010 high earners brought income forward, so the first year raised little; when it fell to 45% in 2013 they delayed it. Estimates of the revenue-maximising top rate for the UK cluster in the 40s and 50s.
The cut is from 30% to 20%, on the left of T*, where the curve slopes upward. A cut there lowers revenue. The “cut raises revenue” claim only holds in the prohibitive range, to the right of T*.
Evaluate the view that cutting the top rate of income tax would increase tax revenue.
The Laffer curve plots tax revenue against the tax rate. Revenue is zero at a rate of 0% and again at 100%, when there is no reward for working, investing or declaring income, so it must rise and then fall, peaking at some revenue-maximising rate T*. To the right of T*, in the prohibitive range, a cut in the rate raises revenue because the tax base, the income declared and earned, grows by more than the rate falls; to the left, a cut lowers revenue.
Whether cutting the top rate would raise revenue therefore depends on where the UK sits. The mechanism is the responsiveness of taxable income to the rate: a lower rate can increase hours and effort, reduce avoidance and emigration, and encourage income to be taken as pay rather than sheltered. When the top rate rose to 50% in 2010 and fell to 45% in 2013, HMRC found that high earners shifted the timing of their income around the changes, so the 50p rate raised much less than forecast in its first year. Most estimates of the revenue-maximising top rate for the UK lie in the 40s or 50s, close to the current 45%.
**However,** that evidence suggests a cut from 45% would more likely lose revenue than gain it: the large responses observed were mainly timing and avoidance, not extra work, and closing avoidance routes would raise T* rather than justify a lower rate. A cut that lost revenue would widen the deficit or require higher taxes elsewhere, and would make the system less progressive at a time when frozen thresholds are already pulling middle earners into the 40% band. Tax is also judged on fairness and simplicity, not revenue alone.
On balance, the Laffer argument is logically sound but empirically weak for the UK top rate: a cut would probably reduce revenue, modestly. The stronger case for reform lies in the cliff edges and high marginal rates created by the withdrawal of the personal allowance above £100,000, where the effective rate reaches 60%, than in the headline rate itself.
Threshold and tax-burden figures: Office for Budget Responsibility, Economic and Fiscal Outlook, November 2025 and March 2026; HM Revenue and Customs income tax rates for 2026/27 (England, Wales and Northern Ireland; Scotland sets its own bands). The Laffer curve on the diagram is a sketch, not an estimate. Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed.