Income tax is levied directly on the earnings (income) of the individual.

The following discussion illustrates the coverage and operation of income tax.

Income tax is levied on pay, pension payments upon retirement, unemployment benefit, profits from business, income from property, bank and building society interest and dividends on shares. Income tax is not paid on certain privileged savings products such as National Savings Certificates.

Income tax is collected by the Inland Revenue on a 'cumulative basis'. This means that a person is taxed on the basis of what they are going to earn in the whole year and not just month by month. Most income tax is collected by the PAYE or 'Pay As You Earn' scheme. This means that employers deduct the tax directly out of a person's wages and then transfer this to the Inland Revenue.

The structure of income tax in the UK operates via a system of allowances and bands. All individuals have a personal allowance which is deducted from total pre-tax income in order to get to the taxable income. In other words, the first bit of their income is tax-free. The rest of a person's income is then taxable and is subject to different tax rates depending upon the 'tax band' that income falls within.

For illustrative purposes we'll use the tax year 2000-2001

The tax bands and personal allowance for the tax year 2000-2001 starts on 6 April 2000 and ends on 5 April 2001, is,

• Personal allowance £4,385
• Personal allowance (age 65-74) £5,790
• Personal allowance (age 75 and over) £6,050
• Rates of tax and bands of taxable income

The following example illustrates how a cumulative income tax is calculated. Assume the person was earning £9,000 a year, their income tax would be;

• Gross Earnings = £9000
• Allowance = £4385

Therefore, Taxed Income = (9000 - 4385) = £4615

Starting Band

• 10% of 1520 = £152.00 paid in tax on a cumulative income of (4385+1520) £5905.

Basic Rate

• 22% of £3095 (9000-5905) is £680.90 paid in tax.

The total income tax for the year on a salary of £9000, is £832.90. Therefore, the net income is £8167.10.