The Pay As You Earn (PAYE) system has been set up to collect the tax due on earned income as wages and salaries are paid so that employed people pay tax each week or month and therefore don’t build up a tax bill to be paid all at once.
No one likes paying tax but the PAYE system is the least painful way of paying tax and has been designed to work smoothly.
Everyone is entitled to earn an amount of income in a year without paying any tax. For the year from April 6 2019 to April 5 2020 this amounts to £12,500. This is known as the standard Personal Allowance and is reviewed each year in the Budget. This applies to the vast majority of employed people although those earning over £100,000 have a reduction applied.
In order to ensure that PAYE operates in a fair way the system incorporates a number of features:
- Tax is only applied to income over and above the Personal Allowance. For example if someone earns £13,000 over a tax year they only pay tax on £500 (£13,000 less £12,500). This ensures people aren’t faced with a sudden big increase in tax if income goes above the Personal Allowance.
- The excess over the Personal Allowance is called Taxable Income
- The Paye system works on an annual basis but recognises that people are paid regularly during the year (weekly or monthly) so is applied cumulatively through the year.
What this means is that for people who are paid weekly they get one week’s allowance set against their week’s earnings. So in week 1 they get £240.38 (12,500/52). In week 2 They get a further £240.38 to make £480.76 for the year to date which is allowed against cumulative earnings for the year.
Similarly people paid monthly get allowance of £1,041.67 for the first month and cumulatively £2,083.33 for month 2 and so on.
This may seem an unnecessary complication but it is intended to smooth out the effects of variations in income during the year. Income can vary for a number of reasons such as overtime, seasonal work, bonuses, commissions etc and if a separate allowance is given for each month excessive tax would be paid in a period with higher earnings and over the year someone with variable income would pay a different amount of tax for the year from someone whose income was fixed each period even if their total income for the year was the same.
- The cumulative system works by setting the cumulative allowance for the year against cumulative income to find cumulative taxable income. Cumulative tax due is calculated and tax due up to the previous period is deducted so only the additional tax due is paid. In this way irregularities are evened out.
- As an example, if the system worked on a period basis someone who was paid £2500 in one month and nothing in the next month would pay tax of £291 while someone who earned £2500 in two payments of £1250 would pay only £83. The cumulative system ensures that both pay the same amount of tax.