There have been a number of high-profile changes to the amount of tax we pay on the money we earn. Here is a guide to income tax.

History of income tax

Income tax was introduced in 1799 by William Pitt the Younger, then Prime Minister, to pay for the war against the French forces under Napoleon. However, it was the Addington Act, introduced in 1803 by Henry Addington, which set in place the foundations for the income tax system that we use today.

Recent changes in the tax system

The beginner's guide to income tax

• Gordon Brown cornered as rebellion over 10p tax reform grows

• Government challenged over tax rise for big cars

• MPs demand £23,000 tax-free grant to hide expenses

Background

• How to reduce your inheritance tax bill

• The beginner's guide to self-assessment

• Council tax explained

• Tax credits explained

• Capital gains tax explained

Related Links

• Brown cornered as 10p tax rebellion grows

• Tax rise for big cars challenged

• MPs demand £23,000 grant to hide expenses

In the 2007 Budget Gordon Brown, who was then Chancellor, announced that he was scrapping the 10 per cent tax band. He also lowered the basic rate of tax from 22 per cent to 20 per cent.

These changes came into effect at the begining of the 2008 tax year and it became apparent that low-income taxpayers would be hit hardest by these changes.

To remedy this, on May 13, 2008, the Government amended its Budget proposals, announced plans to raise the level of personal allowances and lower the higher-rate tax threshold. These changes have been backdated to the beginning of the tax year 2008-09 and taxpayers receive a refund if they have overpaid tax at some point in the preceeding months.

What is income tax?

It is a tax paid on the money that we earn. Income that is taxed includes your salary, some state benefits, savings and pensions. Employee benefits, such as company cars, are also taxed. Income that is not taxed includes Isa savings accounts and some National Savings & Investments accounts. There is no minimum age that you become liable to pay income tax.

How much tax do you pay?

The amount of tax you pay depends on the size of your income.

The personal allowance threshold for the tax year 2008-09 is £6,035. This is the revised threshold announced in May. Everyone is allowed to earn up to this amount in a single year without being taxed.

For those aged 65 to 74 the personal allowance is £9,030. For those aged 75 and over it is £9,180.

The rest of your income, up to £34,800, is taxed at the basic rate of 20 per cent. This is the revised rate for 2008-09 announced by the Chancellor in May, which came into effect in September.

Earnings above £34,800 are taxed at the higher rate of 40 per cent.

These bands apply to all earnings. However, there are two exceptions. The interest paid on your savings is taxed at an initial starting rate of 10 per cent on the first £1 to £2,320 above your personal allowance. Above this, the basic rate and higher rates are applied as with other earnings.

Income tax on dividends is also slightly different. The basic rate is 10 per cent, rather than 20 per cent, and the higher rate is 32.5 per cent, rather than 40 per cent.

There is also a blind persons allowance, and various married couples allowances based on age. Check here for details of these.

The tax system is liable to regular adjustments, so it is worth checking here to make sure these figures are up to date.

How do you pay income tax?

If you are employed, income tax is collected through PAYE (Pay As You Earn). If you have a pension, your provider will collect it in much the same way. Your employer or pension provider uses a tax code to determine how much tax you should pay. This code is determined by HM Revenue & Customs.

If you are paying too much tax because you are on the wrong code, or on a temporary code, you will receive a refund.

Details of your code and how much tax you have paid are on your P60 or P45 forms. If you think that there has been an error or that you are on the wrong code, contact your local tax office.

If you are self-employed, you will pay tax by self-assessment. If you have complex tax affairs you will also have to fill out a self-assessment form, as well as having tax deducted through PAYE.

Tax is also deducted from the interest you receive on your bank or building society savings accounts. It is usually taken off your interest before you receive it.

National insurance

This is taken in addition to income tax. Originally designed to fund social security benefits, such as your state pension, national insurance is now effectively another layer of general taxation. If you earn betweem £105 and £770 a week, 11 per cent is deducted in national insurance. Above £770, 1 per cent of earnings is deducted.

Tax relief

In some circumstances the Government will refund the tax that you have paid on your earnings. This is called tax relief. For example, the Government believes that you should not have to pay income tax on money that you are donating to charity through Gift Aid or that you are putting into your pension.

In the case of Gift Aid, the Government returns the tax you had paid on your donation at the basic rate of 20 per cent and adds this to your donation. For example, on donations of £1, the Government returns 28p.

You can also gain tax relief on money spent on business mileage when you use your own car, or on fuel for a company car.

For a full list of instances where you can claim tax relief, click here.

Five news stories

Chancellor Alistair Darling to rush out cash payments for 10p tax losers

Gordon Brown pays £2.7 billion to end 10p tax crisis

Unusual suspects in 10p tax rebels' ranks

Alistair Darling tries to buy off 10p tax rate rebels with ‘help for poor later’

SNP denies local income tax will cost more

Five features

How the 10p tax U-turn will affect you

Will you benefit from Labour's running repairs?

Is it time you got to grips with capital gains tax?

Sign up for as many perks as possible

Send your Isa application now

Five Websites

Directgov

HM Revenue & Customs

Citizens Advice

Low Incomes Tax Reform Group

Chartered Institute of Taxation

Five videos

Prime Minister's Questions

HMRC Tax codes, the importance of having the right one

Tax tips: What if students only work during the holidays

Teddy Bear uses Gift Aid

What is national insurance all about?