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 (updated to take account of changes in the 2009 Budget).

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 March 2009 Budget contained a huge number of surprises, chief among these was a new 50 per cent super tax rate. This will be introduced in April 2010 for those earning £150,000 or more.

Currently there is a basic rate of tax of 20 per cent and a higher rate of tax of 40 per cent.

From April 6, 2010 there will be three bands of tax: a basic rate band at 20 per cent; a higher rate band at 40 per cent; and a super tax band at 50 per cent.

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 Isas and some National Savings & Investments accounts. You can be liable to income tax at any age.

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 2009-10 is £6,475. 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 £9,490. For those aged 75 and over it is £9,640.

The rest of your income, up to £37,400, is taxed at the basic rate of 20 per cent. That means that anyone under 65 earning £43,878 or less will only pay tax at the basic rate.

Earnings above £43,878 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 £2,440 above your personal allowance.

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 person's allowance, and various married couple's 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 £95 and £844 a week, 11 per cent is deducted in national insurance. Above £844, 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 20p. If you pay higher rate tax, you can claim the difference between the higher rate of tax (40 per cent) and the basic rate of tax (20 per cent) using your self assessment tax return.

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.

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