A basic truth about taxation is that any and every Chancellor just loves, adores, fiscal drag. Which comes in two forms. The first is that inflation exists – indeed it’s public policy that we shouldn’t have price stability and that’s for perfectly reasonable reasons. We might even prefer price stability if we were in a first best world, we’re not. The second is that wages normally rise faster than inflation – real wages have been rising for a couple of centuries now.
Both – if we concern ourselves purely with taxes upon income – pull ever more people into the tax net over time, at ever higher rates. Reversing the effect takes huge political energy – I know, I’ve been part of one such attempt.
It is all this which explains:[perfectpullquote align=”full” bordertop=”false” cite=”” link=”” color=”” class=”” size=””] More than 1m middle class families and individuals are losing more than £1 billion in tax allowances and child benefits because of fiscal drag, the Institute for Fiscal Studies (IFS) has revealed. An extra 340,000 people have seen their income tax personal allowance withdrawn over the past decade because the Government has frozen the salary threshold at £100,000 since 2018. As a result, the total number of people affected has risen to 986,000 from 647,000. They would have been paying more than £1 billion less in tax if the Government had uprated the £100,000 threshold in line with inflation. [/perfectpullquote]
Here we’ve the first form. Think it was G. Brown with the bright idea – maybe Darling – of insisting that those in the top 5% or so of the income distribution shouldn’t have any personal allowance. Thus it gets phased out at that £100,000 level – it’s completely gone by perhaps £115,000. This gives us a higher income tax rate in this income band than in any other. Bit weird but there we are.
So, what happens? Inflation chugs along at 2% a year. Wages keep up with this. But the tax band doesn’t change. Every year that no allowance limit creeps down the income distribution. More and more people become subject to this tax rise. We get 5 and 6 and 10% of the population caught in our higher tax rate.
The second form we’ve seen with the personal allowance itself. Over the decades it’s been upgraded in line with inflation but not with rising wages. Same too with the higher rate limit. So, if real wages rise 1 or 2% a year – historical average-ish – then again, we capturing ever more people in these tax rates.
We can even combine the two as when G Brown didn’t even raise the personal allowance by inflation at least once.
The effect here is to pull ever more into the tax net, as above. So that income tax used to be a concern only of the middle and upper earners. The higher rate was upper earners only. A decade back we had the ludicrous situation whereby people working part time on the minimum wage were paying income tax – that personal allowance was so low. The higher rate kicked in at median wages plus perhaps 50%. That’s not upper part of the distribution, that’s just well trained nurse sorta levels.
And why do Chancellors love this so much? It’s a tax rise without having to announce one. To reverse it requires the expenditure of vast political effort. As with that campaign to raise the personal allowance even up to something like the full year, full time, minimum wage. Just reversing the effects of fiscal drag becomes a concession, a sweetie, to offer the voters.
Tax rises that happen without doing anything. Which take vast political capital to reverse, which can be painted as concessions when they are? Why wouldn’t Chancellors love this? Note, all of them, this has been done by Tory and Labor alike.