Rising Tax Revenues and Fiscal Drag: Inflation Unleashes £40 Billion Stealth Tax Surge in the UK

A recent report by the Resolution Foundation think-tank, published in the Financial Times, reveals that the UK’s Chancellor, Rishi Sunak, is set to collect an additional £40 billion per year in taxes by 2028 due to stubborn inflation. This is £10 billion more than previously estimated just a few months ago. This substantial increase in tax revenue is a result of a fiscal phenomenon known as “fiscal drag,” where the freezing of income tax allowances and thresholds leads to higher revenues for the government. This article explores the implications of this fiscal drag and its impact on the UK economy.

Fiscal Drag: A Stealthy Tax Rise

When a government freezes income tax thresholds while citizens’ salaries continue to grow, as is happening during a period of high inflation, it results in increased tax revenues for the treasury. The Resolution Foundation’s principal economist, Adam Corlett, highlights that this tactic of abandoning the usual uprating of tax thresholds is a long-established method for governments to raise revenues. What is striking in this case is the unexpected scale of this tax increase, now projected to reach £40 billion annually.

A Look Back: The Origins of the Freeze

The freeze in income tax allowances and thresholds was first announced by Chancellor Rishi Sunak in 2021. At the time, the Treasury anticipated that this move would raise £8 billion annually by 2026. However, as inflation rates surged, the Office for Budget Responsibility (OBR), the fiscal watchdog, adjusted its projections. By the 2022 spring Budget, the OBR estimated the annual figure to be £18 billion. This figure continued to climb, reaching £29 billion annually by March of the following year. These adjustments were not solely attributed to inflation but also due to Chancellor Jeremy Hunt’s decision to extend the thresholds freeze for an additional two years.

Inflation’s Impact on Taxpayers

The relentless rise in inflation has far-reaching consequences. It has pushed more individuals into higher income tax brackets and forced low earners to pay the tax for the first time. The Resolution Foundation predicts that this fiscal drag will result in a staggering £40 billion annually by the time the freeze ends in 2028, marking the largest income tax increase in the UK in at least 50 years.

Inflation Projections and Tax Thresholds

In March, the OBR expected inflation to decrease to 5.4 percent by September 2023, which is the typical time for tax thresholds to be updated for the following tax year. However, the Bank of England’s August forecast painted a different picture, predicting a rate of 6.9 percent for September. Furthermore, the Bank projected a total inflation rate of 6 percent from the third quarter of 2023 to the third quarter of 2026, compared to the OBR’s spring forecast of just 1 percent for the same period. This led the Resolution Foundation to revise its estimate upwards to £40 billion annually, taking into account the Bank’s latest inflation forecasts.

Thresholds and the Impact on Taxpayers

Currently, individuals start paying income tax when their annual income reaches £12,570. This threshold is set to remain unchanged until April 2028. However, if this threshold were to be adjusted in line with expected inflation over this period, it would rise to approximately £16,200.

Economic Implications and Fiscal Mandates

Ruth Gregory, deputy UK chief economist at consultancy Capital Economics, suggests that the Resolution Foundation’s calculations provide Chancellor Sunak with more fiscal headroom to meet his primary fiscal mandate, which requires him to ensure that underlying debt as a share of GDP is decreasing within five years. If the policies indeed generate £40 billion annually by 2027-28 instead of the OBR’s predicted £29.3 billion, this would add approximately £11 billion to the £6.5 billion headroom the chancellor has against his fiscal mandate.

However, Gregory also warns that higher inflation will translate into higher government borrowing costs. Since March, market rate expectations and longer-dated gilt yields have risen, which will lead to increased debt servicing costs for the government.

Government’s Stance and Future Outlook

A Treasury spokesperson clarified that the government’s focus is on combating inflation rather than borrowing money to fund tax cuts. They emphasized that the government has taken steps to remove 3 million people from the tax net entirely since 2010 by raising personal thresholds. The chancellor has also expressed a desire to further reduce the tax burden but has underscored the importance of maintaining sound financial management.

Conclusion

The UK’s fiscal landscape is evolving rapidly due to stubborn inflation and the associated fiscal drag. While the government is set to benefit from significantly increased tax revenues, taxpayers may face higher bills due to inflation-induced shifts in income tax thresholds. The challenge for policymakers is to strike a balance between managing inflation, maintaining fiscal mandates, and ensuring the financial well-being of citizens. The implications of these evolving economic conditions will continue to shape the country’s fiscal policies in the years ahead.