Fiscal Drag: The Impact of Tax Threshold Freezes in the UK

The British government has implemented a strategy known as “fiscal drag” to increase tax revenue without raising headline tax rates. This tactic involves freezing tax thresholds, causing more individuals to be pushed into higher tax brackets. But what does this mean?

What is Fiscal Drag?

Fiscal drag occurs where tax thresholds in an economy fail to keep up with the rising cost of living. Tax thresholds are adjusted, usually every year, to justify the inflation, and so freezing these thresholds lets the government increase tax revenue when bringing more people into the higher tax brackets, allowing the government to benefit from the rising cost of living, the current inflation rate in the UK is 11.1%, the highest it has been in nearly 40 years. Inflation hasn’t been this high since 1981!

Jeremy Hunt (chancellor) announced a succession of spending cuts and tax rises thereof, intended to address the country’s challenges where fiscal is involved, in his autumn statement. Instead of raising headline tax rates, he opted to freeze tax thresholds, a demonstration of fiscal drag.

Currently, UK taxpayers benefit from a tax-free allowance of £12,570. Anything above that amount is obligated to pay the basic rate of 20% income tax and earnings surpassing £50,271, individuals are required to pay the higher rate of income tax, of 40%.

Hunt’s announcement specifies that these tax thresholds will remain frozen, failing to keep pace with inflation. He has also lowered the threshold for the top 45% tax rate from £150,000 to £125,140. This reduction is expected to bring in an estimated 250,000 more UK workers into the highest tax bracket.

The freezing of tax thresholds is not a once-off strategy to implement as it extends a four-year freeze initially carried out by the former chancellor, Rishi Sunak, and is set to remain in effect until 2028.

The Office for Budget Responsibility’s predictions state that this six-year freeze will result in the creation of around 3.2 million new taxpayers altogether, and 2.6 million higher-rate taxpayers.

The Effect On Public Finance

Freezing the income tax personal allowance and higher rate threshold could mean that the government is projected to raise around £26 billion more, relative to allowing these thresholds to rise in line with inflation.

While high-profile cuts to income tax rates and national insurance may seem beneficial to many households, the Institute for Fiscal Studies (IFS) warns that these freezes and stealthy policy choices may nullify any gains—for every £1 gained from high-profile cuts, households could lose £2 due to freezes and other furtive measures.

The IFS mentions that these freezes have a larger impact on household incomes as compared to other more in your face discretionary measures.

This approach to raising tax revenue can significantly affect individuals’ financial well-being and exacerbate income inequality amid the already frustrating cost of living crisis.

What Does this Mean for British Taxpayers?

The effect of fiscal drag is noticeable in the increasing number of British taxpayers pushed into higher tax brackets. According to HM Revenue & Customs data, nearly 4 million more Britons have paid income tax over the last three years.

In this year alone, 35.9 million earners are likely to fall under the 20% income tax rate because their income exceeds the £12,570 bracket, up from the 31.7 million people in the tax year prior.

The number of people paying the 40% tax rate is also expected to increase from 4 million to 5.6 million, while those in the other 45% rate will decrease. 2021’s tax threshold freeze resulted in 1.6 million more people falling under the higher 40% tax bracket.

A higher tax obligation as a result of the tax freezing will impact many UK workers and taxpayers significantly.

Fiscal drag as a revenue-raising framework has sparked criticism across quarters. Some argue that freezing tax thresholds can be harmful to lower to middle level taxpayers, as they are more likely to be pushed into higher tax brackets, enforcing wealth inequality and placing more of a financial strain on those who struggle to afford their survival and the ability take care of their basic needs and wants.

What Are the Long Term Effects?

Reduced Economic Growth:

In the long run, fiscal drag could affect the UK’s economic growth by creating a cycle as when tax thresholds can’t keep up with the constantly rising costs of living, the result is that more people pay higher tax resulting in lower disposable income for their livelihoods.

The less income available in households, the less spending and investing takes place, resulting in a lowered demand for products and services. This in turn affects businesses, employees and other economic development overall which can really harm the road to economic recovery in the country.

Unequal Distribution of Wealth:

The long-term effects of the fiscal drag lets the phrase “rich get richer and poor get poorer” come into play as lower and middle-income earners will be the most affected, due to their requirement to pay more tax with the same salaries, while higher income earners will only see minor changes with their tax payable.

As a result, the socio-economic difference and gap between less and more wealthy employees grows, resulting in less access to more opportunities for everyday citizens and vice versa for the affluent.

Government Revenue and Public Finance:

As much as a fiscal drag can temporarily raise government revenue in the short term, its long term consequences might be more complex: as more people are forced into higher tax brackets, there may be a perception that tax loads are increasing, which could result in resentment from taxpayers and worries about overtaxation.

This can also result in decreased consumer spending and slow economic expansion, eventually making it more difficult for the government to produce stable tax sources.

Policymakers might then be obliged to think of different ways to raise money or put themselves in a tricky position where they have trouble in the future paying for important public investments and services.

Calls for Alternative Approaches to Revenue Generation

As the fiscal drag strategy continues to unfold, it has sparked calls for alternative approaches to revenue generation that could result in a more equitable distribution of the tax burden.

Progressive taxation is one such approach. Rather than freezing tax thresholds, progressive taxation levies higher rates on those with higher incomes, reducing the burden on lower and middle-income earners.

Proponents argue that this system not only promotes greater fairness in taxation, but can also fuel funding for vital social welfare programmes and services, cultivating a more balanced society.

Meanwhile, a wealth tax is gaining momentum as another alternative. Distinct from income tax, a wealth tax zeroes in on an individual’s net worth, including assets such as property, investments, and other high-value possessions.

Those advocating for a wealth tax maintain that it could alleviate income inequality and tap into significant revenue from the wealthiest who frequently hold substantial assets.

However, careful orchestration would be required to introduce a wealth tax to sidestep unintended consequences, like capital flight or asset devaluation.

There is also a strong demand for tougher implementation of current tax regulations and a crackdown on tax evasion. When people or businesses avoid paying their fair share of taxes, the government loses money.

Government income can be increased without putting a strain on the economy by closing tax loopholes and combating tax evasion. This strategy must be successful in order to effectively battle offshore tax havens, which requires increased tax enforcement and international cooperation.

There is yet another option to freezing tax limits: inflation-indexed tax thresholds. The government may avoid the fiscal impact that comes from forcing more individuals into higher tax rates by adjusting tax thresholds to correspond with the rising cost of living.

In this approach, taxpayers’ purchasing power is kept fairly consistent and they are not forced to pay greater taxes as a result of inflationary pressures alone.

Expansion of tax brackets is a different strategy that can be considered. The government could look into the idea of expanding current tax brackets rather than sustaining current tax thresholds.

Increased tax revenue can be allocated more fairly across different income levels by adding additional tax bands with higher income thresholds. This strategy may make it possible to have a more progressive tax system, where people with higher incomes pay more in taxes, which would benefit those with lower and intermediate incomes.

Finally, it has also been suggested to change the emphasis from income-based to consumption-based taxation. A consumption tax, such as a sales tax or a value-added tax (VAT), could raise money without significantly affecting income levels.

Although such types of taxes might encourage saving and investing, it would need to be carefully considered to make sure that it does not unfairly impact those with lower incomes.

In summary, while the UK’s current fiscal drag strategy has generated some controversy, it has also stimulated productive discussions about alternative methods of revenue generation. These diverse approaches could potentially offer a more balanced and equitable taxation system for all citizens.