3 March 2021

How Rishi’s (fiscal) drag act hurts the lowest earners

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It’s an easy trick that many a Chancellor has pulled when in need of revenue. But fiscal drag is not only poorly understood by the general public, it’s immoral. By reaching for it again today, Rishi Sunak has undone one of the obviously good and decent tax policies of the past decade.

Let me start by explaining what fiscal drag is. We live in a world with inflation – it can vary but it’s been a long long time since we’ve had any substantial period without it. We also live in a world where real incomes rise over time – that’s what economic growth means. As a result allowances for this and exemptions from that need to change over time in nominal terms in order to remain the same in reality. If you don’t change them it looks like you’re doing nothing, but in fact tax burdens increase in real terms – that’s fiscal drag.

Today’s example, and it’s one that’s been done for decades now, is to freeze the personal allowance: it will move to the amount previously promised, a fraction over £12,500 a year, then be frozen until 2026. This has also been done for the higher rate but I consider that very much less important.

I have personal reasons for objecting to this.

Back in the dull days of the Brown Terror both the Centre for Policy Studies (the publishers of CapX) and I noted that we had an absurdity. Someone working part time on the newly introduced minimum wage was having to pay income tax. At the same time as the living wage campaign began, arguing that wages should be higher. It didn’t take much calculation to show that the difference between the living wage, and the amount earned on the minimum, was entirely explained by the amount of tax charged to those low incomes.

The obvious solution was – and is – to raise the personal allowance to meet the minimum wage. Without the Government taking a slice, the minimum wage would be a living wage. There is also a strong moral case for this. The very idea of a minimum wage is that there is some, well, minimum amount that an hour of labour is worth. If that’s so on moral grounds then reducing it through taxation is immoral.

We got into this situation because of fiscal drag. Income tax started out only applying to the very highest earners, but as the economy changed it took bites out of progressively lower incomes. By not raising the personal allowance enough, successive chancellors gathered ever more people into the system – first the middle classes, then the working class and finally part timers. Some years the allowance was not raised even by inflation, and it was never increased by the rise in real incomes.

Until, in the 00s, someone working only part time on the new minimum wage was paying income tax. That same person who was could also be getting tax credits for a low income. Absurd.

Thus mine and the CPS’s insistence that the personal allowance needed to be raised substantially, which thankfully recent Governments have listened to. It’s possible to show that it was our insistences which led to the rise in the personal allowance we’ve seen over the last decade. The current amount is £12,500, which is what the full year, full time minimum wage was back in 2010/11 when we were making the argument. So the logic that the personal allowance should equal the minimum salary of a full-time worker was accepted. On that basis, the personal allowance should now be £17,374.50 a year, the equivalent if 37.5 hours a week on the minimum wage of £8.91.

Freezing that allowance now just takes us back to those days of fiscal drag which is what got us into the problem in the first place. But then that’s exactly why the Chancellor did it: fiscal drag is a great source of revenue.

Balancing the books is a useful part of a Chancellor’s job. Doing something about the budget deficit at some point equally sounds like a good idea. But balancing said books on the backs of, perhaps the incomes of, the poor is a bad way to do it. Plus there’s the moral point that the only possible justification for a minimum wage is that it is some just minimum – which should not, therefore, be taxed.

Far from freezing the personal allowance, Sunak should have raised it to the full year, full time minimum wage. True, it might not then be possible to balance the books by increasing revenue. We do, after all, face Laffer Curve problems with taxing the richer even more than they already pay. Which would mean that a just and moral system might have to reduce expenditure – something which, I have to admit, would not break my heart. Less government isn’t all that appalling an idea.

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Tim Worstall works for the Adam Smith Institute and the Continental Telegraph.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.