29 April 2022

It’s time to inflation-proof the tax system

By Peter Young

Figures released this week showed that ‘low-tax Conservative’ Rishi Sunak had managed to push tax receipts in 2021/22 to their highest level on record. At £718 billion, it was an increase of almost a quarter on the previous year.

Much of this can be attributed to the effects of inflation, which amounts to a deliberate stealth tax, given that the Chancellor has not raised any thresholds or allowances in line with rising prices. In fact, he has frozen thresholds and allowances until 2026, so we can expect even bigger increases in tax receipts in future years.

The statistics are really quite striking: inflation and fiscal drag have already doubled the scale of the tax rises Sunak announced last year. At least a million people, probably many more, will be dragged into paying the higher rate of tax and more than 1.5 million low earners will be pulled into paying the lower 20% rate of tax than if the personal allowance rose in line with inflation. 

Increasing tax revenues through inflation is a fundamentally underhand approach to public finances. It relies on deceiving taxpayers about the extent of tax rises, the scale of which cannot be known by the Treasury in advance, as they clearly have little idea of how inflation will develop.

A firm principle should be adopted: state tax revenues should not benefit in any way because of the state’s inability or unwillingness to keep inflation under control.

This would mean not just raising income tax brackets in line with inflation but also indexing all allowances and making sure that the state was not taxing inflationary gains in other ways.

In the case of income tax, the now frozen personal allowance and higher rate tax brackets should be indexed to inflation. So too should the various income tax allowances such as savings allowance, ISAs, Venture Capital Trusts and so on.

But it’s not just about the allowances. Savings income above the frozen £1,000 allowance is now fully taxed. But with inflation at 6% or 9%, (depending on whether one uses the government’s CPI or RPI measures), and interest on savings at a maximum of around 1%, it is an absurdity for that puny 1% of savings income to be taxed.

The issue is similar with capital gains tax. Of course the £12,300 annual allowance should be increased in line with inflation, but the main problem is that illusory inflationary gains are taxed as if they are real gains. The more government fails to control inflation the more it makes from capital gains tax.

Take an asset bought for £200,000 and sold two years later. If we had an annual inflation rate of only 5%, the asset would have to be sold for at least £220,500, just to compensate for the effect of inflation. If sold for less than this, the owner of the asset would actually incur a loss, despite a nominal gain. Yet the state would still collect tax on this entirely fictional ‘gain’.

Inheritance tax (IHT) is yet another example. The state is now raking in hugely increased revenues from this tax thanks to the combination of freezing the allowances and rampant house and asset price inflation. IHT was originally considered as a tax on the wealthy, but now the average UK property price is just £50,288 short of the standard residence nil rate band. Both the nil rate band and the nil rate residence band have been frozen until 2026. Indeed the nil rate band itself was last increased in 2009. Leaving aside questions of whether IHT should exist at all, thresholds should be increased to take account of inflation since 2009 and then adjusted for inflation annually.

Pensions are also increasingly subject to punitive taxes as a result of inflation. As the Telegraph’s excellent ‘Hands off our pensions’ campaign is highlighting, some 1.6 million more people will now be hit by punitive 55% taxes on their pensions because this government is not raising allowances in line with inflation. Doctors and other professional are being forced into early retirement as a result.

The answer is for it to become a legal requirement for all tax thresholds and allowances to be automatically increased in line with inflation and for inflationary gains no longer to be taxed. This is scarcely a revolutionary policy, it is standard practice in the US for example. The Office for Budget Responsibility should be tasked with reporting on whether the inflation-adjusting is being done properly.

This proposal will not be popular with either the Treasury or politicians. We are currently in some kind of tax-and-spend doom-loop. Politicians increase spending to try and gain favour with particular voter groups, the Treasury then tries to force taxes upward to at least partially cover the increased spending. Politicians then spend even more money, and so on. 

Our current set of politicians appear addicted to tax and spend. Just this week, in an attempt to ingratiate themselves with football fans, the Government announced that it was going to donate £250m of taxpayers’ money to football clubs to spend on stadiums, as well as set up a totally unnecessary football regulator. Football is doing just fine in the private sector and does not need to be subject to this profligacy.

In yet another example, this week it was announced that at least 34 companies that had received largesse from the Chancellor’s £1.1 billion ‘Future Fund’ were already in the process of being wound up, including a betting business which lost its gambling licence in Malta and a firm run by someone whose previous failed ventures had already cost investors £140m. Given that there is no shortage of capital for start-ups in Britain it is unclear why Rishi needed to demonstrate his generosity with taxpayers’ money in this way.

Just as drunks are best helped by denying them access to alcohol, we need to reduce the availability of easy money that politicians can spray around. Inflation-proofing the tax system would remove one huge source of cash that they can surreptitiously extract from unknowing taxpayers. If politicians want to raise taxes they should make the case for them and do it transparently.

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Peter Young is former Head of Research at the Adam Smith Institute.

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