Thirty years of fiscal drag

It might be thought that a succession of ‘tax cutting’ governments from 1979 and a government pledged to reduce inequality from 1997 would have led to a huge increase in the personal tax allowance so that we could keep more of our income without paying tax. If there was one thing on which you would expect Margaret Thatcher and the dour ‘son of the manse’ Gordon Brown to be agreed it is that the working poor should have their tax burden reduced. However, both Thatcher’s Chancellors and Brown focused on cutting marginal rates. Whilst the basic rate of tax fell by over half of its 1979 rate, the tax allowance did not even manage to flat-line relative to wages.

The following graph shows the personal tax allowance (the amount of income on which no tax is paid) from 1978 to 2010:

Even the recovery in the personal allowance at the end of the period only took place because of the controversy over a completely different issue (the abolition of the 10 pence rate of tax) and the desire of the Chancellor to throw some scraps to the electorate – though there has now, finally, been a policy change under the coalition since 2010.

There was a big increase in the allowance in Geoffrey Howe’s first budget and, if we take the core period from then until 2008, the personal allowance fell, relative to wages by well over 20%.

If the picture looks grim at the bottom end of the income scale, it looks grimmer still for the middle class. Higher-rate tax – once the domain of the rich – is rapidly spreading to those who are not remotely well off (especially if they are living in the south-east of England). The following graph shows the amount of income on which basic rate tax is paid:

Essentially, after the 1979 emergency budget, the higher rate tax band has dropped relative to wages by nearly 40%. Although the amount of untaxed income that we are allowed to keep is being increased over the period from 2010 to 2013, the amount of income we can earn in addition to that before we pay higher-rate tax is falling by a further 10% in just three years. This will mean that relative to wages the amount of income on which basic rate tax is paid will have halved in just over 30 years. If the next 30 years is like the last 30 years (and there is no sign of a slowdown, never mind a reversing of the trend), individuals on average salaries will be paying higher-rate tax in the whole of the UK (the picture is much worse in the south east).

What is the problem here? Technically, the problem is fiscal drag. Tax allowances are indexed to prices and not to wages. That means that, as real wages rise, the Exchequer increases tax receipts as a proportion of our incomes. Indeed, even the inflation indexing has been weakened recently (and is sometimes suspended). Allowing this to happen is an easy way for the government to increase the tax take without advertising it. It is a ‘public choice’ problem. Tax cuts (and means-tested benefits increases) can be targeted at interest groups and they can be financed by a silent tax increase spread across the whole population.

It has, however, gone too far (indeed, it had gone too far by 1984). Hopefully, a young MP might be able to make his mark like Rooker, Wise and Lawson did in the 1970s and propose the statutory indexing of tax allowances to average wage levels. Then the government would have to explicitly announce and call for a vote when it chose not to implement the indexation.

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

3 thoughts on “Thirty years of fiscal drag”

  1. Posted 17/05/2012 at 14:04 | Permalink

    While part of me thinks it would be an excellent idea to take as many people out of income tax as possible, another part thinks that the electorate would become even more irresponsible if an even larger part of it didn’t pay overt taxation. People would still pay NI VAT Council Tax etc, but these are less visible.

    To make the point more strongly, perhaps we should abolish PAYE too so that we all have to write cheques to the government rather than have it quietly disappear from our gross pay without us really noticing the full amount.

    So long as the government continues to take such a huge chunk of GDP as many people as possible need to be reminded of this rather than simply thinking that it is other – “rich” – people who pay tax.

    Incidentally, much discussion recently about squillionaires being made to pay a minimum amnount of tax. Examples quoted of people with incomes of £10 million pa ‘only’ paying 10% in tax. That’s still £1 million, approximately what 150 people on median earnings pay. If there is to be a minimum tax payment for the super-rich, perhaps there ought to be a maximum too.

  2. Posted 18/05/2012 at 17:17 | Permalink

    ‘The dour son of the manse Gordon Brown’. Philip, how on earth does this have any bearing on the academic purpose of this article? Who cares if Brown is ‘dour’ -many would disagree incidently. I’m sure there’s plenty of adjectives we could prefix to the IEA’s beloved Margaret Thatcher, yet choose not to for the sake of remaining impartial.

    If I wanted an article adorned with the essence of rhetorical flourish, the IEA isn’t the first place I’d look to, nor should it be. I enjoyed reading the article, but are the pointless slurs against Brown quite neccessary?

  3. Posted 18/05/2012 at 19:10 | Permalink

    @jay – many apologies, it was not meant to be a slur at all. I was merely trying to convey the impression that here we had somebody concerned about inequality and whose first reaction, one would assume (given his character) would be to allow the poor to keep more of their income (just like Thatcher – whose instincts in that particular respect one would expect to be the same). But I accept that it was not very obvious. I don’t really regard being dour as something for which one is culpable so it is not something which I would use as a criticism. But you make a fair point.

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