Successive budgets have frozen the Personal Tax Allowance that can be deducted from the incomes of people in the UK before tax has to be paid. Victor Bulmer-Thomas writes that while this policy is widely regarded as a “stealth tax”, more attention should be paid to its impact on those with lower incomes.
Much has been written about stealth taxes – those increases in the tax burden that the public either ignores or of which it is unaware. Governments love them as by definition they carry no electoral liability and opposition parties – or at least those with realistic chances of governing in the future – often fail to draw attention to them as they might hope to benefit from the same fiscal “gift” in the future.
Yet stealth taxes can be pernicious – especially when those on lower incomes are most affected. Indeed, such an outcome will increase income inequality on some measures and may well cancel out all efforts to improve the distribution of income through other policies. In addition, the lack of transparency with regard to the working of fiscal policy implied by stealth taxes is not something that should be promoted in a modern state.
The frozen personal allowance
Since the fiscal year 2021/22, a number of tax allowances in the UK have been “frozen”, meaning they have no longer been increased in line with the cost of living. The most important of these allowances is the Personal Tax Allowance, which is the amount that can be deducted from gross income before tax needs to be paid.
Specifically, in March 2021 (the Spring budget) the Chancellor of the Exchequer at the time, Rishi Sunak, announced that the Personal Tax Allowance would increase in 2021/22 as normal in line with inflation (as measured by the Consumer Price Index). However, it would be “frozen” thereafter until 2025/26. And in 2022, another Chancellor of the Exchequer, Jeremy Hunt, announced the freeze would continue until 2027/28. Nor is there any guarantee the freeze will not be extended beyond April 2028 if circumstances change.
Jeremy Hunt, looking for an electoral boost, had an opportunity to raise the allowance (frozen at £12,570 per year) in his 2023 autumn budget but chose to concentrate instead on other fiscal changes. This suggests the frozen allowance does indeed have limited electoral toxicity and can be safely described as a stealth tax. Freezing of the Personal Tax Allowance is therefore likely to endure until at least 2027/28. And the opposition Labour Party has given no hint of whether this aspect of fiscal policy might change if there is a Labour Government.
The months of the freeze, since it started, have been accompanied by high inflation (by recent standards) and thus the impact of a frozen Personal Tax Allowance has already been large and will become much bigger. The reason is simple. We can expect earned incomes to rise at least in line with inflation during the years of the freeze and possibly faster due to labour market conditions. Thus, a higher proportion of income will be subject to income tax due to the freezing of the Personal Tax Allowance and will bring in proportionately more tax for the government.
This “fiscal drag”, as it is often called, can be illustrated very easily. Imagine an individual on a gross earned income of £30,000 in 2021/22 and no other sources of income. After application of the Personal Tax Allowance, tax at the basic rate of 20 per cent in England, Wales and Northern Ireland (not Scotland where the basic tax rate is different) must be paid on £17,430 (£30,000 less the Personal Tax Allowance of £12,570). This amounts to a tax bill of £3,486, which is equivalent to an average tax rate of 11.6 per cent, which is the tax bill divided by gross income.
The effect of freezing the Personal Tax Allowance is to push the individual’s average tax rate up from 11.6 per cent in 2021/2 to 13.6 per cent in 2027/8.
By 2027/8, officially the last year of the freeze, cumulative inflation over the intervening years might easily reach 30 per cent. If the individual’s gross income rises by the same rate as inflation, it would be £39,000. However, the Personal Tax Allowance stays the same so income tax must be paid (still at 20 per cent) on £26,430. This yields £5,286 in tax, which is an increase of 51.6 per cent in the tax burden.
The effect of freezing the Personal Tax Allowance is to push the individual’s average tax rate up from 11.6 per cent in 2021/22 to 13.6 per cent in 2027/28. This may seem like a small increase and many individuals may either not notice it or choose to ignore it as their gross income has risen over the period of the freeze. Furthermore, there has been no increase in the basic rate of income tax – still magically “frozen” at 20 per cent.
However, let us now imagine what would have to happen if the government had indexed the Personal Tax Allowance in line with inflation and still wanted to raise the same amount of income tax. It would then have to raise the basic rate of tax above 20 per cent. In this example, the Personal Tax Allowance would rise to £16,341 by 2027/28, the taxable income would be £22,655 and the basic rate of tax would have to increase to 23.33 per cent in order to raise the same amount of tax (£5,286).
We can now see why this particular stealth tax is so popular with the current government (and possibly the next one). Rather than having to announce a politically disastrous increase in the basic rate of tax from 20 per cent to 23.33 per cent, it can claim that there has been no increase in the basic rate and therefore boast that it has protected income earners while at the same time surreptitiously raising huge sums of money for the Exchequer.
The value of this extra revenue could be anything between £50 and £100 billion according to official forecasts, the exact amount depending on wage inflation, other frozen allowances and a few other variables. When one thinks how long it took to reduce the basic rate of tax by this amount in previous administrations, it is not surprising that the current one has been tempted to use stealth taxes to raise the basic rate by such a spectacular amount without much – if any – political outcry.
A cruel and unnecessary policy
Or so it would seem. The distributional impact of this particular stealth tax may come back to bite the administration that imposed it. The reason is that the impact is much more severe on those on lower incomes than those on higher ones, as I will now demonstrate.
At the end of the fiscal year 2021/22, the median pay of a full-time worker in the UK was £33,374 similar to the example of the individual I used above. The median pay of the bottom decile of full-time workers (the lowest ten per cent) was £20,691. Using all the same assumptions as above with regard to inflation, wage increases and applying the frozen Personal Tax Allowance, a “typical” individual in the lowest decile would see their tax bill increase from £1,624 to £2,906.
This is a jump in the average tax rate from 7.8 per cent to 10.7 per cent, which is an increase of 37.7 per cent. Furthermore, the basic rate of tax needed to secure the same amount of tax from this individual would have to be 27.7 per cent – a massive increase on the “official” rate of 20 per cent.
No government would survive for long if it transparently imposed tax increases of this magnitude on the poorest in society. And yet by doing so through stealth taxes, it becomes politically feasible – at least for a while. The fact that post-tax income distribution on some measures has become even less equal can be dismissed as “collateral damage” while the government enjoys the windfall from this particular application of fiscal drag. And even when (if?) the Personal Tax Allowance is unfrozen, rising in line with future inflation, it will not undo the impact of the shift in income distribution during the years of the freeze. Other policies will be needed to do that.
There was a series of articles about fiscal drag around the time of the autumn statement in 2023, but much of this was focused on the impact of stealth taxes on the better paid. It is true that fiscal drag will move a large number of people from paying only the basic rate of tax to being liable to the higher rate (40 per cent) or even the additional rate (45 per cent). However, none of this should detract from the dramatic impact of the frozen Personal Tax Allowance on the post-tax income of the lowest decile. It is a cruel and unnecessary policy.
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