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How stealth taxes became Gordon Brown’s grimmest legacy

·5-min read
income tax thresholds stealth tax
income tax thresholds stealth tax

For a brief moment, the curse of “fiscal drag” - the most pernicious of stealth taxes - appeared to have been banished from British politics.

Under the Coalition Government, workers’ tax-free allowance steadily increased above inflation year after year, meaning a shrinking share of the population paid income tax to the Treasury. It was a Liberal Democrat policy, enthusiastically adopted by Conservatives as their own.

From 2010-11, the personal allowance rose from £6,475, reaching £10,600 by the end of the Coalition in 2015-16, and then £12,500 by 2019-20.

If it had increased in line with inflation, the threshold would have been closer to £7,800 - meaning workers paying tax on an additional £4,700 of their incomes.

The Conservatives’ policy marked a stark change from the Gordon Brown years in the Treasury and Number 10. Under the Labour leader - who continued “fiscal drag” from the 1970s - tax thresholds went up in line with inflation. Wages, however, rose at a faster pace, meaning more people qualified for a higher tax bracket each year.

It was considered a stealth tax, with a bigger share of the population paying by default - and the Treasury raking in easy money.

In times of prosperity, few noticed. But now, with inflation now heading for 13pc and the threshold frozen - not even increasing alongside inflation - the stealth taxes make for a grim legacy.

Figures from the Institute for Fiscal Studies (IFS) show the share of the population paying income tax rose from 56.6pc when Labour came to power in 1997 to a peak of 65.5pc in 2007-08, before dropping back slightly as the financial crisis ravaged workers’ earnings and pushed up inflation.

However, the rise in the numbers paying the higher rate of tax, currently at 40pc, has been even more stark.

Initially conceived as a tax on high earners, in 1990-91, it was paid by 1.7m people, or 3.7pc of the population. By the eve of the financial crisis, that was up to almost 8pc. It took some time to recover, but hit a new high of 8.7pc in 2013-14. This year, it is expected to hit 11.2pc this year, meaning one worker in every nine pays the higher rate.

John O’Connell at the Taxpayers’ Alliance says “the higher rate of tax is supposed to be for the best paid workers in the country, but instead it's fairly commonplace.”

Workers do not always spot the extra bill - they are still getting better off in cash terms, and usually in real terms too, even as an extra slice is taken by Whitehall.

It can be very lucrative for the public purse, says Douglas McWilliams at the Centre for Economics and Business Research, but is not necessarily good policy.

“It depends where your political preferences lie,” he says. “I am in favour of transparency, and I think if people’s tax burden is going up, the Government should say so.”

George Osborne, the Chancellor in the Coalition, did not entirely abandon fiscal drag. Those big jumps in the starting rate for income tax were important, but the higher rate threshold rose more slowly. In some years, it even came down to stop higher earners benefitting from the bigger tax-free allowance - hence the 11pc now paying the 40pc rate or more.

More fiscal drag came in the form of the additional rate of tax, a 50p levy on those earning more than £150,000 - introduced by Labour just before the Coalition took over.

The rate was later cut to 45p, but the threshold has stayed the same. Had it risen with inflation, the threshold should now be pushing £190,000.

Alongside those smaller taxes, fiscal drag is now back with a vengeance. Rishi Sunak, when he was Chancellor, decided to return not merely to the old system in which the tax-free allowance and thresholds rise with inflation, as per the Brown era, but to freeze them completely.

This effectively puts fiscal drag on steroids, particularly at a time when inflation is rampaging at levels not seen in 40 years and wages are failing to keep up.

It means workers face rising tax bills even as higher prices mean their pay packets do not go as far as they used to.

Even before the latest spike in inflation, the Office for Budget Responsibility in March predicted the freeze to the middle of this decade would drag the best part of 3m more people into tax and 2m into the higher bracket. Officials will have to raise that estimate as inflation and pay growth forecasts rise.

It represents an unexpected windfall for the Treasury. The IFS puts the extra take at £30bn, rather than the £8bn which the OBR estimated when the threshold freeze was first announced in March 2021.

Chris Sanger, head of tax policy at EY, says that while the old practice of indexing thresholds to prices meant chancellors did not feel like they were surrendering revenue by raising the point at which workers start to pay tax, “there was no follow-up policy” after the Coalition’s bigger increases “which has given rise to questions now about the way that fiscal drag is operating.”

Freezing the thresholds then leaves workers and the public finances exposed to unpredictable changes in inflation and pay. The fiscal dragnet on Britons’ pay is just getting started.