Sunday, May 28, 2023
Our high inflation wreaks havoc on taxes and inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

Let me today take you back just over two years to March 2021 when Rishi Sunak, the then chancellor, unveiled his second budget. He was, he said, determined to begin the task of repairing the public finances, by announcing a tax policy that was “progressive and fair”. The policy was to freeze income tax allowances and thresholds for five years from April 2022, the exact opposite of the approach that had been followed by Tory chancellors since 2010.

I mention it now because, with the latest inflation figures, we have seen the consequences of the second freeze in those allowances and thresholds. The first freeze, in April last year, occurred with inflation at 9 per cent. The second, last month, occurred with a similar inflation rate, 8.7 per cent. The higher the inflation rate, and associated pay rises, the more the freeze increases the amount of tax people pay. This is fiscal drag at its most aggressive.

This was not supposed to happen. When Sunak announced the freeze two years ago, he was taking a scalpel to the public finances. Inflation, according to the official forecaster the Office for Budget Responsibility, was predicted to be less than 2 per cent for much of the period, only getting to that level in 2025. By 2025-26, the policy was expected to raise an eventual £8 billion annually compared with the usual approach of raising these allowances and thresholds in line with inflation.

But, while the policy has turned out to be much harsher than expected, it was extended for two years by Jeremy Hunt last autumn. High inflation means that it will raise £27 billion a year by 2025-26, more than three times the original plan, and £29 billion by 2027-28. Instead of a scalpel, this is a machete.

It is the biggest stealth tax increase in British history, and the biggest tax increase of any kind according to the Institute for Fiscal Studies (IFS), since Sir Geoffrey Howe increased VAT from 8 per cent (12.5 per cent for “luxuries”) to 15 per cent in 1979. To be fair to the former chancellor, his VAT increase was accompanied by big cuts in income tax.

This huge tax increase will have consequences for years to come. The OBR estimates that it will lead to 3.2 million more income taxpayers, 2.1 million more people paying the higher 40 per cent rate and 350,000 more paying the additional 45 per cent rate. The IFS says that by 2027-28 14 per cent of people will be paying income tax at the higher rate, compared with 3.5 per cent in the early 1990s. By then, 3.1 per cent will be on marginal rates of 45 or 60 per cent (the rate prevailing between £100,000 and £125,140. This is how, despite talk of pre-election tax cuts, Britain is becoming a high tax country.

This stealth tax increase was made much bigger by high inflation, and it not the only effect. The latest inflation figures, though showing a drop from 10.1 to 8.7 per cent, were acutely disappointing. Though inflation is on course to drop more sharply from the middle of the year, particularly with Ofgem’s announcement of a reduction in the energy price cap to £2,074 from July, compared with an average household bill of £2,500 now, the underlying picture remains worrying.

Food price inflation at 19.1 per cent, down only fractionally from 19.2 per cent the previous month, is now taking over from energy as the key inflation concern. For the Bank of England, however, the rise in “core” inflation, excluding energy, food, alcohol and tobacco, from 6.2 to 6.8 per cent, was the most worrying element. UK inflation is proving very sticky.

Core inflation, now the highest since April 1992, has risen from 4.2 per cent when the Bank started raising rates in December 2021 to nearly 7 per cent now. If the definition of insanity is doing the same thing over and over again and expecting different results, this would appear to be a living example.

The Bank, however, would appear to have little choice but to continue with the insanity, and it would be a surprise if its monetary policy committee (MPC) does not raise official interest rates again next month. Markets now think 5.5 per cent will be the peak, which would be higher than the rate prevailing for much of the period before the global financial crisis in 2008-9.

Higher official rates will be a problem for borrowers, making the adjustment to a new normal for interest rates that more difficult. Even more troubling may be that two-year swap rates and gilt yields, important for setting rates on fixed-rate mortgages have risen sharply, echoing the levels they reached after Kwasi Kwarteng’s unfortunate mini budget last September. Sunak and Hunt calmed markets but the inflation figures have undone some of their efforts. UK 10-year gilt yields are substantially higher than those in America, Germany and France,

reflecting the fact that Britain is leading the G7, and not in a good way, by having the highest inflation rate, and the highest rate for food-price inflation. The fear is that high inflation is becoming embedded and is shifting from mainly caused by international factors to being domestically generated. Service sector inflation is running at 6.9 per cent.

The corrosive effects of high inflation can be seen in bigger than intended increases in tax and higher mortgage rates, both of which will hamper the recovery. Crowing about the UK’s stronger growth, when the International Monetary Fund forecast is for a 0.4 per cent rise in gross domestic product (GDP) this year, and other countries’ forecasts have yet to be revised in the context of an improving international environment, looks like clutching at straws.

It is not the only factor. Tucked away in the latest public borrowing figures, which showed the second highest April budget deficit on record, was the news that the Treasury had to transfer £9.8 billion to the Bank last month to cover losses on its quantitative easing (QE) programme.

Those losses, which are set to reach £30 billion in the current fiscal year, mainly arise from the fact that official interest rates are higher than the returns on the Bank’s portfolio of gilts acquired under QE. Every increase in Bank rate adds to those losses. High inflation is corrosive, as is the response to it, and in ways that we did not have to think about in the past.