Fiscal Drag is Very Problematic

By this time next week Rachel Reeves will have delivered her first Budget as Chancellor of the Exchequer. There has obviously been lots of speculation as to what will be in it and the debate has centred around what constitutes ‘working people’ and what it means to increase taxes on this group. The last two weeks has seen Labour pretty much admit that they will be increasing Employers’ National Insurance Contributions – I have a piece coming out shortly on why this would constitute a tax increase on working people – which I’ll obviously share here when it’s finally published. As of yesterday this debate has taken the form of whether or not you’re a working person if you own shares, which means that the government will likely increase Capital Gains Tax (a bad idea).

However, what has largely gone undiscussed in all this is the fact that in all likelihood Rachel Reeves will follow the example of Jeremy Hunt and will actually increase Income Tax and National Insurance Contributions. The reason for this is due to Fiscal Drag (which sounds like the name of a contestant on the excellent RuPaul) and it occurs when the government keeps tax brackets frozen rather than increasing them in line with inflation. The result is that people who may technically be earning more as their gross income may have increased in nominal terms as they have received a pay rise find themselves dragged into a higher tax bracket.

This is wrong for a number of reasons.

First, it simply isn’t fair. People might technically be on a higher salary, but this is only true in nominal terms. They are actually no better off in reality. They might technically have more money but they can’t buy more of the things they need and want for themselves and their families because everything is now more expensive due to inflation. They are not actually wealthier – and in some cases may even be worse off – so why is the government taxing them as though they are?

This would be an issue at any time but it is particularly galling given the period of incredibly high inflation which the country has endured over the past few years. Thankfully inflation has now returned to around target, but this has come after years of many households really struggling to make ends meet. It just isn’t fair that the government should be treating people in middle class roles – many of whom have had to tighten their belts – as if they are high earners.

Second, it is an increase in taxes on working people which is a breach of the government’s manifesto promise. Of course Rachel Reeves can get round this by arguing that she isn’t actually increasing the rate of Income Tax or NICs, the result is still the same: many working people will be forced to hand over more of their wages to the State. Reeves and Labour can claim that they are simply doing what the Tories were simply continuing a Tory policy – and they would be correct to say that – but it doesn’t mean it’s the right thing to do. It is not a transparent way in which to raise revenue. Governments love increasing tax via stealth as it allows them to technically not lie when they say they’re not increasing taxes while also allowing them to get their hands on extra revenue, but it is a very sneaky way of going about things and is no way to treat the public.

Third, given that it is actually a tax increase then this isn’t a good thing. As I wrote in my last post, tax increases are a form of austerity, which obviously isn’t ideal. What is more, when you levy or increase a tax on an activity, then you tend to see less of it. Sometimes this is a good thing (which is why we should be in favour of Pigouvian taxes). However, work is obviously a very good thing. We should want people to be working as much as they can and doing it in the most productive manner possible. This is good for businesses, economic growth, and the public finances. As such, the government should be trying to incentivise people to do more of it. I’m not suggesting that the government abolish taxes on labour, but it certainly is unwise to increase the burden on it – especially if its stated aim is to go for growth.

Finally, given that Fiscal Drag is such an easy revenue raiser for HM Treasury, it stops it doing the hard work on actual tax reform. I’ve written before that rather than simply raising or lowering certain taxes, the government needs to do some serious thinking about tax reform. It needs to consider what it thinks the State should actually be responsible for and then look at how it can raise revenue to fund this in a way which does not distort economic activity, promotes investment, and boosts growth. This is really tricky and will mean that the government would have to do some really unpopular things but are the right thing to do. Successive governments have shirked this responsibility and have taken the easier option, Rachel Reeves prides herself on being a trailblazer as the first female Chancellor and she is rightly proud of this. She should match this with her actions and go for serious tax reform.

While I certainly can’t blame Reeves for not putting an end to Fiscal Drag – she is just following in the footsteps of her predecessor and it is an easy way to raise money – this does not make it right. If she is serious about allowing working people to keep more of their money while going for growth then the Chancellor should commit to ending Fiscal Drag and going for serious tax reform instead.

Thanks as ever for reading. I’ll probably write another post or two next week after the Budget. Have a great weekend!