Chancellor Rishi Sunak’s fiscal policy could be pocketing the government a lot more than initially estimated, thanks to the ever-persistent inflation.

The Stealth of Fiscal Drag

Here’s a term to become familiar with – fiscal drag. In plain English, this means that when the government decides not to increase the amount where people start paying taxes, known as the income tax threshold, and wages increase due to inflation, more of your salary could be taxed.

Let’s break this down a bit:

1. Normally, if you earn up to £12,570 a year, you wouldn’t have to pay income tax. This figure usually increases as inflation rises so that you aren’t unfairly taxed on what’s considered a basic income.
2. However, Sunak decided this threshold would remain unchanged until 2028. If it had risen with predicted inflation, you would only start paying tax when you earn around £16,200 a year.
3. With more people’s salaries now falling above this unchanged threshold, the government will see more income from tax.

Adam Corlett from the Resolution Foundation points out that this method isn’t new. Various governments have used it to discreetly increase revenue. But what’s eyebrow-raising this time is the scale – a potential increase to £40 billion by 2028.

But Didn’t We Start With a Lower Estimate?

You’re absolutely right. When Sunak first announced this freeze back in 2021, the forecast was for it to net the Treasury an extra £8 billion a year by 2026. But the relentless creep of inflation, alongside a decision to extend this freeze, has changed these predictions.

By March this year, new estimates suggested this would bring in £29 billion a year from 2028 onwards. Now, with the Bank of England’s latest forecasts, the Resolution Foundation is predicting the policy could rake in a whopping £40 billion a year by 2027-28. That’s Britain’s most significant tax rise in over 50 years.

What Does This Mean for the UK’s Finances?

Higher tax revenues might sound like good news for the government’s purse strings, but there’s a catch. Higher inflation rates can also lead to increased borrowing costs for the government.

Ruth Gregory from Capital Economics notes that if these policies do bring in £40 billion a year by 2027-28, this could provide the chancellor with some extra financial cushioning. But rising costs could wipe out some of these gains.

The Treasury remains optimistic, highlighting its aim to reduce inflation and expressing its commitment to prudent financial management.