Since 2019, UK personal taxes (income tax and national insurance) have been increasing as a proportion of incomes and total tax revenues have been increasing as a proportion of GDP. However, in his Autumn Statement of 22 November, the Chancellor, Jeremy Hunt, announced a 2 percentage point cut in the national insurance rate for employees from 12% to 10%. The government hailed this as a significant tax cut. But, despite this, taxes are set to continue increasing. According to the Office for Budget Responsibility (OBR), from 2019/20 to 2028/29, taxes will have increased by 4.5 per cent of GDP (see chart below), raising an extra £44.6 billion per year by 2028/29. One third of this is the result of ‘fiscal drag’ from the freezing of tax thresholds.
According to the OBR
Fiscal drag is the process by which faster growth in earnings than in income tax thresholds results in more people being subject to income tax and more of their income being subject to higher tax rates, both of which raise the average tax rate on total incomes.
Income tax thresholds have been unchanged for the past three years and the current plan is that they will remain frozen until at least 2027/28. This is illustrated in the following table.
If there were no inflation, fiscal drag would still apply if real incomes rose. In other words, people would be paying a higher average rate of tax. Part of the reason is that some people on low incomes would be dragged into paying tax for the first time and more people would be paying taxes at higher rates. Even in the case of people whose income rise did not pull them into a higher tax bracket (i.e. they were paying the same marginal rate of tax), they would still be paying a higher average rate of tax as the personal allowance would account for a smaller proportion of their income.
Inflation compounds this effect. Tax bands are in nominal not real terms. Assume that real incomes stay the same and that tax bands are frozen. Nominal incomes will rise by the rate of inflation and thus fiscal drag will occur: the real value of the personal allowance will fall and a higher proportion of incomes will be paid at higher rates. Since 2021, some 2.2 million workers, who previously paid no income taxes as their incomes were below the personal allowance, are now paying tax on some of their wages at the 20% rate. A further 1.6 million workers have moved to the higher tax bracket with a marginal rate of 40%.
The net effect is that, although national insurance rates have been cut by 2 percentage points, the tax burden will continue rising. The OBR estimates that by 2027/28, tax revenues will be 37.4% of GDP; they were 33.1% in 2019/20. This is illustrated in the chart (click here for a PowerPoint).
Much of this rise will be the result of fiscal drag. According to the OBR, fiscal drag from freezing personal allowances, even after the cut in national insurance rates, will raise an extra £42.9 billion per year by 2027/28. This would be equivalent of the amount raised by a rise in national insurance rates of 10 percentage points. By comparison, the total cost to the government of the furlough scheme during the pandemic was £70 billion. For further analysis by the OBR of the magnitude of fiscal drag, see Box 3.1 (p 69) in the November 2023 edition of its Economic and fiscal outlook.
Support measures during the pandemic and its aftermath and subsidies for energy bills have led to a rise in government debt. This has put a burden on public finances, compounded by sluggish growth and higher interest rates increasing the cost of servicing government debt. This leaves the government (and future governments) in a dilemma. It must either allow fiscal drag to take place by not raising allowances or even raise tax rates, cut government expenditure or increase borrowing; or it must try to stimulate economic growth to provide a larger tax base; or it must do some combination of all of these. These are not easy choices. Higher economic growth would be the best solution for the government, but it is difficult for governments to achieve. Spending on infrastructure, which would support growth, is planned to be cut in an attempt to reduce borrowing. According to the OBR, under current government plans, public-sector net investment is set to decline from 2.6% of GDP in 2023/24 to 1.8% by 2028/29.
The government is attempting to achieve growth by market-orientated supply-side measures, such as making permanent the current 100% corporation tax allowance for investment. Other measures include streamlining the planning system for commercial projects, a business rates support package for small businesses and targeted government support for specific sectors, such as digital technology. Critics argue that this will not be sufficient to offset the decline in public investment and renew crumbling infrastructure.
To support public finances, the government is using a combination of higher taxation, largely through fiscal drag, and cuts in government expenditure (from 44.8% of GDP in 2023/24 to a planned 42.7% by 2028/29). If the government succeeds in doing this, the OBR forecasts that public-sector net borrowing will fall from 4.5% of GDP in 2023/24 to 1.1% by 2028/29. But higher taxes and squeezed public expenditure will make many people feel worse off, especially those that rely on public services.
- Fiscal drag
Sky News Politics Hub on X, Sophy Ridge (22/11/23)
- Fiscal drag
Sky News Politics Hub on X, Beth Rigby (22/11/23)
- Autumn Statement 2023 response
IFS, Stuart Adam, Bee Boileau, Isaac Delestre, Carl Emmerson, Paul Johnson, Robert Joyce, Martin Mikloš, Helen Miller, David Phillips, Sam Ray-Chaudhuri, Isabel Stockton Tom Waters, Tom Wernham and Ben Zaranko (22/11/23)
- Autumn Statement: Jeremy Hunt cuts National Insurance but tax burden still rises
BBC News, Brian Wheeler (23/11/23)
- The hidden tax rise in the Autumn Statement
BBC News, Michael Race (23/11/23)
- How is National Insurance changing and what is income tax?
BBC News (23/11/23)
- UK income tax: how fiscal drag leads to people falling into higher rates
The Guardian, Antonio Voce and Ashley Kirk (22/11/23)
- Will I be pulled into a higher tax band? How ‘fiscal drag’ affects your pay
i News, Alex Dakers (23/11/23)
- Fiscal drag could cost high earners £4,000 by 2027
MoneyWeek, Marc Shoffman (16/11/23)
- Why the UK government’s tax cuts still leave workers worse off
CNBC, Elliot Smith (23/11/23)
- National insurance cuts swamped by stealth tax rise, says fiscal watchdog
Financial Times, Emma Agyemang (22/11/23)
- Frozen income tax bands eat into benefits of NI cut, say experts
FT Adviser, Tara O’Connor (23/11/23)
- Jeremy Hunt’s fiscal fudge
Financial Times editorial (22/11/23)
Report and data from the OBR
- Would fiscal drag occur with frozen nominal tax bands if there were zero real growth in incomes? Explain.
- Examine the arguments for continuing to borrow to fund a Budget deficit over a number of years.
- When interest rates rise, how much does this affect the cost of servicing public-sector debt? Why is the effect likely to be greater in the long run than in the short run?
- If the government decides that it wishes to increase tax revenues as a proportion of GDP (for example, to fund increased government expenditure on infrastructure and socially desirable projects and benefits), examine the arguments for increasing personal allowances and tax bands in line with inflation but raising the rates of income tax in order to raise sufficient revenue?
- Distinguish between market-orientated and interventionist supply-side policies? Why do political parties differ in their approaches to supply-side policy?
The UK has always been an attractive place for investment, as foreign companies look to cities such as London for stable investment opportunities. This provides not only jobs and output, but also tax revenue for the government. However, one drawback is the lost tax revenue through tax avoidance schemes and big businesses say that if the UK is to remain competitive it needs to look at cutting taxes and bureaucracy.
In recent months, we have seen cases of individuals being prosecuted for tax evasion and more recently in the USA, Microsoft and Hewlett-Packard have been criticized by the Senate for allegedly moving an estimated £13bn to offshore accounts. (Microsoft and HP deny any wrong-doing). It is cases like this that provide an argument for governments to cut business rates and avoid losing business and jobs to other tax havens. Lord Fink, who is a Director of Firms located in a variety of tax havens said:
’I don’t see why the UK should not compete for jobs that at present are going to the Cayman Islands’
Tax havens are obviously attractive to firms, as they provide a means of retaining more of a firm’s earnings and hence their profits. By offering a much lower rate of tax than countries such as the UK, they help to ease the tax burden on wealthy individuals and investors in hedge funds, along with many others.
The question is, do these lower tax rates discourage investment into the UK and thus would a relaxation of Revenue Customs’ rules mean an increase in inward investment and the other positive things that this would bring? Or would a decrease in tax rates for wealthy investors send the wrong message?
In a time of austerity, tax cuts for the rich are never going to be a popular policy – at least not amongst the ‘non-rich’ – in truth, the majority of the population. Furthermore, many simply see tax havens as morally wrong – or as George Osborne put it ‘morally repugnant’. The use of them provides the better off with a means of paying less to the taxman, whilst the worse off continue to pay their share.
The controversy surrounding tax havens is perhaps even more of an issue given the size of the public-sector deficit. With tax havens being used by those who should be paying the most, tax revenues are lower than would be the case without tax evasion and avoidance. Is this adding to the burden of basic rate tax payers?
This doesn’t help the gap between government expenditure and revenue, which has contributed to the largest amount of UK public-sector borrowing in August 2012 since records began. Net borrowing reached £14.4bn, as things like corporation tax receipts fell and benefit payments rose. Money that should go in to the government’s coffers is undoubtedly making its way into tax havens, but does that also mean that jobs are making their way out of the country? If tax rates in the UK were cut, cities such as London may become even more attractive places to invest, which could potentially create a much needed boost for the economy. But, at what cost? The following articles consider the controversy of tax havens.
Microsoft and HP rapped by US Senate over tax havens BBC News (20/9/12)
Morally repugnant tax avoiders can rest easy under David Cameron Guardian, Tanya Gold (21/9/12)
Britain could prevent the use of tax havens by ending ‘archaic’ business rules Telegraph, Rowena Mason (21/9/12)
UK public-sector borrowing hits record high of £14.4bn BBC News (21/9/12)
The top Tory who wants to make Britain a tax haven for millionaires Guardian, Martin Williams and Rajeev Syal (20/9/12)
Make UK a tax haven to attract investment from millionaires, urges Tory treasurer Mail Online, Daniel Martin (21/9/12)
Microsoft saved billions using Irish tax havens Irish Times, Genevieve Carbery (21/9/12)
Microsoft, HP skirted taxes via offshore units: U.S. Senate Panel Reuters, Kim Dixon (21/9/12)
Danny Alexander says tax avoidance ‘adds 2p in every £1 to basic tax rate’ Independent, Oliver Wright (24/6/12)
- What are the key features of tax havens?
- Briefly explain the arguments in favour of tax havens and those against. Think about them from all points of view.
- Explain the way in which a cut in UK tax rates could create jobs and how the multiplier effect may provide a boost for the UK economy.
- If tax rates were cut, how might this affect an individual’s decision to work? What about an individual’s decision to invest? Use indifference analysis to help explain your answer.
- How does tax avoidance and evasion affect public sector borrowing? Is there any way a cut in tax rates on foreign investment could improve the government’s finances?
- Do you think there is any truth in the argument that the UK is losing out to other countries because of its higher tax rates? Is a reduction in tax rates necessary to help us compete?
Recently there have been calls from business leaders and Conservative politicians to scrap the UK’s 50% income tax rate, which is paid on taxable incomes over £150,000. The 50% income tax rate is thus paid by top earners, who comprise around just 1% of taxpayers.
And yet the government receives about 30% of income tax revenue from this 1% – and this was before the introduction of the 50% rate in April 2010. (In fact, with the marginal national insurance rate of 2%, top earners are paying an effective marginal rate of 52%.)
One argument used by those who favour reducing the 50% rate is that the rich would pay more income tax, not less. There are four reasons given for this. The first is that people would be encouraged to work harder and/or seek promotion if they knew they would keep more of any rise in income. The second is that fewer rich people would be encouraged to leave the country or to relocate their businesses abroad. The third is that more people would be encouraged to work in or set up businesses in the UK. The fourth is that there would be less temptation to evade taxes by not declaring all income earned or to find clever ways of avoiding tax.
These arguments were put forward in the 1980s by Art Laffer, an adviser to President Reagan. His famous ‘Laffer curve’ (see Economics (8th edition) Box 10.3 or Economics (7th edition) Box 10.4) illustrated that tax revenues are maximised at a particular tax rate. The idea behind the Laffer curve is very simple. At a tax rate of 0%, tax revenue will be zero – but so too at a rate of 100%, since no-one would work if they had to pay all their income in taxes. As the tax rate rises from 0%, so tax revenue would rise. And so too, as the tax rate falls from 100%, the tax rate would rise. It follows that there will be some tax rate between 0% and 100% that maximises tax revenue.
Those arguing that a cut in the top rate of income tax would increase tax revenue are arguing that the 50% rate is beyond the peak of the Laffer curve. But this is an empirical issue. In other words, to assess the argument you would need to look at the evidence as, theoretically, the peak of the Laffer curve could be below or above 50%. Indeed, some argue that the peak is more likely to be at around 75%.
The following podcasts and articles consider the arguments. As you will see, the authors are not all agreed! Consider carefully their arguments and try to identify any flaws in their analysis.
On 27 June 2012, Arthur Laffer appeared on the BBC Today Programme to discuss the Laffer curve and its implications for UK income tax policy. You can hear it from the link below
Should the 50p tax rate be ditched? BBC Today Programme, John Redwood and Paul Johnson (3/3/12)
Arthur Laffer: Tax rate should ‘provide for growth’ BBC Today Programme (27/6/12)
Where’s the High Point on the Laffer Curve? And Where Are We? Business Insider, Angry bear Blog (3/3/12)
Tax cuts: we can have our cake and eat it The Telegraph, Ruth Porter (22/2/12)
‘Scrap the 50p tax rate’ say 500 UK entrepreneurs Management Today, Rebecca Burn-Callander (1/3/12)
The Laffer Curve Appears in the UK Forbes, Tim Worstall (22/2/12)
Memo to 50p tax trashers: Laffer Curve peaks at over 75 per cent Left Foot Forward, Alex Hern (1/3/12)
- Explain how a cut in income tax could lead to an increase in tax revenue.
- Distinguish between the income effect and the substitution effect of a tax cut. Which would have to be bigger if a tax cut were to increase tax revenue?
- If, in a given year, the top rate of tax were raised and tax revenue fell, would this prove that the economy was now past the peak of the Laffer curve?
- What would cause the Laffer curve to shift/change shape? To what extent could the government affect the shape of the Laffer curve?
- If the government retains the 50% top tax rate, what can it do to increase the revenue earned from people paying the top rate?
- What other objectives might the government have for having a high marginal income tax rate on top earners?
- Investigate the marginal income tax and national insurance (social protection) rates in other countries. How progressive are UK income taxes compared with those in other countries?
A huge majority of the British population are in agreement on one thing: UK drinking is out of control. At a cost to the NHS of over £2 billion per annum, it’s quite obvious that the current ‘binge drinking’ culture is unsustainable for those doing the drinking and for the NHS.
This issue was raised back in January 2010, when the Labour government came under pressure to impose a minimum price on alcohol. (see All-you-can-drink bans) The report published in early January suggested that a minimum price on alcohol of 50p per unit would save more than 3000 lives per year. Dr. Richard Taylor said:
“The evidence we took showed that minimum pricing was the most effective way forward and at the moment you can sometimes buy beer cheaper than water. Our message is that the price would be put up but only by a little for moderate drinkers. Surely that is a sacrifice to pay for the good health of young people.”
The Coalition’s plan is to introduce a minimum price for alcohol, which would increase the price of a can of lager to a minimum of 38p and a litre bottle of vodka would be a minimum of £10.71. By increasing the price of alcohol, it is hoped that demand will be reduced and this will go some way to tackling the problem of binge drinking.
However, many argue that the proposal will be ineffective. Some believe that the minimum price is not high enough and that such a small increase will have no effect. Others argue that it will only affect small supermarkets and will have a significantly adverse effect on pubs, which are already struggling. Furthermore, a concern is that by raising the price of alcohol, the only people who will suffer are the so-called ‘sensible’ drinkers. Those who go out and binge drink will be largely unresponsive to the higher price.
How can raising the price of alcohol improve health BBC News, Michelle Roberts (18/1/11)
Pub association responds to alcohol minimum price BBC News (18/1/11)
SNP refuses Britain-wide alcohol minimum price Telegraph, Simon Johnson (19/1/11)
Experts say the new minimum prices on alcohol sales are not enough Wales Online, Abby Alford (19/1/11)
UK drinking ‘is out of control’, two thirds of public believe Guardian, Alan Travis (18/1/11)
Alcohol price plans will only save 21 lives per year, says expert Telegraph, Tom Whitehead (19/1/11)
Supermarkets forced to charge ‘minimum price’ for alcohol in bid to curb binge drinking Mirror News, James Lyons (18/1/11)
Alcohol House of Commons Health Committee (10/12/09)
- Using a diagram, explain how a minimum price control on alcohol will work. What are the likely effects?
- Which factors will determine the effectiveness of the minimum price?
- Why is it that ‘binge drinkers’ may not be responsive to the higher price?
- The Mirror article refers to ‘loss leaders’. What are they and how are they relevant here?
- What other policies could be used to tackle binge drinking?
- Given that taxes on products such as alcohol and cigarettes raise so much tax revenue for the government, would there be an adverse effect by raising the minimum price on alcohol?
- Why is the current drinking culture unsustainable?
- Is alcohol a de-merit good? Why is it an example of market failure?
Over the past week, Greece has been hogging the headlines when it comes to debt crisis. However, there is concern that there are a number of other countries ‘where credit defaults swaps are unusually high, suggesting there is risk in terms of default’. Greece’s deficit stands at 12.7% (£259bn), which is over 4 times higher than EU rules allow and its debt levels are expected to reach 120% of GDP this year if help is not given. Furthermore, if Greece’s debt problems are not tackled, there is a worry that other countries with big deficits, such as Portugal and Spain will become vulnerable. Public spending in Greece had been rising for some time but the tax revenue hadn’t increased to match this. As government spending rose and tax revenues fell, the growing debt was inevitable.
What is just as concerning is the cost of servicing this debt. This is costing Greece about 11.6% of GDP and the Greek government has estimated that it will need to borrow €53bn this year to cover budget shortfalls. Strikes by public-sector workers have also affected the country, as figures show that the unemployment rate has increased to 10.6%.
However, there are now reports that an agreement has been reached at the EU summit to rescue Greece and help it tackle its debt problems. Herman Van Rompuy, the European Union’s President, said that an agreement had been reached. The news was immediately welcomed by jittery markets, with the euro regaining some of its losses. Initially, it was thought that British taxpayers would be a part of any bailout package, but Alistair Darling, said there was no plan to use UK taxpayers’ money to support Greece. When asked about the comparison of the UK with Greece, Alistair Darling commented that:
“I don’t think you can compare the UK with Greece. We have different policies. We have a very good track record and, most importantly, the maturity of UK debt is much longer.”
The EU summit was officially meant to cover medium-term European economic strategy, but it was dominated by the Greek crisis. Germany and France are likely to stand together and pledge to come to Athens’s aid by guaranteeing Greek solvency, but only time will tell whether this will happen or will work.
EU leaders reach deal to rescue Greece from debt crisis, President Barroso says Telegraph, Bruno Waterfield (11/2/10)
Mervyn King on Greece, Britain’s deficit and a hung Parliament Telegraph (10/2/10)
FTSE rises amid Greece rescue hopes The Press Association (11/2/10)
Greece’s unemployment rate hits 10% BBC News (11/2/10)
Debt crisis: Experts see more skeletons tumbling News Center (11/2/10)
EU deal ‘agreed’ on Greece debt woes BBC News (11/2/10)
Greek bailout deal reached at EU summit Guardian, Ian Traynor and Graeme Wearden (11/2/10)
Greek bailout would hurt Eurozone – Germany’s Issing Reuters (29/1/10)
Greece must meet deficit target to get aid Reuters (11/2/10)
Could bailout be on the cards for Greece BBC News (10/2/10)
Germans must start buying to save Europe’s stragglers Financial Times, Martin Wolf (10/2/10)
Thinking the unthinkable BBC News Blogs, Stephanomics, Stephanie Flanders (11/2/10)
Angela Merkel dashes Greek hopes of rescue bid Guardian, Ian Traynor (11/2/10)
Greece faces devaluation, default or deflation. Next stop the IMF Guardian, Larry Elliott (11/2/10)
Germany demands austerity, not bailout, for spendthrift Athens Guardian, Ian Traynor (11/2/10)
See also the Guardian podcast in the news item, Debt and the euro
See too the news item from October 2008, The eurozone – our economic saviour?
- What is the cause of Greece’s debt problems?
- According to the European Central Bank chief economist Otmar Issing, a Greek bailout would weaken the euro and hurt the reputation and image of the eurozone. How can we explain this?
- What do we mean by servicing a debt?
- How could Greece’s debt problems cause problems for other countries with large debts, such as Ireland, Portugal and Spain?
- Which country is better off: the UK or Greece?
- Who will be the loser from a bailout?
- Are the EU rules about debt and deficit levels a good thing or are they too restrictive to be helpful?
- What are the arguments for and against the ECB increasing its target rate of inflation, say to 4%, as a means of stimulating recovery?