Pretty much the first pledge that our new prime minister made when campaigning to become Tory party leader was to increase the point at which people start to pay the higher 40 per cent rate of income tax from £50,000 a year to £80,000. After considerable criticism, he has since rowed back somewhat, indicating that it is a longer-term ambition rather than something to be implemented immediately. Given that it would cost £9 billion a year and largely be a giveaway to the richest 10 per cent of the population, the criticism is hardly surprising and the pulling back probably sensible.
He did have one point, though, that is even more applicable to some other parts of the tax system. This is one place where, largely unannounced, fiscal drag has played a big role. Because over time the point at which the 40 per cent rate kicks in has not risen as quickly as prices and earnings, the number of people facing higher-rate tax has grown a lot, from about one and a half million in the early 1990s to well over four million today. That may be fine, but nobody so far as I can recall ever explicitly announced a policy of pulling far more people within the higher-rate net, so an open debate about where the threshold should actually stand surely would be a good thing.
At least that threshold has risen in cash terms over time and, by default, should rise in line with inflation going forward. Yet more and more of elements of the income tax system do not respond to rising prices or incomes at all. Some of them are becoming increasingly important.
Take the threshold for the top, 45 per cent, rate of income tax. That has remained at £150,000 in cash terms since a top rate was first introduced in 2010. Had it risen in line with inflation, it would stand now at about £180,000. The result is that the top rate is now paid by more than 400,000 people, compared with the 300,000 or so originally intended to be affected. That’s still not so many, but it will continue to grow over time. Which may be fine, but why the correct threshold should be lower in the future than it is today by an amount determined by whatever inflation turns out to be, and why the appropriate number of top-rate payers should rise inexorably, both perhaps need to be spelt out.
There are other less well-known thresholds that are frozen and affect rather more people. One of the more bizarre aspects of our present income tax system is the 60 per cent band that today applies to incomes between £100,000 and £125,000. The £100,000 point at which it begins to bite was set back in 2008 and hasn’t changed since it was introduced in 2010. Today more than a million people have incomes over £100,000 and are affected by this band, an increase of over 400,000 since it was first mooted.
Near the middle of that 60 per cent band is another threshold frozen in cash terms, a threshold that is now causing real problems. This is the £110,000 point at which a big tax charge can be triggered if the value of annual pension contributions exceeds £40,000 (another fixed threshold). This has made it so costly for some doctors, and other public sector workers in equally generous and inflexible pension schemes, to earn any extra money that they are deliberately cutting back on their hours. This is an absurd state of affairs. Designing tax and pension systems that punish people for working more is in nobody’s interest.
When we’re looking at people with incomes over £100,000, of course, we are still considering only the top 3 per cent or 4 per cent of those paying income tax. No need, perhaps, to shed too many tears for them. There is another frozen threshold, however, that hits people on half that level of income. That’s the point at which child benefit starts to be taxed away. Since 2013 child benefit has been gradually withdrawn from families where either parent has an income over £50,000 and is wholly unavailable to families where someone earns more than £60,000. And, yes, those limits have not changed at all since 2013. So a policy originally designed to affect about one family in eight soon will mean that child benefit is withdrawn, in part or in its entirety, from one family in five.
Today the higher-rate threshold and the point at which child benefit starts to be withdrawn are aligned at £50,000 a year. Originally, child benefit withdrawal was specifically designed to start well above the higher-rate threshold. Going forward, policy is to raise the higher-rate threshold in line with prices — or perhaps faster, if Mr Johnson gets his way — while the child benefit threshold remains frozen. If that happens, then basic-rate taxpayers will start losing child benefit for the first time and in ever increasing numbers.
All of these freezes are effectively hidden annual tax rises. With present levels of inflation, they are small rises each year, but they cumulate over time and result in often-hidden changes to the nature of the tax system.
The default policy ought to be to index everything at least in line with inflation. If the chancellor of the day wants to do something different, then he should have to announce it. That remains the rule for most parts of the income tax system after the famous (in tax circles at least) Rooker-Wise amendment all the way back in 1977. This was designed to ensure that any deviation from indexation had to be explicitly announced and agreed. In the interest of transparency and good government, we should go back to that principle and apply it to all thresholds in the income tax system.
Paul Johnson is director of the Institute for Fiscal Studies. Follow him on @PJTheEconomist
This article was first published in The Times and is reproduced here with permission.