At the Conservative Party Conference earlier this month, Rishi Sunak told delegates “I know you want tax cuts. I want them too and we will deliver them. But the best tax cut we can give people right now is to halve inflation and ease the cost of living”.
At first listen, this seems like a nice soundbite: after all, higher taxes and higher inflation both leave people feeling poorer. Although the current government has avoided explicit tax hikes on households, they have introduced a swathe of threshold freezes. These sound innocuous, but have seen earners dragged into higher tax brackets, with painful results. Earlier this year, the Resolution Foundation calculated that someone earning £62,000 would lose £1,600 thanks to this ‘fiscal drag’.
Higher inflation also has a pernicious impact. At a 2 per cent rate of inflation, prices take 35 years to double. This doubling time shrinks to 14 years once inflation hits 5 per cent and takes just eight years when inflation reaches 9 per cent. This is a huge problem if your income isn’t keeping up with inflation – which has been the case for the average worker for much of this inflationary surge. Higher taxes and higher inflation have both left households worse off.
Conversely, when the government cuts taxes, people get more money into their pockets (assuming all other things remain equal). This was illustrated by Truss’s ill fated ‘mini’ Budget, which proposed cutting the additional rate of income tax from 45 to 40 per cent. Analysts at the Institute for Fiscal Studies think tank worked out that this would have left the average additional rate taxpayer £10,000 better off.
But unfortunately, ‘cutting’ inflation doesn’t have quite the same effect. The government has pledged to ‘halve inflation’ to 5 per cent by the end of the year, while the Bank of England expects it to return to its 2 per cent target by early 2025. This is undoubtedly good news: at 2 per cent inflation, money loses its value at a far slower rate, as the calculations above show.
Yet the last time inflation was below target was May 2021. Even if inflation does return to 2 per cent by early 2025, the cost of goods will be a staggering 25 per cent higher, a quick calculation using the Bank of England’s figures shows. Prices will never go back to May 2021 levels, excluding a massive deflationary spiral, something policymakers would be desperate to avoid. After all, lower inflation does not mean lower prices – only that they are increasing at a slower rate.
Matters are made even more complicated by frozen tax thresholds. As wages rise in response to inflation, fiscal drag will pull more workers into higher tax brackets. According to the Institute for Fiscal Studies, income tax and National Insurance threshold freezes are on track to raise £52bn for the government by 2027-28. This is, crucially, far more than anticipated just months ago – and 40 per cent more than the Office for Budget Responsibility expected in its March forecasts. The IFS thinks that this could lead to a record two-thirds of adults paying income tax – and a record one-sixth of adults paying higher rate tax.
By referring to lower inflation as a tax cut, the government might hope that it can bask in the glow of a successful inflation battle while signalling a commitment to tax cuts at some point in the future.
But this could be a risky game. When inflation returns to target by 2025, prices will still be significantly higher than they were before the price level spiked, and millions of people will have been dragged into higher tax brackets due to threshold freezes. As a result, it seems very unlikely that the electorate will feel as though they have had “the best tax cut”. This questionable economics could turn out to be questionable politics, too.