The government plans to continue to freeze tax thresholds until 2028. I am not sure many people will have spotted that this is a rather underhand trick.
This is how it works. There are three tax bands. As your salary increases you can cross a ‘threshold’ into another higher tax level band. For that part of your salary below the first tax threshold, you receive 100% of your earnings. In the next level up, that bit of your salary above the tax threshold is taxed at a rate of 20%. The National Insurance Employee Contribution also kicks in at this threshold, at a rate of 8%.
If a person receives a pay rise, the extra income will be in the higher tax band, meaning a smaller proportion of their new salary will be tax-free. This means that after the pay rise, the percent increase in take-home pay will be less than the apparent, nominal, pay rise.
What is particularly pernicious is that lower paid workers close to the tax threshold are hardest hit.
A regressive policy
Suppose you have been awarded a pay rise of 3.6% and inflation is 3.4%. Are you better off? The table gives three examples of how this works at different incomes.
As a person’s income rises above the threshold so the share that is liable to tax also rises. At the lower level, here shown as equivalent to the tax threshold, an increase in pay for next year of 3.6% will mean moving up into the tax bracket such that take-home pay only rises 2.59%, which, after inflation, is a fall in actual real pay of 0.81%.
The point is, as the table shows, that as a person’s income increases, the less impact inflation has on the change in real take-home pay. By the time income has reached £45,000 a year, a 3.6% pay increase next year will mean a fall of only 0.15% in take-home pay. That is, better off people are being impacted less.
In the past, Chancellors would frequently increase the thresholds more or less in line with inflation. Since 2021 however, income tax and National Insurance thresholds have been frozen and will remain so until April 2028.
Each year that the Chancellor freezes tax thresholds, the phenomenon shown in the table will continue: the apparent pay rise will be smaller for everyone, but worse for those at the bottom of the scale than those at the top. Rachel Reeves is taking exactly the same amount of extra tax from every taxpayer. Inflation is currently 3.4%, so regardless of need, she takes an extra £120, whether you earn £12,570 or £45,000.
The difference may seem trivial, but it is expected that a freeze will raise £7 billion or more a year, with a significant proportion coming from those worst off. This is clearly a steady drive towards greater inequality.
Pensioners take the brunt
A particular effect of this policy will be on pensioners. It is predicted that the maximum state pension will soon start to rise above the frozen tax threshold. This means that as the state pension is adjusted each year for inflation, more and more pensioners will receive a below inflation increase.
But why must those who are barely surviving pay tax at all? The cynical answer is that in due course the Government will announce a new benefit. With great fanfare this will give back to those in greatest need some of the money it has just taken from them.
Of course, we will be told “We would like to raise tax thresholds, but we can’t afford it”. This is just untrue. When those in greatest need have more money, they spend it, supporting businesses, creating jobs and growing the economy. The money gradually comes back to the Government as tax. If government planners could lift their noses from their textbooks, they should see that improving more people’s lives makes economic sense.
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