Extending the freeze on tax thresholds hurts the young and the poor

By continuing the freeze on Income Tax and NICs’ thresholds until 2027-28, the government has condemned the young and the poor to bear a larger share of the national tax burden. Alec Haglund, IF Researcher, discusses why the young and the poor are hit the hardest.

Extending the freeze

In the Spring Budget of 2021, when Rishi Sunak held the position of Chancellor, he announced that Income Tax thresholds would be frozen until 2025-26. Jeremy Hunt, the current Chancellor, extended the period of threshold freezes up until 2027-28. Without further changes to this policy, this would imply a six-year period of frozen income tax thresholds.

The same measure was imposed on the threshold for National Insurance Contributions (NICs) in the 2022 Spring statement. Usually, Income Tax and NIC thresholds rise in line with inflation. Together, these policies amount to a massive increase in the tax-take.

Raising taxes “without raising taxes”

The primary reason for the freezing of thresholds is to raise taxes in a manner that is less obvious to the taxpayer, since the actual rates do not change. Since the Prime Minister’s political party was elected on a platform not to raise taxes, the freezing of thresholds gets around that promise. This is how it works. The freezing of thresholds raises total tax revenue as the tax-free personal allowance decreases in generosity each year due to inflation. As the prices of goods, services, and wages rise, a larger proportion of everyone’s salary will be above the tax-free threshold, thus bringing in more revenue for the government. The same occurs for the thresholds of different rates with more people pulled into paying higher rates, again resulting in increased tax revenue. Economists call this effect “fiscal drag”.

Fiscal drag hurts the young and the poor

While it is understandable that the government may want to increase the tax take to support spending ambitions, doing so by freezing thresholds disproportionately hurts the young and low- and middle-income workers.

The Intergenerational Foundation released a report on the effect of the policy when it was initially announced, showing that young people will be disproportionately negatively affected by the policy, particularly as student loan repayment thresholds also have been frozen. The young and the poor are particularly hurt by fiscal drag since their income is almost exclusively earned through work, in comparison to older and wealthier generations for whom unearned income in the form of dividends, rents or capital gains is much more common.

Since the wages of the young and low-income workers are relatively low, it means that the proportional impact of fiscal drag on their salaries will affect their spending power more than that of high-income earners. In addition, young people use a larger percentage of their spending on essentials (rent, food, bills etc.) than any other age group, and the prices of essentials have increased even more than general price levels during the past couple of years, particularly in terms of soaring rent costs.

Inflation is still high

However, since the release of the report, the UK has witnessed a cost-of-living crisis due to high inflation while wages have struggled to keep up with the general rise in prices and services. Fiscal drag already impacts young people and the poor negatively when inflation is at normal levels, but the effect is more pronounced the higher the level of inflation.

The Institute for Fiscal Studies have calculated that the effect of freezing Income Tax and NICs thresholds will have raised an additional £52 billion by 2027-28, or an average of £8 billion per year over the time period. This is a massive tax hike, and almost entirely paid by those who earn their incomes through work. Simultaneously, interest rates are still at high levels, which impacts the young and the poor negatively by putting downward pressures on wages.

Intergenerationally fair options for increasing tax revenue

If the government wants to increase the tax take, IF would like to see it done in a way that is intergenerationally fair instead of letting most of the burden fall on the young and low-income workers. One good way to start would be to equalise the taxation of earned and unearned income, which could raise approximately £30 billion per year.

Wealth, and income from wealth, is highly divided in the UK both intra-generationally and intergenerationally. Income from wealth is taxed at much lower levels than income from work, so much so that a graduate earning £35,000 per year from work pays an effective tax rate that is four times higher than that of someone earning the same amount from receiving dividends.

This highlights the intergenerational unfairness of our tax system. Young people and those on low incomes pay tax at much higher effective rates than those who are fortunate enough to hold substantial levels of wealth that can generate unearned income in the form of dividends, rent, or capital gains. Therefore, IF calls on the government to unfreeze all Income Tax and NICs’ thresholds and uprate them in line with inflation while reforming the tax system so that all incomes are treated in the same way, ensuring that those with the broadest shoulders pay their fair share.

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