What is ‘fiscal drag’ and how has Hunt used it in his autumn statement?

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Jeremy Hunt has used his autumn statement to announce billions of pounds in spending cuts and tax rises. However, many of the changes are being done by stealth and without raising headline tax rates.

What is fiscal drag?

In the push for budget savings, the chancellor has used a tactic known by economists as “fiscal drag” – when tax thresholds do not increase with the rising cost of living. This in turn has the effect of pulling more people into higher tax brackets.

Many tax and benefit thresholds and allowances are by default increased each year with inflation. Freezing them while inflation is now running at 11.1%, the highest rate since 1981, will turn eye-watering increases in the cost of living to the chancellor’s advantage.

What has the chancellor announced?

At present, workers benefit from a tax-free personal allowance of £12,570, above which the basic rate of income tax is payable at 20%. On earnings above £50,271, workers pay the higher rate of income tax at 40%. Hunt has frozen these thresholds, rather than raise them to keep pace with inflation.

He has also lowered the threshold for people to pay the top 45%, from £150,000 to £125,140, which could drag another 250,000 people into that band.

The freezing of thresholds will extend a four-year freeze put in place earlier this year by Sunak when he was chancellor to 2028. The Office for Budget Responsibility estimates there will be 3.2 million newer taxpayers and 2.6 million higher-rate payers created by the six-year freeze.

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What will it mean for the public finances?

The OBR estimates that an additional £26bn will be raised by freezing the income tax personal allowance and higher rate threshold, relative to allowing the tax brackets to rise in-line with inflation.

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Earlier this month the Institute for Fiscal Studies estimated that for every £1 households gain from high-profile cuts to rates of income tax and national insurance, they will lose £2 from freezes to other thresholds and stealthy policy options.

“These freezes – which represent a stealthy and arbitrary way to raise tax revenue – often have a bigger impact on household incomes than more eye-catching discretionary measures,” the IFS said.

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