The chancellor faces some challenging choices at the budget next month.
With forecast productivity growth likely to be revised down by the Office for Budget Responsibility, she will need to close a gap in public finances of around £20bn if she is to stick within her fiscal rules.
With many public services on their knees and in desperate need of investment, big cuts in public spending do not look viable. Some have argued for the fiscal rules themselves to be changed. They are self-imposed after all, rather than being an iron law of economics. But big changes to the fiscal rules risk losing the faith of the bond markets, which would send our borrowing costs spiking.
So – if we are to provide the funding our public services need – the chancellor will need to raise taxes at the budget.
Labour’s manifesto significantly narrowed the options available to the chancellor. It ruled out increases in the rate of income tax, employee national insurance, or VAT. These taxes together raise around three quarters of government revenue.
But there are still options available. In our recent Fabian Society report, we brought together policymakers, economists and policy experts to explore the options that are available to the chancellor.
Freezing tax thresholds is surely the best of these.
In normal times, the thresholds at which you start paying income tax, or the higher rate of tax, go up in line with inflation. This means that – if the rate of income tax is not changed – the amount of tax raised stays broadly flat over time.
However, over the last three years, the thresholds have been frozen. This means that – as wages increase over time – a greater proportion of income is taxable, and more people are brought into the higher rate bracket. The process, known as ‘fiscal drag’, means that tax revenue increases, even if the rate of tax does not.
This has raised a vast amount of income for the Treasury in recent years. The Office for Budget Responsibility estimates that by 2027/28, the freeze on thresholds will have increased tax revenue by £45bn.
The freeze thresholds had been due to end in two years time. Given the very challenging circumstances, the freeze should be extended for a further two years.
There are a number of reasons why this is an attractive option.
First, continuing the freeze would raise a significant proportion of the funding the chancellor needs. Rather than raising the odd billion here and there, a two-year freeze would increase revenue to the Treasury by £11.7bn. This would plug half of the fiscal gap facing the chancellor.
Second, the measure would be highly progressive. The chancellor has said – rightly – that those with the broadest shoulders should bear the largest burden. Our analysis shows that half (49%) of the revenue raised would come from highest earning fifth of households. Just 4% comes from the lowest earning fifth of households.
Third, freezing thresholds would come with relatively little political risk, certainly by comparison with the amount of revenue that would be raised, and the alternative options available. The government is rumoured to be looking at increasing income tax, which would be a clear break of Labour’s manifesto pledge. This would be a mistake, and it would come with a significant political cost. Rather than breaking commitments made to voters, the government could raise a similar amount by freezing thresholds; something which was not ruled out by Labour’s manifesto.
There would be risks with this approach.
While freezing thresholds is progressive, it would still have some impact on working families recovering from the cost of living crisis. The average household would pay an additional £20 in tax a month by 2030.
It would mean more workers would be drawn into the higher rate of tax. And – as the state pension increases – it would mean that for the first time, someone living only on the state pension would have to pay income tax. But by comparison with the other options available, these risks are relatively minor.
The chancellor will need to increase taxes in the upcoming autumn budget if we are to avoid either big cuts to public services, or the risk of a debt crisis. In these circumstances, freezing thresholds is the best available option. It would raise half of the revenue needed, with the burden falling on those with the broadest shoulders. The chancellor should continue the freeze.
Freeze tax thresholds to plug the fiscal gap
