Thursday, 24 March 2011

A £10,000 tax threshold: how a little inflation goes a long way

The Bank of England has warned that inflation risks pushing past 5%, well above the 2% target. While the government is committed to lower inflation, Howard Reed of Landman Economics shows how higher inflation will take George Osborne closer to his aim of a £10,000 income tax threshold, in nominal terms at least.


One of the key policy aims of the Coalition government is the increase in the income tax personal allowance to £10,000 – an aim enshrined in the May 2010 Coalition agreement (PDF):

“We will increase the personal allowance for income tax to help lower and middle income earners. We will announce in the first Budget a substantial increase in the personal allowance from April 2011… We will further increase the personal allowance to £10,000, making real terms steps each year towards meeting this as a longer term policy objective.”

When the Coalition took office in April 2010, the personal allowance stood at £6,475. Implemented in one go, an increase to £10,000 would be a huge tax cut – research by Tim Horton and myself published by the Fabian Society before the 2010 election suggested that it would have cost £17 billion to raise the allowance to £10,000 immediately.

However, it is important to realise, that the £10,000 target has been defined in nominal rather than real terms.

Even in the absence of any active policy decisions by the Chancellor on Budget Day, the value of the personal allowance increases by inflation each year.

The previous Labour Government used the Retail Prices Index (RPI) to uprate tax allowances, although the Coalition has now changed to using the Consumer Price Index (CPI), which increases more slowly.

But, whichever index is used, it is instructive to look at the impact of inflation on the value of the personal allowance over time.

The table below shows the impact of sustained price inflation at levels between 2% (the Bank of England Monetary Policy Committee’s CPI target) and 7% on what the value of the personal allowance would be by 2015, starting with an allowance of £6,475 in 2010 and indexing for inflation every year.

The table also shows the number of years required to reach an allowance level of £10,000 using inflation indexation only.

Inflation rate After 5 years How many years to £10,000? (by indexation only)
2% ................£7,148 ............22
3% ................£7,506 ............15
4% ................£7,877 ............12
5% ................£8,263 ............9
6% ................£8,665 ............8
7% ................£9,081 ............7

At the Bank of England’s 2% target inflation rate, indexation would increase the value of the personal allowance by less than £700 over the course of a parliament – less than George Osborne managed in his very first budget, which increased the allowance by £1,000.

However, at higher rates of inflation, indexation increases the allowance much faster than this.

At 4% - an inflation rate which the RPI measure has exceeded more than half the time over the last five years – it would take only just over two parliaments to reach £10,000 through indexation alone.

At 6%, £10,000 would be comfortably achieved midway through a Coalition government’s second term in office - without George Osborne having to make any real terms increase in the value of the allowance.

Bear in mind that the current rate of RPI inflation is 5.5%, and in the short term the Bank of England expects inflation to go even higher than this.

What the simple example above demonstrates is that, while high inflation creates a headache for the Government on many fronts, in terms of meeting its tax pledge it makes matters much easier.

By the same token, high inflation means that increasing the personal allowance to £10,000 lifts far fewer people out of income tax altogether than if inflation is low – provided, of course, that incomes are rising in real terms (which at the moment is not the case).

In retrospect, should the Coalition agreement have specified a target for raising the personal allowance in real terms?

Unless, that is, it is also in large part a symbolic goal, as setting it in nominal terms might suggest.

In that case, higher inflation will make the symbolic £10,000 figure much easier to reach.

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