‘People earn more’ shocker – what a drag

“More than a million extra people have been drawn into the top-rate tax net since Labour took power as a result of Gordon Brown’s failure to lift personal allowances to keep pace with rising pay, The Times can reveal.”

I’ve never understood why some people get worked up about fiscal drag (when earnings rise at a faster rate than tax band thresholds and allowances). Actually, I understand perfectly well: those people are anti-tax generally and see this as a convenient pretext for moaning. Thus George Osborne:

“Fiscal drag is a sly and stealthy way of extracting more tax from earners while avoiding headline increases in tax rates. Since 1997, Labour has raised the marginal rate of tax for millions of middle-income families.”

What I really don’t see is any principled case for fiscal drag being bad, if thresholds and allowances rise in line with inflation but earnings rise more quickly (so technically I’m talking about real fiscal drag).

Say I earn £38,334, just below the 40% income tax threshold (which I don’t). I pay no income tax on the first £5,035, I pay 10% on the next £2,150 (£215), and I pay 22% on the remaining £31,149 (£6,852.78). My total income tax is £7,067.78, leaving me with £31,266.22. (See here for rates. I’m ignoring NI for simplicity’s sake; the principle is the same.)

Now, say my income goes up by 4.1% (the most recent figure for average earnings growth, for Nov 2006). And say the tax thresholds all go up by 2.7% (the Nov 06 CPI inflation figure).

This puts my new gross income at £39,905.69. Now I pay nothing on the first £5,170.95, I pay 10% on the next £2,208.05 (£220.81), I pay 22% on the next £31,991.05 (£7,038.03), and I pay 40% on the remaining £535.64 (£214.26). My total IT is £7,473.10, leaving me with £32,432.59.

Two obvious points: I am better off than I was, not worse off (net pay up 3.73%, which is higher than inflation so I’m better off in real terms); and I would be better off still had the thresholds been raised in line with average earnings growth. Well, I say they’re obvious, but the first is generally ignored by the right, who instead will fret about how I’ll ever afford to pay my increased income taxes.

So here’s the question: what, on principled grounds (not the ‘reduce-the-tax-take-by-any-means’ principle or the ‘squeeze-as-much-money-out-of-the-economy-as-possible’ principle), should be the default setting? Raising tax thresholds in line with prices or with earnings growth?

Let’s try a little thought-experiment with an interesting yet simple default setting: imagine there’s no tax at all and that society somehow just functions. Those of you who are hardline right-wingers will be very excited by this fantasy, so I recommend you dig out your John Redwood 1995 calendars and rejoin us after a few minutes.

(I don’t think I’ll ever forgive myself for creating that mental image.)

Right, so, no tax. And let’s again say inflation is 2.7%. What pay rise will I need to maintain my standard of living? Easy: 2.7% to stay as I am, and more than 2.7% to become better off in real terms. And as long as taxes stay at zero, if I get the inflation-only raise then I do indeed maintain my standard. That sounds fair.

Now, let’s see if we can devise a system of multi-band income tax that allows me to maintain my standard of living if I only get a cost-of-living raise, in the same way that our tax-free paradise does.

So starting from gross income £38,334 (net income £31,266.22) – as in my original example – let’s give me just a 2.7% rise and have the thresholds again going up by this same amount. My new gross income is £39,369.02. I’ll spare you the details, but now my total income tax is £7,258.61, leaving me with £32,110.41.

My take-home pay has gone up by… 2.7%. The system of uprating thresholds in line with inflation and not earnings produces an outcome that allows the maintenance of living standards every bit as well as does the no-tax scenario. The suggestion that this sort of uprating is a ‘tax rise’ that makes people worse off is plain untrue.

Of course, I get to keep less of my pay if income tax exists, but that’s rather the point. And where there are a number of progressive bands, the richer you become, the less you keep, but that’s also a defining feature of the system. If ‘me this year’ is richer in real terms than ‘me last year’ (with an above-inflation raise), then a higher overall tax rate is as fair as if ‘me this year’ is richer than ‘you this year’.

So why is uprating thresholds in line with average earnings assumed to be the morally acceptable default? Is there something sacrosanct about the proportion of the workforce in a given tax band? Is there something economically meaningful about using the 1997 spread of earners among tax bands as a baseline? What happens when the income distribution changes shape, as it does every year? Most pay rises are not the average, and jobs aren’t created and lost equally across the distribution. How do you justify all the bands moving at the same rate as average earnings when the people right by any individual threshold will likely be getting pay rises not identical to the overall average?

I’m asking pretty rhetorically, but if someone has good answers, I’m all ears.

(And sorry again about the John Redwood calendar thing. At least I didn’t say swimsuit calendar. Uughhh!)