While the UK inflation rate fell slightly in August, falling from 10.1% in July to 9 .9%, it is still at a near 40-year high. Some experts believe that UK inflation could hit more than 13% in the short to medium-term, decimating household income and relative spending power. As inflation hits all areas of business and personal finance, this prompts the question, is inflation a form of tax?
What is inflation?
In its most basic form, inflation is the change in the cost of goods and services over a given period. This wider rate is measured using the cost of a “typical basket of goods”, which includes various products/services based on general spending habits. You will find different variations on the primary Consumer Price Index (CPI), which may exclude, for example, rental income or focus wholly on food price inflation.
In light of the 2007/8 mortgage crisis and the financial consequences of the Covid pandemic, Warren Buffett seemingly predicted the current “onslaught of inflation”:-
“Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.”
Fiscal drag
You will often hear the term fiscal drag, which is a sleight of hand trick used by governments to increase tax income without raising tax rates. This is achieved by freezing tax allowances which have traditionally increased in line with inflation. As inflation increases the cost of goods and services, individuals and businesses require increased income to retain their spending power. This places pressure on wage settlements, feeding the beast, which is inflation. Unfortunately, this will see many people move into a higher tax bracket, paying tax at a higher rate.
As you can see from the table below, fiscal drag can be a potent fundraising tool for the government. In this instance, we have assumed inflation of 10%, increasing the individual’s income by the rate of inflation for four years. If the basic rate tax band were to increase in line with the inflation rate, the individual would remain in the basic rate tax band. As the basic rate tax band has been frozen, they pay slightly more tax at the basic rate, and an element of their income is taxed at a higher rate. A gross rise in income of £23,205 over the four years equates to a net improvement of just £13,977 per annum.
| Tax Band | Taxable income | Tax rate | Income £50,000 | Income £55,000 | Income £60,500 | Income £66,550 | Income £73,205 |
| Personal Allowance | Up to £12,570 | 0% | £0 | £0 | £0 | £0 | £0 |
| Basic rate | £12,571 to £50,270 | 20% | £7,486 | £7,540 | £7,540 | £7,540 | £7,540 |
| Higher rate | £50,271 to £150,000 | 40% | £0 | £1,892 | £4,092 | £6,512 | £9,174 |
| Additional rate | over £150,000 | 45% | £0 | £0 | £0 | £0 | £0 |
| Tax Paid | £7,486 | £9,431 | £11,631 | £14,051 | £16,713 | ||
| Tax % gross income | 14.97% | 17.14% | 19.22% | 21.11% | 22.83% | ||
| Net income | £42,514 | £45,569 | £48,869 | £52,499 | £56,492 |
In addition, those earning between £50,000 and £60,000 per annum will be subject to the Higher Income Child Benefit Charge. This charge equates to 1% of a family’s child benefit for every £100 of income over £50,000 a year. Those earning more than £60,000 a year will be charged the equivalent of the total child benefit received.
Beware of the 60% tax trap
The above table illustrates the impact of freezing tax bands while income increases in line with inflation to retain spending power. However, there is an often overlooked situation for those earning £100,000 plus per year.
If you earn £100,000 or more per year, then you will lose your personal tax allowance at a rate of £1 for every £2 you earn above £100,000. Consequently, those who make a minimum of £125,140 yearly will lose their entire personal tax-free allowance. So, for each additional £100 of income in this range, £40 would be taken in higher rate income tax and £20 with the tapering of the personal allowance, a 60% tax charge. It is not difficult to see how some people could be dragged into this scenario with tax bands frozen.
VAT – the tax that keeps on giving
There is a tendency to focus on income tax, frozen tax bands and the impact of various allowances and deductions. The following graph from the UK government website illustrates the rise in VAT income going back to the tax year 2010/11. While there was a reduction in light of the Covid pandemic, between 2010/11 and 2018/19, VAT income increased by more than 50%. While some of this will come from additional economic capacity, a significant element is directly attributable to inflation and the rising cost of goods and services.
Those who argue that inflation is a form of taxation may feel justified pointing to VAT and the various quirks in the income tax system. Considering that the Bank of England has an official inflation target of 2% per annum, which is central to monetary policy, VAT receipts should still increase in traditional times. Is VAT a fair tax?
The broader impact of inflation
While there is a widely held belief that controlled inflation is critical to long-term economic growth, it is easy to forget that inflation constantly erodes spending power. There are other areas in which inflation can have a significant detrimental impact:-
Exchange rates
All things being equal, sterling would suffer against the likes of the dollar if UK inflation was higher than US inflation. This reduction in the exchange rate leads to a higher cost of imports which will also attract increased VAT income. In reality, governments would attempt to control inflation by raising interest rates. This would make sterling more attractive to overseas investors, reduce demand and eventually weaken the rate of inflation. However, as we see now, this is not always as straightforward as it looks!
Government expenditure
As inflation directly impacts the cost of goods and services, unless government departmental budgets increase by inflation, there will be a reduction in relative services. In some cases, this may lead to reduced physical and financial assistance, often resulting in additional costs for individuals and businesses. Could this be considered an indirect cost/tax?
Conversely, the government could be forced to increase taxes to maintain relative spending in challenging times. Either way, relatively high inflation will considerably impact public services.
Low-income families
There is evidence to suggest that high inflation has a disproportionate impact on low-income families. This is because low-income families spend a higher proportion of their income on unavoidable necessities compared to those on higher incomes. Those on lower incomes are also less likely to own assets such as real estate, which have often been a valuable hedge against inflation.
Higher base rates
Central banks worldwide use a relatively blunt tool to combat the threat of inflation in the shape of interest rates. So, you could argue that out-of-control inflation, as a consequence of central bank monetary policy, could lead to higher interest rates. This will significantly impact mortgage payments, debt repayments and stock market returns. Could this also be seen as a form of taxation linked to inflation?
Stagflation
The term stagflation, a phrase coined by Conservative politician Ian McLeod back in 1965, is a mixture of stagnation and inflation. For many years, economists thought stagflation was impossible, how could economies slow/shrink while inflation and the cost of goods/services were rising?
It turns out this was possible but would need to be the result of a significant economic shock. The 1970s oil crisis, the Covid pandemic and the massive increase in energy costs due to the Russian invasion of Ukraine were three such seismic events. This is why governments and central banks are keen to increase interest rates, reduce inflation and return to more controlled levels. If the short-term cost is an economy dipping into recession, central banks and governments would say this is a cost worth paying.
Long-term stagflation will eat away at the value of money, spending power, government income, household incomes and living standards. Whether the Bank of England has been quick enough to react to the step jump in inflation over the last 12 months remains to be seen.
Summary
Controlled inflation is good for economies, so we are told. This is because it allows a general increase in prices, the cost of services, and household income. However, whether through increased income tax payments or VAT, this constant increase in the cost of goods and services means we will pay more tax in the future. On that basis, whether inflation is a tax is debatable, but inflation can certainly increase government tax income, making individuals, households and businesses poorer in the process.