The Way Things Were

Forecasting the economy can be considered 20% analysis, 70% speculation and 15% hoping no-one looks to closely.

Here we look at two significant increases over the years, the rise of the higher rate taxpayer and of course, our old friend inflation and how the way things were better then.

Higher Rate Taxpayers - From 3.5% to 14% in 36 years

Cast your mind back to the early 1990s, if you can. John Major was Prime Minister and his successor as Chancellor, Norman Lamont, ran a distinctly different income tax strategy from the current incumbents of 10 and 11 Downing Street. Just how different was highlighted in recent research published by the Institute for Fiscal Studies (IFS).

Then to now…and beyond

In 1991/92, basic rate income tax – then at 25% – was the top rate of tax paid by 96.5% of UK adults. The remaining select 3.5% paid higher rate tax (at 40%, as it is now outside Scotland). Up until the end of the 2000s, the starting point for higher rate tax generally followed inflation. However, in that period earnings outpaced prices, with the result that there was a steady rise in the numbers dragged into higher rate tax.

Matters worsened in the 2010s, with both freezes in the higher rate threshold and the introduction of additional rate tax on incomes over £150,000. The freezes stopped after 2015/16, only to reappear in the 2021 Budget. The Chancellor at the time, Rishi Sunak, fixed the higher rate threshold (again outside Scotland) at £50,270 through to 5 April 2026. At the time inflation was not projected to rise to the dizzy heights of 2% until 2025, meaning the impact of the freeze was expected to be limited.

In March 2023, Mr Sunak’s next but two successor as Chancellor, Jeremy Hunt announced:

• a further two-year extension to the higher rate threshold freeze (outside Scotland), meaning it would run up to and including 2027/28; and

• a reduction in the threshold for additional rate tax (45% outside Scotland) from £150,000 to £125,140 (a move Scotland followed).

The Result

The IFS used data from the Office for Budget Responsibility (OBR) to calculate the impact of the Sunak and Hunt freezes combined with inflation at a level which was almost inconceivable just over two years ago. By April 2028, 14% of all adults and about one in five of all taxpayers will face a marginal rate of tax of 40% or more. The graph below shows the unhappy trend. In terms of tax increases, the IFS calculates that the threshold freezes will represent the single most significant tax increase since the rate of VAT was raised from 8% to 15% in 1979.

That only one number has changed – the additional rate threshold – makes the size of this tax increase difficult to believe…until you remember inflation. In effect, the Treasury has delegated tax policy to the soaring Consumer Prices Index (CPI).

Sources: HMRC, OBR

What can you do?

If you pay tax at more than basic rate already, or are likely to in the next five years, there are a range of factors to consider:

• What is your marginal rate of tax – the tax you pay on the next £1 of income? It may not be either of the ‘advertised’ rates of 40% (42% in Scotland, 33.75% on dividends) or 45% (47% in Scotland, 39.35% on dividends). The labyrinthine structure of the UK tax system with tapered allowances and cliff edge eligibility thresholds can create much higher marginal tax rates. For example, if your income is between £100,000 and £125,140 your marginal tax rate could well be as high as 60% (63% in Scotland).

• Are your investments held in the optimum framework, given your marginal tax rate? You may have been dragged into a higher tax band because of the threshold freezes, in which case the way you hold your investments may need to be revised. Remember too that the dividend allowance has been halved to £1,000 this tax year and will halve again in 2024/25. You could soon be a dividend taxpayer, if you are not already.

• Can you take advantage of independent taxation? Married couples and civil partners are taxed individually, so it might make sense to transfer investments if you each have different marginal tax rates.

• Can you restructure your income? For instance, if you are a private company director you may be able to choose between dividends and salary and save tax.

• Are you making the most of the tax reliefs available on pensions and venture capital investments? The rules in both areas changed (yet again) in 2023/24, creating some new opportunities.

Action

It is still relatively early in the tax year, so there is time to take action that can have an impact on your 2023/24 tax bill. But the longer you delay, the more you will experience the chill of threshold freezes.

Inflation - From 0.2% to 11.1% in 26 months

A couple of years ago, inflation appeared to be a dragon that had been well and truly slain. Bar a few hiccups, the Bank of England had succeeded in meeting its remit to keep inflation, as measured by the CPI, at 2%. For example, between December 2009 and December 2019, CPI averaged 2.1% and only once briefly exceeded 5%. This decade started with pandemic-driven concerns about deflation – falling prices. As recently as August 2020, annual CPI inflation reached a low of 0.2%.

The picture began to change in the following year, although even as recently as July 2021 inflation was spot on the Bank’s target at 2.0%. However, by December 2021 it had risen to 5.4%, a figure which was regarded as ‘transitory’ by many economists. As we now know, they were wrong.

Where are we now?

Inflation now looks as if it peaked at 11.1% in October 2022. It was still 10.1% in March 2023, but in April it dropped to 8.7%. The drop was not a surprise – in fact the consensus had been for a larger fall to 8.2%. The decline is currently expected to continue for the remainder of 2023, before slowing in 2024.

April’s sharp fall is a quirk of the way inflation is measured. For example, March 2023 inflation is the increase in prices between March 2022 and March 2023 and April 2023 inflation is similarly the increase in prices between April 2022 and April 2023. That means the difference between March 2023 annual inflation and April 2023 annual inflation is accounted for by only two months:

• Inflation between March 2022 and April 2022, which drops out of the annual comparison; and

• Inflation between March 2023 and April 2023, which enters the annual comparison.

Between March and April last year, utility prices jumped as the Ofgem cap rose by 54.3%. In 2023 there was only a minimal change in utility prices, thanks to the Government energy price guarantee. Thus, April 2023’s annual inflation had a built-in fall. The same step down will happen again, albeit to a lesser degree, in July and October as new Ofgem price caps replace last year’s limits.

So, can we forget inflation again?

The answer is no. Even before April’s disappointing inflation numbers, the Bank of England did not see inflation reaching its 2.0% goal until early in 2025 – it estimated 2023 inflation would end at around 5%. That would be just enough to allow the Prime Minister to meet the pledge he made in early January to halve inflation in 2023, which relied heavily on that utility price mathematics. Falling inflation is good news, but:

• It does not mean that overall prices are falling. Some prices may drop year-on-year – energy costs being the classic example – but, more broadly, price increases will continue, albeit at a slower rate. Think of the impact of overall inflation as a ratchet: what goes up normally stays up. Periods of falling overall prices – deflation – are rare and not good news for the economy.

• The impact of previous inflation does not disappear. Based on April 2023’s CPI, the January 2020 £1 now has a purchasing power of 83.36p. Had inflation been at the Bank’s 2.0% target, the figure would be 93.77p.

Those two facts are directly relevant to your personal financial plans. A corollary of the falling value of money is that your January 2020 level of life cover, income protection, pension contributions and savings need to be a fifth higher just to stand still in purchasing power terms. No fall in the future rate of inflation will change that fact – unless inflation turns negative.

Action

Price inflation has outpaced earnings in recent years and tax allowances and bands have been frozen, meaning the buying power of your net income has probably dropped even faster. In such circumstances, there may be difficult choices about which parts of your financial planning to update.

And finally, in keeping with my pastime of rewriting song lyrics, a topical updating of The Way We Were.

Could it really have been all so simple then?

Or has Brexit re-adjusted every figure?

If we had the chance to vote again

Tell me, would we?

Could we?

So it's growth and profit

We will remember

Whenever we recall

Low interest rates

The way things were