Monetary Policy - Inflation - Costs

Further work - Fiscal drag

All taxpayers receive a tax-free allowance on their income. However, when their incomes rise with inflation, the value of this tax-free allowance is gradually eroded away. Taxpayers will be taxed on more and more of their income. This phenomenon is known as fiscal drag. It can be helpful to governments as it increases their tax revenue without increasing tax rates. However, it reduces the disposable income of taxpayers. For example, if a person is earning £10,000 per year and has a tax free allowance of £2000, their taxable income is £8000. If the tax rate is 20% they will pay £1,600 in tax. If their income rises with inflation to £11,000 but the tax free allowance stays the same their taxable income now will be £9,000 and means they will pay £1,800 in tax. If the allowance is increased by 10% also then the new allowance would be £2,200 but this would still mean that the tax paid would be £1760!

The same can also happen when personal allowances don't keep up with the rate of average earnings growth. If allowances increase slower than the rate of earnings growth, then people are gradually being taxed on a larger and larger proportion of their income. This also helps increase the government's revenue from income tax.

Fiscal drag is a subtle way for Chancellors to get more money without increasing tax rates! It will lead to the average rate of tax increasing, but with no change to marginal rates.