Economics 101: The difference between “Fiscal Drag” and “Bracket Creep”

Gordon Brown is a tricky soul, isn’t he?

He maintains that he has been raising the income tax brackets in line with inflation – in fact, that this has been the case since 1977. Yet somehow over a million more people are paying higher rate income tax than when he became Chancellor. How has he managed to square both?

The key is in the difference between Bracket Creep and Fiscal Drag (often called Real Fiscal Drag, with the clue being in the “Real”). Bracket Creep is the effect of inflation on taxpayers: if tax thresholds stay the same, but inflation raises wages, people are carried into higher tax brackets even if they are earning the same real income (because inflation affects outgoings as well as incomes).

Real Fiscal Drag is something different. Inflation may be harmful, but as the years pass we would all hope that our wages would rise because we ultimately expect to become richer. If this simply referred to individuals getting richer as they get older then this may not be a concern – richer people pay more tax in our progressive system, and age is no defence.

But we do not simply expect to get richer as individuals. We expect to get richer as a society; I expect an average 34 year old to have a far higher real income in 2020 than the average 34 year old now. For this to be the case – and it generally is, if one does not live in a blighted country such as Zimbabwe or Venezuela – incomes must rise faster than prices and so faster than inflation as a whole.

This is where Real Fiscal Drag kicks in. Because our real incomes are rising, more of us will end up paying higher rates of income tax even if the tax thresholds are raised in line with price inflation.

So the Chancellor can claim to be raising tax thresholds in line with inflation while using the growing prosperity of society to draw ever more people into higher rates of taxation. In a parody of a David Cameron expression, Brown expects the share the proceeds of our growth with us by taking ever larger portions of our increasing wealth.

I’m not generally a fan of the phrase “Stealth taxes” but Gordon Brown’s ability to increase by 56 per cent the number of people burdened with marginal taxes of 40 per cent is frankly underhanded.

Who knows what tricks he’ll pull once he’s moved next door!