The Budget's secret tax hike

Income tax may have been cut for low earners, but that lost cash has to come from somewhere. And that somewhere could well be your pocket!

Like him or loathe him, there’s no doubt that the Chancellor George Osborne is a smooth operator.

A cursory glance at his last Budget seems to reveal a fairly positive and generous set of economic measures. Income tax cuts for low earners, public money for first time buyers and investment in small businesses... I thought we were in the midst of a recession?

But as my mother always tells me, ‘nothing in this life comes for free’* – and this certainly rings true for Mr Osborne’s big income tax giveaway...

Slower rises

Buried in the Budget, under the rafts of media-friendly growth plans and recession-busting sound bites (but surprisingly only one appearance of “we’re all in this together”), was an innocent sounding change with a nasty sting in its tail.

“From April 2012, the default indexation assumption for direct taxes will move to CPI,” said the Chancellor.

What he’s referring to is the linking of tax to inflation – a measure that ensures the amount of tax-free savings we all enjoy is upped in line with rising prices and wages. This prevents our tax bills from rising as a result of small, inflationary increases to wages and prices.

The problem is there are two measures of inflation; the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). Both measures are based on the price of a ‘typical’ basket of goods, which the Office for National Statistics makes public each year. Currently the inflation basket includes garlic bread, cereal bars, smartphone apps and even lip gloss.

But there are differences between the two measures; the principle one being that RPI includes measures of housing costs, such as mortgage interest payments and council tax rates. This means that RPI generally rises at a faster rate than CPI. Indeed by 2015 it’s estimated that RPI will be running at 3.8% per year, while CPI will be at just 2% per year.

So by changing the inflation link from the faster rising RPI to the slower rising CPI, the Chancellor has sneakily slashed the speed at which all of our tax-free allowances rise.

Thresholds

National Insurance – a tax in all but its name – will be hit by this change. The current lower earning employees' limit stands at £7,225; but it will rise less quickly from 2012 when it is pegged to CPI. The Capital Gains Tax exemption – currently at £10,100 will also increase at a slower rate when the changes are made in the next financial year.

ISAs will be affected by the change as well. This is because from June 2010, the annual tax-free ISA allowance we all receive has been increasing in line with RPI. This will change to CPI from 2012 – and hence the amount of tax-free savings we’ll all be able to keep in an ISA will increase at a slower rate.

In theory, income and inheritance tax should also be affected by the indexation shift. But as both of these levies are currently subject to separate arrangements to increase or freeze them, they will both be exempt from the change.

It’s estimated that by making this shift to CPI the treasury will trouser an extra £1.1 billion in tax payments. A figure that is, coincidentally, exactly the same amount that Osborne will be giving away through the expansion of the personal tax allowance.

But many people think this amount could eventually end up being far higher.

Benefits and pension mismatch

Benefits including local housing allowance and child tax credits will also have their inflation link changed from RPI to CPI from 2012. This means that the government will have to shell out less every year as the levels of benefits increase at a slower rate.

State and public sector pensions as well as some final salary pensions will also be hit by the change. These payouts have typically been inflation-proofed by linking the payments to RPI – they too will change to CPI from April 2012, leaving millions of pensioners out of pocket.

Yet while more people are dragged into tax thresholds and benefits and pensions are reduced as a result of the CPI link – many taxes and charges will remain pegged to the faster rising RPI. This is because levies are also indexed to inflation to ensure that they are not left behind by rising prices.

For example, water rates, student loan interest rates, fuel duty and rail fares will stay linked to RPI meaning that the amount we pay will increase at a faster rate than the exemptions we are granted.

But there are still a few ways you can cut your tax bill.

Beat the tax-man!

Despite what UK Uncut may think, tax avoidance is a perfectly legal and acceptable way to boost your income. ISAs are a great way of doing this as they offer a tax-free return on your savings up to a set allowance each year. The allowance for 2011/12 is £10,680 – of which you can invest £5,340 in a Cash ISA and any amount in a Stocks and Shares ISA. Check out this article for some more tips on investing in tax-free accounts or head straight to our ISA centre to compare the current market leading deals.

Specialist tax writer Sam Thewlis also put together some more useful tax-avoidance tips earlier this year – you can find them all in How to avoid tax... legally and Dodge tax like a footballer.

What do you think?

Is this just another stealth tax rise? Or is it a legitimate way to fill the gap in the public finances?

Let us know your thoughts in the comment box below.

(*Apart from these 10 things which you should always get for free!)

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