Strong economy is a real fiscal drag

In the election battle between the main parties over their tax and spending plans, the Conservatives have tried to make capital out of the fact that the number of people paying the top 40% rate of income tax has shot up by more than half under Labour.

The charge is undoubtedly true. The number of top-rate taxpayers has risen from about 2 million when Labour swept to power in 1997 to around 3.4 million now.

This, say the Tories, means that many ordinary people such as police inspectors, hospital matrons or deputy headteachers have been dragged into the top band, which kicks in at a relatively low £32,400 a year of taxable income.

The reason it has happened is that the threshold for the tax has risen in line with inflation (about 2.5%) while average earnings have grown around 4% to 4.5% a year, as they normally do. This process is known as "fiscal drag" and has been a big help to the Labour government in bringing in more tax revenues to help pay for its increased spending on health and education.

The Institute for Fiscal Studies calculated that if the next government continued to raise the upper-rate threshold in line with inflation, rather than earnings, then more than 4 million people would be top-rate taxpayers by 2009-10.

The government retorts that the rise in the number of top-rate taxpayers is a symbol of economic success. Indeed, Gordon Brown boasted last week that the number of people earning more than £30,000 a year had doubled under Labour, as had the number earning more than £50,000 and those paid more than £100,000.

This process of fiscal drag applies to other taxes too, such as inheritance tax, stamp duty and capital gains tax and is a long-established way for governments to rake in more tax without raising tax rates.

It partly explains why the Treasury, in the latest budget red book, can show tax receipts rising in future without that necessarily implying an increase in tax rates.

The problem for Brown, if Labour wins the election, is that most independent analysts, including the International Monetary Fund, think fiscal drag and corporation tax will not yield the inflows that he is hoping for, meaning he will need to raise taxes in the next parliament to meet his self-imposed fiscal rules.