The wrong kind of inflation

Rising prices, though painful, would normally benefit Britain’s public finances. This time is different

August 15, 2023
All pain no gain? The governor of the Bank of England, Andrew Bailey, speaks to press earlier this month after the Bank announced its 14th consecutive hike to interest rates. Image: AP Photo / Alastair Grant, Pool
All pain no gain? The governor of the Bank of England, Andrew Bailey, speaks to press earlier this month after the Bank announced its 14th consecutive hike to interest rates. Image: AP Photo / Alastair Grant, Pool

Finance ministers around the world share a guilty secret. However much they may deplore a burst of inflation, it can improve the public finances. This is happening in most advanced European economies, with government debt as a share of GDP expected to fall this year, but not in Britain, where it is forecast to rise. Why is the Treasury under Jeremy Hunt missing out on such a windfall?

Inflation is usually a chancellor’s ally because taxation is based on nominal rather than real GDP, the inflation-adjusted measure that hogs the headlines. Changes in nominal GDP, the cash value of the economy, reflect what is happening to prices as well as to the overall volume of output. Even if GDP is flat in real terms, nominal GDP will rise in inflationary times. That raises the tax base, which in turn produces higher revenues—a notable example being more income tax from rising earnings—while avoiding the political pain of explicit hikes in tax rates. 

Since the late 1970s, this stealth tax has been mitigated by legislation making it standard practice to raise income tax allowances and thresholds every year in line with inflation. Chancellors can override that automatic indexation but must get explicit parliamentary approval to do so. Even when they abide by the default procedure, the Treasury will still benefit if incomes are rising faster than inflation—a process called “fiscal drag”. 

But in the spring of 2022, the income tax personal allowance and higher-rate threshold were frozen for four financial years. The surge in inflation is making this freeze extraordinarily remunerative for the Treasury. When Rishi Sunak, then chancellor, announced the plan in March 2021 (starting in April 2022), it was expected to raise £3.7 billion in the second year, 2023–24. But this March, the independent Office for Budget Responsibility (OBR) reckoned it would rake in £13.1 billion. Moreover, one of the first steps that Hunt took on becoming chancellor in the autumn of 2022 was to extend the freeze by a further two financial years, through to 2027–28.  

This makes it all the more remarkable that overall the Treasury is currently losing rather than gaining from the surge in prices. That owes a lot to the unusual nature of the current bout of inflation. When Britain’s railways were disrupted by snow in 1991, it was blamed on the “wrong kind of snow”. Britain’s public finances have been beset by the “wrong sort of inflation”, the OBR pointed out in July.

The right kind, for the public finances at least, is a homegrown variety that drives up the price index called (unhelpfully) the GDP deflator, which is the broadest measure of inflation in the domestic economy, covering the prices of goods and services produced in Britain. But for the most part, Britain has not been experiencing that type of inflation. Consumer prices paid by households have risen so sharply primarily because of higher import prices and energy costs set in global markets.

That has driven a wedge between the GDP deflator and consumer prices.  Inflation in 2022 was 5.4 per cent measured by the former, but 9.1 per cent according to the consumer prices index (CPI) and an even higher 11.6 per cent according to the older retail prices index (RPI). These are the biggest gaps with respect to the GDP deflator on record (going back to 1949), according to the OBR. 

 As a result, two big chunks of public spending have risen faster than the GDP deflator has increased the tax base. First, the cost of uprating benefits in line with CPI inflation was especially high this spring. Pensions and working-age benefits were increased from April by the CPI inflation rate the previous September, which was 10.1 per cent. 

The Treasury has been caught in a trap of its own making

 A second and even more painful consequence has been vaulting interest payments on government debt. The government has been a prolific issuer of index-linked bonds, which provide protection against inflation through uprating both interest payments and the principal (the sum of money originally borrowed) in line with rising prices. Such debt makes up 25 per cent of the outstanding value of British government bonds (known as gilts), the highest among the G7 economies and double the level of the next highest country, Italy, which has 12 per cent linked to inflation. The impact of inflation on the cost of servicing these index-linked gilts is swift and has been magnified by the fact that the prices index used for uprating is the higher RPI measure. 

 Propelled by higher debt servicing charges on index-linked bonds, the government’s interest bill jumped to 10.4 per cent of government revenue in 2022 and will remain at that level this year, according to recent figures from credit-rating agency Fitch. That will make Britain’s the highest among some 20 advanced economies (it was pipped by Iceland in 2022) and exceeds Italy’s, even though Italian government debt as a share of GDP is much higher.

The Treasury has been caught in a trap of its own making. When it became the first big advanced economy to issue index-linked bonds, in 1981, it wanted to convey a message to the markets that the government was serious about controlling inflation. But after making the Bank of England (BoE) independent to set interest rates in 1997, such bonds were no longer necessary to shore up credibility, especially as inflation subsided and for a long time stayed surprisingly low. Lured by strong demand from pension funds, the Treasury persisted with high issuance even though this apparently cheaper form of funding exposed the exchequer to the danger of a sudden inflationary upset. 

The BoE has come in for stick for its failure to anticipate both the surge in inflation and its persistence. The Bank has now turned to Ben Bernanke, a former top US central banker, to lead a review of its forecasting methods. By contrast, the Treasury has largely escaped criticism for allowing the public finances to become so vulnerable to the wrong kind of inflation. It should face some searching questions about this latest policy debacle.