This box set out the various impacts that higher inflation has on the public finances. These include direct effects (e.g. on income tax and debt interest spending), the impact on nominal tax bases (such as household consumption) and the impact on departmental spending.

Higher inflation has a variety of effects on the public finances. These include both the direct effects from indexation and the impact on nominal tax bases.

Direct effects

  • The overall impact on receipts from indexation would be small. Higher inflation would push up tax allowances and thresholds for income tax and NICs. This would reduce receipts. However, higher indexation of excise duties and other indirect taxes as well as a higher business rates multiplier would raise receipts.
  • The overall direct effect of higher inflation on spending would clearly increase borrowing. Higher inflation would mean that benefits, tax credits and public service pensions were uprated by a greater amount. The impact on the basic state pension would depend on whether higher inflation affected the triple guarantee (uprating is by the greater of earnings growth, inflation or 2.5 per cent). There would also be a substantial rise in spending from a higher inflation uplift on indexed-linked gilts, mainly in the year in which RPI inflation had risen.

Impact on nominal tax bases

  • Tax is levied on nominal tax bases such as the wages and salaries of employees, company profits and consumer spending. Higher consumer prices would push up nominal consumer spending and consequently VAT receipts. A higher price level could boost the nominal value of sales for firms, although the impact on profits would depend on the extent to which margins were squeezed by higher costs. The key effect would be the impact of inflation on wage growth since PAYE and NIC account for over 40 per cent of total receipts and have a higher effective tax rate than other taxes.
  • The overall effect of higher inflation on public sector net borrowing would depend on whether the positive effect from a higher nominal tax base offsets the negative direct effects from indexation. With the impact of wages crucial for the size of the impact from a higher nominal tax base and the March forecast assuming that wages remain subdued despite higher inflation in 2011 and 2012, the overall impact of the higher inflation on the public finances is likely to be negative in this forecast.

Impact on departmental spending and the debt-GDP ratio

  • Departmental expenditure limits are set in nominal terms, so higher inflation would not boost such spending. However, higher inflation would result in deeper falls in real spending than previously envisaged.
  • Higher inflation (through the GDP deflator) would raise nominal GDP and lower the public sector net debt to GDP ratio. However, persistently higher inflation is likely to push up gilt rates and increase the cost of servicing the debt.

This box was originally published in Economic and fiscal outlook – March 2011