HOW AN INCOME TAX HIKE COULD MEAN FASTER INTEREST RATE CUTS AND CHEAPER MORTGAGES

A hike in income tax at this month’s Budget could dampen inflation and speed up the course of interest rate cuts from the Bank of England (BoE), economists predict.

Rachel Reeves is reportedly mulling over an increase in taxes paid on income, despite such a move being ruled out in Labour’s general election manifesto.

A hike would mean millions of workers paying hundreds of pounds extra to the exchequer.

However, economists argue that one side effect would be a reduction in demand for goods and services, which would likely lead to lower inflation.

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This lower inflation would likely prompt the BoE to cut interest rates from their current level of 4 per cent at a faster rate.

In turn, mortgage experts say rates on home loans could then fall.

The BoE is set to keep interest rates at 4 per cent when its Monetary Policy Committee meets this week.

Inflation currently sits at nearly twice its target level of 2 per cent, and the bank tends to cut rates when inflation is closer to, or approaching, this target level.

Reeves is under pressure to fill what is thought to be a £20-£30bn hole in the nation’s finances in her budget later this month. Speculation is mounting that she will seek to resolve this with a hit on income tax rather than “tinker” with different indirect taxes.

Such a move will prove politically difficult. Not only will it breach a manifesto pledge, but it will also make her the first Chancellor in 50 years to raise income tax. It will also, in the short term at least, be at odds with Labour’s stated intention of putting more money in people’s pockets.

Currently, someone earning a roughly average salary of £35,000 pays 20 per cent income tax on their income over £12,570 – the level at which you start paying income tax.

This means they pay £4,486 per year in income tax. If the rate was raised by 1p, to 21 per cent, they would pay £4,710.30, which is £224.30 extra per year.

Many economists agree that an income tax rise is the simplest and most effective way of meeting the funding challenge the Treasury faces. A 1p rise on the basic rate would raise around £8bn a year by the end of the decade.

Thomas Pugh, an economist at accountancy firm RSM, told The i Paper: “An income tax hike is deflationary, which would allow the BoE to cut interest rates more quickly to offset some of the impact on the economy.”

Pugh said that a rise in income tax would depress economic growth a little but added: “If you’re going to raise taxes, increasing income tax is a much better way of doing it than a series of inflationary jumps in national insurance from employers and duties like we saw last time.”

Other economists also agreed with the suggestion that an income tax rise could mean faster BoE interest rate cuts.

Samuel Miley, head of forecasting at the Centre for Economics and Business Research, said: “Income tax rises tend to be negative for the demand side of the economy and could slow consumer spending growth further, from its already quite low base.

“This could then present downside potential to inflation and hence impact the pace of interest rate cuts.”

Willem Buiter, a former member of the BoE’s Monetary Policy Committee, added: “A higher income tax would depress household consumption. That will weaken inflationary pressures.”

But he added that there would be a “long” and “uncertain” lag to this taking place.

Mortgage rates could then fall too

Fixed mortgage rates, the most popular type, tend to follow swap rates, which go up or down depending on long-term predictions for where interest rates will go in the future.

As a result, mortgage experts say faster interest rate falls could mean mortgage rates dip.

Justin Moy of EHF Mortgages told The i Paper that lower inflation was “good in the very short-term for mortgage rates”.

But he added that overall, a higher income tax would be “problematic” for the housing market and mortgage holders generally, primarily because households would have less disposable income.

He added: “It kills the property market as prices won’t be settled, with low confidence all round, and the normal cycle of property just standing still.”

At the moment, there are some mortgages available for below 4 per cent – but these are generally only open to those with large deposits or equity in their home.

Earlier in autumn, rates started to rise, but they have since started to drop again, as inflation came in at lower than expected in the latest reading last month.

Though the BoE is not expected to cut rates this week, economists say there is a chance they could be reduced later this year.

The BoE’s Monetary Policy Committee meets in December and there is an expectation that the chance of a cut at that meeting hangs in the balance.

Pugh added: “We expect a 3-6 vote for a hold [on Thursday]. But it throws the door wide open to a rate cut in December, especially if the budget is deflationary.”

2025-11-04T06:19:01Z